Author Topic: SPOT - Spotify  (Read 11319 times)

ajc

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SPOT - Spotify
« on: January 03, 2019, 05:53:02 AM »

Overview

Spotify's now my second largest position after Stitch Fix (http://www.cornerofberkshireandfairfax.ca/forum/investment-ideas/sfix-stitch-fix/). The thesis is relatively straightforward. Right now the bear perspective is the big 3 labels (Sony, Universal, Warner) account for around 85% of Spotify's streaming plays. That gives the labels so much leverage that Spotify will never be able to raise its margins to the level a world-class billion+ user platform would usually be expected to generate. The other part of the bear view is Apple, Alphabet, and Amazon can use music as a loss-leader while Spotify can't. It's argued this free/low-cost distribution from those businesses means Spotify won't be able to charge enough to generate strong margins without bleeding customers to their competitors. As a result, Spotify only trades at a P/S multiple of 3.5 while Facebook sells at 7.3, Tencent at 8.3, and so on. The market's clearly pricing in a future for Spotify where its revenue is less profitable and therefore of the low quality tech variety.


Management

Management owns around 20% of the business. About 9% belongs to CEO Daniel Ek. They also have super-voting shares. Barry McCarthy, Netflix's CFO for 8 years, has been Spotify CFO since 2014. Ek surrounds himself with smart people who understand the dynamics of tech and music. Sean Parker (ex-Napster CEO) was an early investor and important adviser, Mark Zuckerberg is a friend, the list goes on. Their executive hiring has been top notch.

There's a good profile of Ek in the 'recommended reading' section below, but the short version is he taught himself programming very young, ran a highly successful web development business in school while hiring his classmates, made his first million super early. After he got sick of partying and spending money, he looked around for something he was truly passionate about and could dedicate his career to, which is what led to Spotify being founded.

One other thing: Spotify owns a 9% share of Tencent Music after the companies did a swap deal.


The $100B+ question

My thinking is there are a few questions which'll determine whether Spotify can change the leverage equation in its favor and earn a higher multiple together with whatever growth it can achieve over the next decade.

They are:

- Will the big 3 stay on Spotify long enough for Spotify to flip the script on them (say 5 years or more)?
- Will Spotify keep adding enough users for it to get above the billion+ mark and become the dominant music platform?
- Can Spotify take that 85% of all streaming plays number from the big 3 labels down to say somewhere under 50% of all plays?

I'll try explain how they'll likely achieve those and why that changes the leverage equation to being in Spotify's favor.


Keeping the big 3 with Spotify

First thing is, if Spotify's going to transform into a higher margin company it needs to keep the big 3 around long enough for it to be able to execute on changing the platform so that they become a less significant part of the overall product and streaming mix.

I think a few things matter here:

- Old fashioned greed. Streaming is already a game-changer for labels in terms of revenue (https://www.musicbusinessworldwide.com/global-recorded-music-industry-revenues-grew-8-1-in-2017-to-reach-17-3bn/) and we're still early in the game. For the labels to turn away those Spotify cash flows, it would take a superhuman effort on their part.

- The artists. Even if the labels could somehow reject Spotify and find some other approach, the pushback from their major artists would be big. Spotify currently puts the world's biggest artists in front of almost 200 million people and is slated to enter India (with around 1 billion+ citizens over the age of 18) sometime in the next 6 months. I find it unlikely the biggest artists in the world would settle for less exposure and money from their labels instead of more.

- The competitive price any one label would have to pay if they decided to leave Spotify. Mark Mulligan wrote about this very well (scroll half way down - https://musicindustryblog.wordpress.com/2018/10/26/spotify-may-already-be-too-big-for-the-labels-to-stop-it-competing-with-them/). Basically, the big 3 face a prisoners' dilemma. If Sony or Warner left, Universal would get more exposure, streaming income, and be more attractive to future major artists as a label. Similarly if Universal left, Sony and Warner could increase their earnings, streaming market share, and reputation. In other words, it makes no sense for any label to leave Spotify. This was summed up nicely in a recent FT interview with outgoing Sony/ATV chief Martin Bandier who said "the music business used to be a relationship business but . . . the power has shifted from the heads of record companies to streaming services. Now itís important to know Daniel Ek [the CEO of Spotify]" (https://www.ft.com/content/1ba3c9c4-03b0-11e9-99df-6183d3002ee1).

Essentially, between the foregone earnings, artist pushback, and lost reputation, the big 3 labels would have to deal with if they left Spotify while it was still popular and growing, there's no reasonable explanation for why any of them would risk such a move.


Getting to a billion+

YouTube (1.5 billion+ users) is currently the most popular music streaming service in the world followed by Tencent Music (850 million+), NetEase (400 million+), then Spotify (190 million). If Spotify is going to have noticeable leverage in the future, I think it probably needs to get up to the billion user mark in order to make it essential for artists and consumers.

It's worth noting Tencent and NetEase are mainly Chinese. This doesn't mean they can't expand globally (see what TikTok are doing - https://techcrunch.com/2018/11/02/tiktok-surpassed-facebook-instagram-snapchat-youtube-in-downloads-last-month/), but my view tends to be these businesses will mostly serve China, ASEAN, etc. For Spotify, that leaves NAFTA, the EU, S America, Africa, the Middle East, India, and 1 or 2 others. More than enough territories to get over a billion MAU's.

For now I think the traditional 'western-style' music pure play competition is between YouTube and Spotify. In other words, for the majority of people those are the two choices over the coming decade in terms of an app download solely for music and audio purposes. Keep in mind though that YouTube listeners are basically all free accounts and YouTube Music (their paid streaming service) has been kind of a bust so far (see https://www.digitalmusicnews.com/2018/05/28/youtube-music-missing-in-action/ and https://www.engadget.com/2018/08/01/youtube-music-new-features/).

Apple Music doesn't seem like a real worldwide threat (https://www.musicbusinessworldwide.com/apple-music-tops-56m-subscribers-up-6m-in-the-past-six-months/) and Amazon can't seem to really match Spotify either (https://www.musicbusinessworldwide.com/will-amazon-and-apple-music-catch-spotifys-subscriber-base-by-the-end-of-2018/). Obviously, Spotify can't afford to let up but I think in the race to challenge YouTube they're definitely the best bet given where they are and what their trajectory says. Their upcoming India entry (https://www.forbes.com/sites/richardwindsoreurope/2018/11/27/spotify-in-india-will-be-99-9-free-rather-than-9-99-a-month) and recent deal with Samsung (https://www.theverge.com/2018/8/9/17671162/samsung-spotify-bixby-home-speaker-hardware-devices-galaxy), seem to confirm that.

I think other important factors for getting to one billion users for Spotify will be finding a way to make their service the most economical with data usage. Especially in the developing world, this is crucial. Data tends to cost money and money is scarce. Having a service that chews up less data per song than your competitors will be a big advantage overall. That's clearly an engineering and compression problem, so Spotify would ideally lead the industry in that area. There is some evidence that Spotify might already have an edge here (compare these two articles - https://www.finder.com.au/music-streaming-data-usage and https://www.androidauthority.com/spotify-data-usage-918265/). Those articles compare different territories so I can't be sure, but I feel reasonably confident in saying the Spotify 'low quality' setting is for the developing world and gives it an advantage there (especially over YouTube and its need to stream video that's more data heavy).

Finally, having a clean, intuitive interface that makes sense to the average user and is easy to manage will be a differentiator. In my experience, Spotify is already the best offering on this score but they'll have to keep up their minimalist, easy-to-use reputation in this area in order to keep user friction low.

Generally, I think based on their user growth trajectory, their low data usage offerings, and their clean, functional interface, Spotify is doing all the right things to become a billion+ user platform. I also think there's a very good chance it will take over from YouTube as the most widely used and heavily streamed music platform because it offers a far more targeted market for musicians and a much better overall value proposition for users in the developing world. Furthermore, at least on official artist pages, YouTube does not currently have that many more streams per song than Spotify. Both Post Malone and Drake got more Spotify official streams than YouTube ones this year, so I think the YouTube lead might not be as rock-solid as it appears.


Cutting the big 3 down to size

That's a tongue-in-cheek way to say it, since the big 3 labels are important to Spotify's future (together with their back catalogues). Spotify does however need to limit their influence noticeably over time. There are three main things Spotify is doing to change the dynamics substantially in their favor here.

The first thing is Spotify is offering artists tools and support to bypass the labels completely, upload directly, and manage their image and portfolio. Like YouTube and Soundcloud did, Spotify's making a useful DIY experience for creators (http://routenote.com/blog/the-8-powers-spotify-for-artists-gave-to-creators-in-the-last-year/) and paying them a bigger percentage than the labels (https://www.theverge.com/2018/9/20/17879840/spotify-artist-direct-upload-independent-music).

Take for example the late XXXTentacion, a Soundcloud native, who became one of the world's biggest music stars. He took 5 years to get 16 million YouTube subscribers compared to Drake's 17 million. XXXTentacion also has YouTube views for his top 10 videos that compare very well to Drake's numbers. On Spotify, XXXTentacion is not far behind Drake in total streams for their top 10 tracks and well ahead of the Beatles, Michael Jackson, and Jay-Z.
Outside of music and on the topic of YouTube natives, Pewdiepie has 80 million subscribers and 19 billion total views (https://en.wikipedia.org/wiki/List_of_most-viewed_YouTube_channels). That's ahead of Justin Bieber, Taylor Swift, Shakira, etc. Pewdiepie only got to his first million subscribers in 2012 (https://en.wikipedia.org/wiki/PewDiePie).

That means within about 5 to 7 years Spotify will potentially be at, or right near, the forefront of new artist development and distribution globally. They'd suddenly become the hot new place where musicians make their careers and users discover all the interesting new ones. The equation for labels and existing artists becomes more 'can we afford not to be on the hottest, most creative, distribution platform?'. Add direct artist licensing (https://www.hypebot.com/hypebot/2018/09/spotifys-risky-play-direct-artist-licensing.html) and Spotify is laying the necessary groundwork.

The second thing Spotify's doing is bringing in new labels from big territories and diluting the overall stream percentage controlled by the big 3 labels. T-Series is one of India's biggest labels and Spotify has signed them up (https://www.hindustantimes.com/tech/spotify-ties-up-with-t-series-to-launch-in-india-within-next-6-months/story-PA86NGz08ftrfEJoJx1HUN.html). T-Series is also YouTube's most watched channel with 78 million subscribers and 57 billion streams. Agreements like this make the big 3 global labels a smaller piece of the pie and therefore less able to push Spotify around. Spotify can do this in huge markets like Indonesia, Brazil, Pakistan, Nigeria, Bangladesh, Mexico, Ethiopia, etc, over the next decade and lower the overall percentage of streams attributable to Sony, Universal, and Warner.

The final thing Spotify is doing to lessen the role of the big 3 labels is to expand into other audio offerings. For now, Spotify had expanded into podcasts. Other clear choices to my mind are audiobooks, talk radio, regular radio, and live sports commentary. Global recorded music industry revenues in 2017 (including stuff like streaming) were $17B and growing at 8% (https://www.musicbusinessworldwide.com/global-recorded-music-industry-revenues-grew-8-1-in-2017-to-reach-17-3bn/). Podcasting advertising revenues are expected to be $1.6B by 2022 growing at 30%, while total revenues for the global radio industry are at a sizeable $45B (https://www.strategy-business.com/article/The-Podcasting-Revenue-Boom-Has-Started?gko=40bef). The global audiobook industry is also a multi-billion dollar market.

To sum up, Spotify is doing what it needs to heavily lessen the influence of Universal, Sony, and Warner, as a percentage of their total streams over the next 5 to 10 years. Firstly they're offering artists tools and deals to work through Spotify directly and bypass the labels. This should bear fruit within 7 years. Spotify's also bringing in major labels from big territories like India to minimize the overall power of Universal, Sony, and Warner. Another decade of expansion into the rest of the world will mean they rely a lot less on the big 3. Finally, Spotify's expansion into podcasts - and hopefully audiobooks or something similar - is also going to have an impact in getting the big 3 down to a manageable size.


Conclusion

Spotify's a sensible long-term investment at these prices and is doing what's necessary to become a, and more likely 'the', pre-eminent global music platform. It's also using an approach designed to minimize the leverage of the big 3 labels to the point where they really will need to be on Spotify in order to be relevant and keep their artists exposed.

Further, if you take the fact that Spotify is making itself the most user-friendly platform for musicians and will, I think, become ground zero for artist creativity, discovery, and promotion, that also implies Amazon and YouTube will eventually become distribution channels more than anything else. Spotify on the other hand will not just have a similarly large distribution, but will couple that with the greatest musical creative hub, artist ecosystem, and discovery platform, on the planet. Being the destination where all hot new acts want to be posted and where all young people want to engage in music discovery will make Spotify the most exclusive and premium brand of its kind, giving it the leverage it needs to charge higher prices, negotiate better margins, and so on.


Recommended reading

How Spotify could become worth $300B from the LT3000 investment blog (scroll down) - https://lt3000.blogspot.com/2018/05/new-valuation-metrics-for-tech.html

Mark Mulligan's music industry blog where he discusses competitive dynamics, trends, etc (scroll down for some Spotify insights) - https://musicindustryblog.wordpress.com/

In-depth Fast Company profile on CEO Daniel Ek - https://www.fastcompany.com/90213545/exclusive-spotify-ceo-daniel-ek-on-apple-facebook-netflix-and-the-future-of-music


« Last Edit: January 03, 2019, 06:05:46 AM by ajc »
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Re: SPOT - Spotify
« Reply #1 on: January 03, 2019, 06:29:31 AM »
Thanks for these writeups, you obviously put a lot of work into them and they are a great addition to the board (even when about companies on which I have no opinion).
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valueinvestor

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Re: SPOT - Spotify
« Reply #2 on: January 03, 2019, 07:00:04 AM »
Thanks for these writeups, you obviously put a lot of work into them and they are a great addition to the board (even when about companies on which I have no opinion).

Couldn't have said it better.

KJP

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Re: SPOT - Spotify
« Reply #3 on: January 03, 2019, 07:21:49 AM »
Thanks for these writeups, you obviously put a lot of work into them and they are a great addition to the board (even when about companies on which I have no opinion).

Couldn't have said it better.

+1

dwy000

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Re: SPOT - Spotify
« Reply #4 on: January 03, 2019, 09:00:28 AM »
+1

Greg Maffei had some great comments a while back when talking about the music streaming services and why they hadn't bought in (this was before Pandora purchase).  He basically said they didn't see a long term business model because all of the streaming providers give consumers exactly the same product - the only differentiation was user interface and price so it was basically a race to the bottom and when you're in that race against companies willing to subsidize losses for a very long time without noticing (i.e. Apple, Amazon, Google) it was hard to see where value would be created.

I see this a little like Netflix.  For the longest time it was just a consolidator and distributor of product, ultimately at the mercy of those creating the product.  But when it realized there was no future in moat-less distribution and they needed differentiation to survive long term,  they started to curate their own product.  Much like Sirius has on the radio side.

Basically for this to work you need to either have differentiated product or the lowest cost of production (i.e. music rights).  Not sure where that will fall out for Spotify but there are a ton of competitors with deep pockets willing to use this as a loss leader.  I'd wait until the long term model plays out a bit more to pick a winner.  But that's just me....



Jurgis

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Re: SPOT - Spotify
« Reply #5 on: January 03, 2019, 11:13:02 AM »
+1

Greg Maffei had some great comments a while back when talking about the music streaming services and why they hadn't bought in (this was before Pandora purchase).  He basically said they didn't see a long term business model because all of the streaming providers give consumers exactly the same product - the only differentiation was user interface and price so it was basically a race to the bottom and when you're in that race against companies willing to subsidize losses for a very long time without noticing (i.e. Apple, Amazon, Google) it was hard to see where value would be created.

I see this a little like Netflix.  For the longest time it was just a consolidator and distributor of product, ultimately at the mercy of those creating the product.  But when it realized there was no future in moat-less distribution and they needed differentiation to survive long term,  they started to curate their own product.  Much like Sirius has on the radio side.

Basically for this to work you need to either have differentiated product or the lowest cost of production (i.e. music rights).  Not sure where that will fall out for Spotify but there are a ton of competitors with deep pockets willing to use this as a loss leader.  I'd wait until the long term model plays out a bit more to pick a winner.  But that's just me....

I think I disagree somewhat re: Netflix. I think I posted that I wanted to cancel Netflix because we have Amazon Prime and Amazon Prime has been improving and hosting a lot of similar/same content as Netflix. My wife said "no way". And not because she watches Netflix-exclusive or Netflix-produced content. I think it's mostly based on familiarity, UI, long existing watch list. Maybe somewhat based on content that is known to be on Netflix, but not necessarily exclusive: she knows it's on Netflix and she does not want to search/check if it's on Amazon (or will it ever be on Amazon).

So IMO if service has a huge membership like Netflix has, they may have stickiness and moat based on existing relationship with viewers/subscribers. There is a pain point of moving to another service even if that other service may have some of the same content. And Netflix can even raise price and not lose subscribers like that.

Whether this applies to Spotify, I don't know. I'd say that they need to grow a number of users a lot for this to apply, which is one of the points of OP.
It also may be different for music services if the content overlap is very big: i.e. if every service has everything. In movies, nobody has everything. Netflix doesn't, Amazon doesn't. And the availability changes all the time, which BTW I think psychologically makes people more tied to the service, since there is this thought "if I cancel, I may miss movies/shows that might be there next month".
« Last Edit: January 03, 2019, 11:16:58 AM by Jurgis »
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Re: SPOT - Spotify
« Reply #6 on: January 03, 2019, 11:48:20 AM »
Great write up. Saw this below article in FT about their successes in LatAm / global expansion plans

https://www.ft.com/content/2b1b317a-f87b-11e8-8b7c-6fa24bd5409c 

Leverage Capabilities

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Re: SPOT - Spotify
« Reply #7 on: January 03, 2019, 12:02:09 PM »
+1

Greg Maffei had some great comments a while back when talking about the music streaming services and why they hadn't bought in (this was before Pandora purchase).  He basically said they didn't see a long term business model because all of the streaming providers give consumers exactly the same product - the only differentiation was user interface and price so it was basically a race to the bottom and when you're in that race against companies willing to subsidize losses for a very long time without noticing (i.e. Apple, Amazon, Google) it was hard to see where value would be created.

I see this a little like Netflix.  For the longest time it was just a consolidator and distributor of product, ultimately at the mercy of those creating the product.  But when it realized there was no future in moat-less distribution and they needed differentiation to survive long term,  they started to curate their own product.  Much like Sirius has on the radio side.

Basically for this to work you need to either have differentiated product or the lowest cost of production (i.e. music rights).  Not sure where that will fall out for Spotify but there are a ton of competitors with deep pockets willing to use this as a loss leader.  I'd wait until the long term model plays out a bit more to pick a winner.  But that's just me....

I think I disagree somewhat re: Netflix. I think I posted that I wanted to cancel Netflix because we have Amazon Prime and Amazon Prime has been improving and hosting a lot of similar/same content as Netflix. My wife said "no way". And not because she watches Netflix-exclusive or Netflix-produced content. I think it's mostly based on familiarity, UI, long existing watch list. Maybe somewhat based on content that is known to be on Netflix, but not necessarily exclusive: she knows it's on Netflix and she does not want to search/check if it's on Amazon (or will it ever be on Amazon).

So IMO if service has a huge membership like Netflix has, they may have stickiness and moat based on existing relationship with viewers/subscribers. There is a pain point of moving to another service even if that other service may have some of the same content. And Netflix can even raise price and not lose subscribers like that.

Whether this applies to Spotify, I don't know. I'd say that they need to grow a number of users a lot for this to apply, which is one of the points of OP.
It also may be different for music services if the content overlap is very big: i.e. if every service has everything. In movies, nobody has everything. Netflix doesn't, Amazon doesn't. And the availability changes all the time, which BTW I think psychologically makes people more tied to the service, since there is this thought "if I cancel, I may miss movies/shows that might be there next month".

I think there may be a few good parallels between NFLX / SPOT here for existing users. A year or so, I considered making the switch from Spotify to Apple music but really didn't want to deal with recreating playlists (I don't believe there is a viable way to transfer between platforms) or redownloading songs i had already saved for offline use. Additionally, the Spotify-curated playlists have become widely popular and switching platforms will force users to try and find similar curations all over again. While this stickiness can also apply to Apple / AMZN, given Spotify's current lead in user base, i feel like its much more to their advantage. 

IMO the UI for SPOT is way simpler / cleaner than Apple music and i find it significantly easier to find new songs / artists (I tried out Apple w/ a 1 mo. free trial). I also have heard from a number of my friends that the "radio" feature on Spotify is better, although i have not used it much myself.

dwy000

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Re: SPOT - Spotify
« Reply #8 on: January 03, 2019, 12:41:09 PM »
+1

Greg Maffei had some great comments a while back when talking about the music streaming services and why they hadn't bought in (this was before Pandora purchase).  He basically said they didn't see a long term business model because all of the streaming providers give consumers exactly the same product - the only differentiation was user interface and price so it was basically a race to the bottom and when you're in that race against companies willing to subsidize losses for a very long time without noticing (i.e. Apple, Amazon, Google) it was hard to see where value would be created.

I see this a little like Netflix.  For the longest time it was just a consolidator and distributor of product, ultimately at the mercy of those creating the product.  But when it realized there was no future in moat-less distribution and they needed differentiation to survive long term,  they started to curate their own product.  Much like Sirius has on the radio side.

Basically for this to work you need to either have differentiated product or the lowest cost of production (i.e. music rights).  Not sure where that will fall out for Spotify but there are a ton of competitors with deep pockets willing to use this as a loss leader.  I'd wait until the long term model plays out a bit more to pick a winner.  But that's just me....

I think I disagree somewhat re: Netflix. I think I posted that I wanted to cancel Netflix because we have Amazon Prime and Amazon Prime has been improving and hosting a lot of similar/same content as Netflix. My wife said "no way". And not because she watches Netflix-exclusive or Netflix-produced content. I think it's mostly based on familiarity, UI, long existing watch list. Maybe somewhat based on content that is known to be on Netflix, but not necessarily exclusive: she knows it's on Netflix and she does not want to search/check if it's on Amazon (or will it ever be on Amazon).

So IMO if service has a huge membership like Netflix has, they may have stickiness and moat based on existing relationship with viewers/subscribers. There is a pain point of moving to another service even if that other service may have some of the same content. And Netflix can even raise price and not lose subscribers like that.

Whether this applies to Spotify, I don't know. I'd say that they need to grow a number of users a lot for this to apply, which is one of the points of OP.
It also may be different for music services if the content overlap is very big: i.e. if every service has everything. In movies, nobody has everything. Netflix doesn't, Amazon doesn't. And the availability changes all the time, which BTW I think psychologically makes people more tied to the service, since there is this thought "if I cancel, I may miss movies/shows that might be there next month".

That's a good point.  There's definitely stickiness to anything that isn't "flip a switch" to change.  That being said, there's always a price point that makes it worthwhile and it doesn't apply to new users.  When looking for a moat or differentiation though I'm not sure I'd put too much emphasis on people's laziness (although given how lazy most people are that might be an awesome moat!).

chesko182

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Re: SPOT - Spotify
« Reply #9 on: January 05, 2019, 09:29:37 AM »
Great post thank you. I've been following the music industry for some time and have become even more interested recently.

SPOT was originally an easy "too hard pile" for me as I have a hard time seeing what it will look like in 10 years but after doing further research I've become more convinced that the twin bear thesis (deep pocketed tech competition hurting overall market penetration+big3 labels hurting margins) is more unlikely to play out, as you point out.

Someone already mentioned this, but I think curated playlists are a largely overseen feature when it comes to switching costs. I think SPOT claims over 30% of overall streams come from this playlists and this is also growing. This makes the switching costs huge for the average user, along with all the rest of the typical reasons (downloaded songs, saved albums/playlists, UI easiness, and social networking features).

A question that I have is why is SIRI able to pull in much better gross margins than SPOT? I believe it's something like 60% vs SPOT's 25%... that difference just seems way to high to me and in the long term SPOT should be able to close that somewhat given the leverage they will have over the labels. It should end up somewhere more balanced where both the labels and SPOT have decent margins but right now it seems to me labels are f*cking SPOT as they are eating the biggest share of the pie and providing almost no value-add, while SPOT is left with nothing even though they provide most of the value-add. This will probably change eventually as they reach a certain amount of scale.

I absolutely urge everyone who is interested in the space to read Matthew Ball's REDEF article on the future of the Music industry. He lays out a very insightful view of how this should playout in the very long term.

https://redef.com/original/16-years-late-13b-short-but-optimistic-where-growth-will-take-the-music-biz

Also this guy is a must follow if you're interested in TMT in general (especially Netflix).
twitter: @chesko182

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