Thoughts on Spotify

Spotify’s business model has been straightforward. Take music from the creators, let users have frictionless access to the content and generate revenue by either ads or premium subscriptions. The company delivers music in an appealing and user-friendly manner to the point that listeners agree to pay a premium for access every month. On the other side, Spotify pays royalties back to artists or labels every time a song is consumed. As the user base grows, Spotify generates revenue from advertisers which want to convey their marketing messages to an engaged audience.

Yesterday, the company announced their latest quarterly earnings and I found the report interesting. First, the number of subscribers. Both Premium Subscribers and Ad-supported MAUs increased.

Source: Spotify Data

There seems to be a seasonality in the subscriber acquisition. Subscriber acquisition seems to pick up more in Q2 and Q4 than in Q1 and Q3. The increase in premium subscribers in 2018 slows down, compared to the pace in 2017

Meanwhile, the Average Revenue Per User (ARPU) has been on decline.

Source: Spotify Data

With regard to revenue, it seems that the increase in subscriber count outweighs the decline in ARPU as revenue is on the rise

Source: Spotify Data

Both Premium and Ad-Supported revenues seem to be affected by seasonality. Ad-Supported revenue growth fluctuates more than Premium revenue growth. In 2018, revenue from ads grew faster than subscription-based revenue.

Source: Spotify Data

Gross Margin for both revenue streams went up with Ad-Supported gross margin growing at a faster clip in the last four quarters

Source: Spotify Data

In Q4 2018, Spotify became profitable for the first time. Free cash flow also reached the all-time high

Source: Spotify Data

Based on the numbers, it seems that everything is going in the right direction for Spotify. User base is expanding, revenue is going up, free cash flow is growing and the company becomes profitable for the first time. Even though ARPU has been declining, it’s understandable as many users were acquired on a discount. However, it’s necessary to maintain the network effect and grow the user base to attract advertisers.

As Spotify doesn’t own the majority of their content and it still has to pay a small royalty for content enjoyed by free users, Spotify faces two significant risks. First, it relies too much on the labels that can take their content elsewhere. Second, paying for content while generating zero revenue from free users might hurt the company’s margin. Hence, it needs original content. Already featuring original series with Amy Schumer and Guy Raz, the company now seems to switch its focus on another source of originals: podcasts.

During the earning call, Spotify announced the acquisitions of Gimlet Media and Anchor. The former is a podcast production company and the latter is a DIY tool that allows publishers to produce and broadcast original podcasts. In the call, CEO of Spotify mentioned that over time 20% of content on Spotify will be non-music and that several potential acquisitions which the company is considering in 2019 will all be related to podcasts.

The acquisitions and focus on podcasts make sense in terms of original content and monetization. Podcasts are gaining in popularity as a form of engaging content. Media outlets have podcasts. Companies have podcasts. Celebrities have podcasts. As an audio platform, Spotify certainly cannot afford to sit this one out. Having podcasts, in addition to music, makes Spotify more appealing. During the earning call, Daniel Elk, CEO of Spotify, hailed podcasts’ positive impact on the engagement of users on the platform. He indicated that podcasts could lure users who wouldn’t have signed up for Spotify. Plus, it’s definitely easier to have access to different content forms on one app than multiple apps. And what’s the better and faster way to be able to produce content than to acquire a proven production firm?

There is also the monetization piece. One revolutionary aspect of Spotify is to help obscure and less-known artists to get their creativity out to the world and get paid. The more their songs are listened through Spotify, especially the Discovery, the more dollars the artists receive. Spotify is in a position to do the same for podcast creators. According to a blog post by Anchor, nearly all podcast advertising concentrates in the top 1% of podcasts. The other 99% have to hope that their episodes are downloaded to the tunes of thousands to be able to attract advertisers. If Spotify can help podcasts generate revenue for their work in the same way as it has done for artists, Spotify can become the Spotify for podcasts and stand a higher chance of securing exclusives and originals in the future.

All in all, I think Spotify is going in the right direction. Securing key capabilities through acquisitions in a key area such as podcasts is crucial to future growth.

Book: Monetizing Innovation: How Smart Companies Design the Product Around the Price

If you are interested in business strategies and how companies price their products or services, I highly recommend this book. Its thesis can be summarized into: Product the price, don’t price the product. The authors argued that businesses have a better chance at a successful product/service launch if the businesses do meticulous market research beforehand, figure out the willingness to pay from the end users, find out what they want and how much they are willing to pay for the desired features, and finally build the offerings around the price points. A few notable examples that should be studied by business students include:

  • How Porsche could sell 100,000 of their new cars while Fiat Chrysler could only sell 25,000 of theirs
  • How Michelin switched from selling tires to selling kilometers traveled on their premium tires
  • How P&G rose to capture the majority of market share in the razor category in India
  • How DealShield protected billions of dollars in vehicle purchases and earned Manheim millions in revenue and profit

On Compromise Effect

For example, imagine you are in a wine store and want to buy a bottle. You find three options: a $10 bottle, a $25 bottle and a $40 bottle. Which you would you pick? When asked this question, most people would pick the $25…By introducing the $25 wine, you just made the decision process much easier for everyone. They’ll choose the middle option. This strategy is very common in both B2B and B2C companies

On Anchoring Tactics

Another illustration of anchoring is the Economist magazine’s A/B pricing experiment. The experiment divided people into two groups, A and B. The A group was given two choices: $59 for an online only subscription and $125 for a print and online combination. The B group was offered three choices: $59 for online only, $125 for print only and $125 for the print/online bundle. The $125 print-only option was an anchor. Some 84% chose the print/online bundle in group B versus only 32% who chose that bundle in group A.

On Price Conveys Quality

In a 2008 study, Ariely and his colleagues gave two sets of participants the same pill, telling them it was a painkiller (it was a placebo). Informed that the price was $2.5 a pill, 85% of the participants in the first group said the pill reduced their pain. Told the painkiller’s price was discounted to 10 cents, only 61% of the second group believed the pill reduced their pain.

On Apple Watch

At first, it was available only through Apple’s website and the cheapest version was priced at $349, not very cheap. However, Apple’s launch largely drew negative reactions. One stock analyst noted that a components supplier for the watch had produced fewer units than projected, hinting at underwhelming sales. His comment appeared in a July 31 Wall Street Journal headline that sniped, “Glimmers Emerge on Apple Watch Sales and They’re Not Pretty”

All of this was not what Apple wanted to hear. Yet despite the negative press, despite the warnings of purportedly in-the-know investment analysts and reviewers and the rumors of lagging sales, Apple did not drop its price. It held firm.

Based on International Data Corporation and investment analyst estimates of Apple Watch sales from April through September 2015 (the second half of Apple’s most recently completed fiscal year), Apple sold an estimated 8 million watches. Assuming most sold for the entry price of $349, that would make it a $2.8 billion product in its first six months of life.

Book: How the Internet Happened

If you are interested in technology, the intersection of business strategy and technology and the history of the Internet, this book is for you.

It is a succinct chronicle of how Web 1.0 (connecting computers all over the world) and Web 2.0 (connecting all people) happened. Accounts of some of the most iconic and important technology companies in the world were told without lengthy anecdotal details. The author walks you through how Netscape, Yahoo, Google, eBay, Paypal, iPhone and Facebook, to name a few, came into beings and shaped the personal computing. It’s fascinating to read about the bubble in 2001. The fact that companies could raise tons of money regardless of the lack of business models and revenue, let alone profit, is surreal.

Arguably, the biggest point that I get out of this book, in addition to nice history lessons, is that success greatly stems from serendipities. Without an enabling technology, infrastructure or business environment, we wouldn’t have had the household technology names that we do today. For instance, without Netscape developing the Navigator and SSL, who knows whether we would have had different browsers, online payments and arguably the Internet? Without the existence of broadband connection, it’s likely we wouldn’t have had Web 2.0.

Timing is everything. Being early is equal to being wrong, as many companies which went out of business for being ahead of their times could attest. If you doubt the role of luck in success, read this book.

After this book, I can’t wait to read a similar one on the rise of cloud computing and everything that it enables.