Business Matters: How Many Subscribers Does a Digital Music Service Need to be Profitable?

How many subscribers does a music service need to be profitable? Rdio CEO Drew Larner recently told NPR the service would "absolutely be profitable" when it achieves "real scale" of 25 million to 30 million subscribers. Larner's statement is interesting because it gives a rare glimpse into a company's internal dialogue. Executives tend not to discuss hard numbers.
To be sure, a subscription service's breakeven is probably well below 30 million. Exact breakeven points will vary by company, and there are numerous scenarios to consider. For example, a smaller company might achieve profitability with fewer subscribers but be threatened by a larger, unprofitable company that spends to increase market share. (Remember that Amazon puts reinvestment over profitability.) But Larner's statement gets to the heart of the subscription model: the business model won't have middling successes. Subscription services will win big or go home (or be acquired on the cheap). 
Here's how 30 million subscribers look in numbers: 30 million subscribers paying an average of $10 a month would generate $3.6 billion in annual revenue. If royalties consume 70% of revenue, gross profit (revenue less cost of goods sold) would be $1.08 billion left over for expenses. Even if royalties consume 80% of revenue, gross profit would be $720 million.
A service would still fare well if the average monthly fee was lowered in order to attract those tens of millions of subscribers. If 30 million subscribers paid an average of $7 per month, annual revenue would be $2.52 billion and gross margin would range from $504 million (if royalties account for 80% of revenue) to $756 million (if royalties account for 70% of revenue). 
Even in the worst-case scenario, a service that attracts 30 million subscribers will have somewhere around half-a-billion dollars to cover everything from salaries to marketing expense to building leases in dozens of countries around the world. That's a workable business model.
In the same article, David Pakman, a partner at venture capital firm Venrock and frequent critic of digital music licensing schemes, presents a counterpoint. "Digital music has been a perilous one where investors have lost a huge amount of money," Pakman says. That's because royalties and upfront costs create a financial burden that consumes most startups.
For better of worse, the only way to have lasting success in digital music is by achieving the kind of scale Larner talks about. No subscription service is close currently. Spotify's 19-month-old figure is six million subscribers. Deezer has more than three million. Muve Music has roughly 1.7 million.
The best example of the "win big or go home" strategy is Netflix. The company's domestic streaming service -- $7.99 a month -- has 28.6 million subscribers and annual revenue of $2.45 billion. Even though royalties account for 69% of revenue, its contribution profit of $492 million over the past four quarters was 20% of total revenue.
Perhaps the biggest lesson in Netflix is that market share is vital. Netflix accounted for 90% of the subscription on-demand video streaming market in the first quarter, according to NPD Group. Because Netflix is so big, it can solidify its position by putting 12% of revenue toward marketing and another 9% toward technology and development while eking out a small profit. Competitors fighting for the remaining 10% market share don't have the same ability to reinvest in growth and product.

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