Should Spotify Try to Become the 'Netflix Of Music'? Not So Fast
Spotify and Netflix have plenty in common: they exist within media industries which are still grappling with the transition from sales to streaming. They are poaching executives from these very industries that they are disrupting -- from music manager Troy Carter and radio veteran John Marks joining the former, to dozens of executives from 21st Century Fox shifting over to the latter. They both charge monthly subscription fees. But for those calling for Spotify to become the "Netflix of music," those commonalities may not be as similar as they seem.
While average engagement time per user is declining on Netflix but growing on Spotify, and Netflix is actually profitable -- yielding $186.7 million in net income in 2016, versus Spotify’s nearly $600 million in net losses that same year -- those differences haven't stopped entertainment industry executives and analysts from comparing the two, hoping one will offer insight about the other. Mark Mulligan at MIDiA Research has argued that Spotify should become a record label itself, developing and releasing its own artists in a manner similar to how Netflix touts its original shows -- in part to “create the right Wall Street narrative.”
Placing Netflix and Spotify in the same box, however, overlooks several nuances about how streaming serves different financial and psychological needs for music versus video. If it were to become a “Netflix of music,” Spotify would be competing across value chains and industry relationships in a way that is not only economically unsustainable, but would also fail to exploit the company’s strengths.
1. Spotify and Netflix serve fundamentally different consumer needs, even as they develop increasingly similar features
In a 2010 report, former Credit Suisse analyst Spencer Wang -- who now serves as vp finance and investor relations at Netflix -- asserted that the way media corporations were evaluating disruptive companies was misguided. “Incumbents often view disruptive technology as an inadequate substitute for existing products ... but this may ultimately be the right answer to the wrong question,” wrote Wang. “The key is whether the disruptive technology will improve to satisfy what the market needs, not whether the feature set of two technologies are equivalent.”
This means we should ask whether Netflix and Spotify are really trying to satisfy similar consumer needs in the first place. Digging deeper, it becomes clear that they are navigating vastly different turf.
Over the past few years, Spotify has opened up more about its growing value as a contextual service, as it matures and shifts its focus from early adopters to mass audiences. “People don’t look at things like hip-hop or country anymore -- they are looking at things based on events and activities,” Spotify CEO Daniel Ek said at a 2015 press conference. “We need to be able to deliver the right music based on who we are, how we’re feeling and what we’re doing, day-by-day.”
Spotify's homepage greets users with headers such as “Sunday Relaxation” and “Sleep Well!” while the service’s “Peaceful Piano” playlist currently has around 800,000 more followers than “New Music Friday.”
Netflix, by contrast, tends "to have more captive audiences than music venues and streaming services,” Andy Inglis, owner of artist and tour management company 5000 Management, tells Billboard. “When you’re watching films in theaters, you’re instructed to turn off your phone and refrain from speaking; the experience is built for active watching. Even with Netflix, you still need to keep your eyes glued to the screen to get the experience you paid for.”
In contrast, “Music venues aren’t conducive for active watching,” says Inglis. “No matter how much money you pay to see a band live, at some point over the course of a 45 to 50-minute set you will be passive -- talking to your friends, looking at your phone. I think this trickles down to how we consume music overall, and it has something to do with the music industry struggling to communicate to people how much music is actually worth.”
2. Because of their licensing models, Spotify and Netflix have different relationships with their respective industries behind the scenes
Recent news reports have suggested that Netflix and the TV/film industry may no longer need each other. On one hand, Netflix’s catalog has actually dropped by more than 50 percent over the last five years as it works towards a 50-50 split of original and licensed content on its platform (as opposed to the 10-90 ratio it had in 2015). On the other hand, more and more media conglomerates are launching their own VOD streaming services, insinuating that relying only on licensing revenue from third-party platforms has the negative side effect of losing control over their brand. Disney is the first such conglomerate to simultaneously launch its own service and cut ties with Netflix. Yet the competition remains tough: Netflix added 5.2 million subscribers in Q2 2017 alone, eclipsing the number of subscribers that the network-controlled services from HBO, Showtime, Starz and CBS have each accumulated in their entire existences.
This sort of news is unthinkable in music, as record labels seem to have accepted that they no longer control distribution. Both major and indie labels are making a larger proportion of their revenue from streaming with each passing year, and Spotify has enough scale and control over its discovery mechanisms that artists not on the service would be missing out on a vital distribution opportunity.
Dependence is mutual: Spotify needs labels more than ever, in part because music is not substitutable. “If listeners want to hear to the latest from Beyoncé or Ed Sheeran, serving up something that sounds like those artists isn’t nearly the same thing,” says Jan Dawson, chief analyst of Jackdaw Research. “You can create original audio and podcasts, but it won’t be a substitute for the most popular content. If you want to be successful, you need to have the same 30 to 40 million tracks that all the other players have.” Put another way, if Spotify took a cue from Netflix and slashed its catalog by more than 50 percent tomorrow, it would likely go out of business.
In addition, simply transitioning to a 50-50 original/licensed ratio and yielding Netflix-like margins is much easier said than done, because Spotify must license whatever music it gets -- which explains its fight to lower royalty rates to major labels as one of the few possible paths to profitability. In contrast, Netflix can be more selective, designing its licensing approach and catalog to be more in lockstep with its budget. As the balance of power at Netflix shifts towards its originals, the company “becomes more in control of its own economics,” says Dawson. “Spotify is stuck with the same economics, in terms of payouts to rightsholders.”
3. Unlike with Netflix, Spotify’s cash burn is a flaw, not a strategy
Both Spotify and Netflix have been open about their growing investments in licensing as well as in original content. In particular, Netflix is planning to spend $6 billion on content this year, not including the $15.7 billion in streaming content obligations it plans to pay out over the course of several years. As a result, its reported debt-to-earnings ratio surpasses that of Viacom, the media corporation with the next-highest ratio, by nearly 70 percent.
Yet confident investors and commentators almost unanimously claim that this growing debt will pay off in the long run, drawing comparisons to tech behemoths like Amazon that emerged from similar beginnings. “Netflix’s cash burn is a deliberate strategy with a clear objective that’s worth pursuing,” says Dawson. “They’re a transparent, public company that’s making their shift from licensed to original content clear. Even with their spending on content, revenue growth is rapid and growing at a faster pace than their content spend. In contrast, the failure of companies like Spotify and SoundCloud to turn a profit isn’t a deliberate strategy -- it’s a fundamental flaw of the underlying business model that it can’t make money.”
Spotify’s royalty and distribution costs totaled nearly 85 percent of its revenue in 2016, while marketing, product development, salaries and other costs totaled nearly $900 million, or 27 percent of revenue. Part of this problem can be attributed to Spotify’s free tier: whereas paid subscriptions account for the majority of Spotify’s revenue, with up to a 20 percent gross margin, the service’s ad-based tier generates only around 10 percent of revenue, with as low as a negative 20 percent gross margin, despite accounting for over 60 percent of total users.
Therefore, characterizing Spotify’s recent windowing deals with major labels as “Netflix-like” is erroneous, because the term “window” carries different meanings for the two services. Spotify has begun entering windowing deals with major labels for the sole purpose of increasing conversion to paid (and more lucrative) accounts; these paid subscribers, meanwhile, are not affected by the change. In contrast, windowing agreements with major studios actually hinder Netflix’s business by driving potential traffic and revenue away from its platform.
Because Spotify’s debt is so steep, big-tech streaming services such as Apple Music might actually be better positioned than Spotify to compete with Netflix. In fact, Apple Music has already struck exclusive distribution deals with artists, secured high-profile hires from Hollywood and announced $1 billion in investments in yet-to-be-named “original content” in 2017, and its parent company evidently has enough cash to sustain a musical burn, at least in the short term. It is important to remember, however, that Apple’s mission at the end of the day is to sell more devices; the low-margin marketing checkboxes of music and video carry value only insofar as they help Apple achieve this goal.