Music subscription service Rhapsody is growing, shrinking and losing money. Breaking even would probably require a substantial, but not improbable, growth in subscribers in the midst of increased competition.
 
In the first half of 2013, Rhapsody had revenue of $68.6 million, down from $73 million a year earlier, while net loss widened to $9.1 million from $5.6 million. The numbers came from the latest financial statement of RealNetworks, which owns 45% of Rhapsody.

But the dollars and cents don’t tell the whole story. Rhapsody actually has more subscribers than it did a year ago, a company spokesperson tells Billboard. The company will not reveal the exact number of current subscribers.
 
Some of its new subscribers come from low-cost, low-margin plans such as the $5-per-month offer available to subscribers of the prepaid mobile carrier MetroPCS. Rhapsody has a similar partnership with German mobile carrier E-Plus. The mobile carriers partially, but not wholly, subsidize the normal subscription price.
 
In addition, two changes have negatively impacted revenue. Rhapsody stopped selling MP3 downloads in the spring. In addition, the company removed advertising from its properties last fall.
 
The strategy is clear: focus on the core product and partnerships to expand the user base. It will be a success if the greater focus makes up for the loss of (most likely minimal) revenue from discontinued operations. The company "[is] confident we can get the scale to make up for what we gave up," the spokesperson says.
 
As I explained in a recent article about Spotify's 2012 earnings, cost of sales is the key metric in a subscription service's business model. Spotify showed signs it could reach profitability after its cost of sales (royalties and, possibly, transaction costs such as credit card processing fees) declined to 83.5% of revenue in 2012 from 97.7% of revenue in 2011. As a result, Spotify had more money for overhead and other costs after it paid royalties. It still lost money last year, but improved cost of sales put it in a better financial position.
 
The same forces impact Rhapsody. In the first half of the year, the company's cost of sales was a 75.8% of revenue, up slightly from 73.3% from the first half of 2012. It would help if Rhapsody paid out less for royalties, but 75.8% is within a comfortable zone that can lead to profitability down the road.
 
Rhapsody's key in turning a profit will be adding more subscribers in order to generate more revenue and improve its cost of sales. High-margin subscribers who pay full fare are more desirable than low-margin subscribers (from partnerships such as MetroPCS), but the key is finding paying customers.
 
How many more subscribers are needed? That's difficult to say without know Rhapsody's average revenue per user and its number of subscribers. But we can look at Q2 revenue and make some educated guesses. Q2 revenue was $34.7 million. Assuming revenue came entirely from subscriptions (although we know the company had some download revenue) and the average revenue per user (ARPU) is $10 a month, Rhapsody averaged 1.15 million subscribers during the quarter. However, we know ARPU is less than $10 per month because of low-margin subscribers from partnerships.
 
So, for the sake of argument, let's say ARPU is $9 per month. For Rhapsody to wipe away its $4.4 million loss in Q2 it would have needed to generate an additional $17.3 million of revenue from an additional 641,000 subscribers with an ARPU of $9. That number assumes Rhapsody maintains its Q2 cost of sales of 74.7%. (Cost of sales could very well improve over time, thus lowering the amount of incremental subscribers needed to break even.)
 
In this scenario, the break-even point is a 50% increase in subscribers. These numbers are not exact -- Rhapsody does not make available enough information for accurate estimates -- but are probably in the ballpark. In any case, the numbers clearly show subscription music is a difficult business. Without scale, it's an impossible business.

Questions? Comments? Let us know: @billboardbiz

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