Spotify Limited & Apple Records

Can Spotify pull a Netflix?

The following seems inevitable. But sometimes stating the obvious draws some interesting concepts out of the woodwork. Such was the case earlier this week on Twitter when I shared a link to an Economist article suggesting Spotify may become a music label one day. The key bit:

The streaming service’s most intriguing point of leverage is that it could use these advantages to become a recorded-music label itself, working directly with artists. Matthew Ball, an analyst, argues that Spotify is sure to start cutting deals with artists in which it pays an upfront guarantee and promises a percentage of streaming revenue that is much smaller than it pays labels, but far more than artists get now.

This seems like Econ 101. Spotify pays most of its revenue to the labels to license music rights. The labels then pay a small amount of that money to artists. In the age of record pressing, compact disc encoding, physical distribution, and the like, such a middle man was needed. Today, that middle man seems, well, antiquated. The labels, of course, will say they do far more than this, and maybe they do — for now. But come on, this middle man is so getting cut out of the equation at some point.¹

And Spotify, more so than any company before it — aside from maybe Apple (more on that in a bit) — is in a position to do just that. Of course, they can’t come out and say this — though it sure sounds like Jimmy Iovine did recently (again more in a bit) — because it would be declaring open war on their most important partners. But this is inevitable: Spotify will work with artists directly to produce and distribute their music, becoming, effectively, a label.

From the same Economist article:

Becoming a label will not happen soon, partly because it would infuriate the incumbents who supply most music. But the growth of Spotify’s core business has come at a cost that is hard to ignore. Its royalty payments are a built-in, large expense. (Some rights-holders are clamouring for even more; in December Wixen Music Publishing sued Spotify for $1.6bn.) Competition from other paid streaming services mean it is hard for it to raise its own prices. To fund itself Spotify raised $1bn in debt in 2016 under terms that allowed two of the lenders, TPG, a private-equity group, and Dragoneer, a hedge fund, to convert to equity at a discount that increased with time, making an early public listing desirable. As long as its losses mount, it will seek other ways to turn a profit.

As it continues to grow, Spotify can, and has been, renegotiating the cut they must pay out to the labels. But at some point, this is going to stop making sense for new music.² As more money keeps flowing through the system, more folks are going to come in wanting their piece. And again, the biggest part of that piece is going to the labels.³ This fundamental flaw is why most music startups fail. The situation is untenable as its currently constructed.

I believe Spotify knows this and has known this for a long time. They’re playing the game they have to play for now, with their eyes on a much bigger prize. And going after such a prize likely plays into their timing to go public.

In terms of execution, this is going to be closest to the Netflix playbook — with some key differences. Netflix, of course, started the streaming aspect of their business by licensing content from the Hollywood studios. Over time, they were able to gather enough user data to know what might make for a successful show they could produce on their own — hence, House of Cards was born. These days, when you open Netflix the majority of what you see — even if the licensed content tail is still far longer — is original content.

At a high level, Spotify can do the same thing. But it’s going to be a bit different because of the differences between video content (movies and television) and music. But it actually makes even more sense to go direct to the content sources in music because of the aforementioned label take (again, for doing increasingly less and less) with one big “if”.

If, consumers are conditioned by video services like Netflix, Amazon Prime Video, Hulu, and the like to pay for multiple services, Spotify can easily make this move. If consumers are not, this is going to be a lot harder for Spotify to execute — not least because they’re going to enter an even bigger war with Apple (and presumably Amazon, and Google, etc).⁴

That is to say, people are used to paying for a music service and having access to basically all music in existence — which is still wild! They’re not used to having to pay for Spotify and Apple Music in order to get access to all the content they want. I think this will change for the reasons listed above, but it’s going to be a harder transition, largely because music is more passive than video content is — it would (and will) be annoying to have to remember which song is streaming on which service.

Still, beyond the economic equation, as Apple (and Amazon, Google, etc) continue to fight Spotify for market share, this is all inevitable. And again, beyond this going slowly because these guys literally can’t afford to piss off the labels (again, right now — so perhaps they become some sort of newfangled A&R service first, as Christina Warren suggested on Twitter), some artists will probably balk at not having their music available everywhere. Which will be ironic given that this is what other artists — the biggest ones — use as their leverage point for getting what they want.⁵

Now, Apple has already been dipping their toes into some exclusive content. But this has largely been based around exclusive windows — that is, the ability to sell music first. This is the first step towards the above, but it’s something that is really only relevant for the top tier of artists. Spotify used to be adamantly opposed to this, then caved (in exchange, in part, for the lower percentage payouts). Though it’s not even clear the labels actually like this anymore. (Nor that any of us should.) Of course, when you are the label…⁶

The only real question in my mind is when Spotify makes the real move to exclusive content. Or if Apple does it first…

Per above, here’s what Jimmy Iovine said recently:

As an example of what “more interesting might be,” Iovine drew from subscription television. “Netflix has a unique catalog, because they don’t buy HBO and they have their own catalog. Then on top of that they have a little thing called $6 billion in original content. HBO has $3 billion, Amazon probably has $4 billion. Well, guess how much original content streaming has: zero! Fundamentally. All the catalogs are exactly the same,” he told the crowd.

Some wonder if he just means exclusive live content or the like. And maybe he does, at first. But the broader ambition here seems pretty clear. Again: follow the Netflix playbook.

I think that in going public now, Spotify is ramping up for this. While they may not be raising money in their direct listing IPO, it will open them up to easier access to more forms of capital. Apple, of course, needs no more capital. They literally already have more than they know what to do with (but still will undoubtedly continue raising more debt for projects such as this because it’s so cheap).

And how might the labels react? They must know this is coming. They can see what Netflix just did to their Hollywood brethren. And they still remember what Apple did to them in the age of downloads (beyond saving them from piracy, which is conveniently forgotten, of course). I’m just not sure what they can do. Beyond maybe touting their other reasons to exist — promotion! guidance! — none of which are sustainable. But I know something else inevitable: this will all get ugly at some point.⁷

Regardless, I’m pretty bullish on Spotify as it gears up to go public. It won’t be easy or quick, but if they can execute the transition into a label, a new label for a new age, this could be a massive business. Like Netflix, but with an even larger potential base paying them each month. There are a lot of unknowns in terms of timing — and if they get said timing wrong, the company could actually be in trouble. But again, this all feels inevitable. In 10 years, we’ll have Spotify Limited and Apple Records.⁸ And probably Google whatever and Amazon something. And yes, we’ll be paying for all of them.

But at least they won’t be paying the majority of that to the labels.