How is Spotify Growing so Rapidly?

As I'm working on a deeper financial analysis of Spotify, I started pondering how Spotify plans to grow and differentiate itself from the other music streaming services. Based on their latest actions, it appears they are partnering with complementors (which are services that increase the value of Spotify), developing good cross-platform apps, and aggressively pricing and marketing their service.

Partnering with Complementors

There is very little platform lock-in with music streaming services. Anyone can sign up for Beats Music, use it for a few months, and then switch to Spotify. While the playlists you make on one service don't transfer to the one you switch to, it's not an issue for most users. People just want to stream particular artists and songs on demand, which all of the streaming services easily provide. Spotify is well aware of this issue, so its been smart to partner with complementors like Facebook and Uber (in addition to many more). For example, the partnership with Facebook allows you to log into your Spotify account and easily find what all of your Facebook friends are listening to. With this feature, you're able to find curated music choices from the people who matter the most in your life.

In addition to Facebook, Spotify also partnered with Uber last week, further increasing their supply of complementors. This latest partnership allows you to play all of your songs while in an Uber car. The goal here is to further increase the value-add of Spotify, as compared to their competitors.

Spotify also makes available a third-party API that allows application developers to tap into the Spotify music collection. Apps like Djay use this API to add extra features on top of the already existing Spotify service. The effect is to further lock-in users, by providing them with more value. This, of course, comes at a lower cost to Spotify, since they don't have to develop these third-party applications - they only have to build the API.

Cross-Platform Apps

This strategy needs very little explanation. Spotify wants to reach as many users as possible, so it builds applications on as many platforms as it can. It has apps on all of the major platforms (iOS, Android, Windows Phone, Mac OS X, Windows), including the web. If somebody wants to try it, Spotify made sure its service will be available anywhere.

Aggressive Pricing and Marketing

The price for music streaming services is an established $9.99 per month on all the major services. Spotify also offers family and student plans, however. The family plan is $10/month for the first family member, and is discounted to $5/month for additional members. This isn't a novel feature, but not all of the music services offer a family discount. Again, Spotify wants to appeal to as many users as possible.

There is also a student plan that goes for 50% off, or $4.99/month. The aim here is presumably to indoctrinate students, who will eventually graduate and switch to the full price plan. Students are also much more likely to download their music illegally, and having them pay discounted rates is much better than having them pay nothing. Lastly, Spotify must know how vital word of mouth is for younger audiences, which essentially provides free marketing.

It's no wonder why Spotify has been growing faster than their competition - they've been engaging in beneficial partnerships, providing access to all the major platforms, and pricing themselves aggressively. This doesn't mean that they will succeed in the long term, though, it just means they're currently doing well. Perhaps Taylor Swift was foolish to pull her music off Spotify after all?

New Valuation Techniques

I must admit, in the past I was highly skeptical of staggering acquisitions like WhatsApp, which sold for $19 billion. I did not believe that a company such as WhatsApp, with almost no revenues and an unclear business model, would be able to monetize and provide that amount of value in a million years. To be perfectly honest, I still am a bit skeptical, but I am now more willing to accept these insanely pricey acquisitions. My thinking on this topic has changed fairly recently, as I've been trying to think outside of my traditional business education, and understand this new wave of valuations. 

I'm not the only one who is trying to understand valuations in high growth industries. Here is what Jeff Liu and Jim Reinhart write in a report for EY: 

Clearly, traditional valuation metrics based on multiples of current earnings or revenues don’t accurately reflect the future expectations that the valuations imply in recent large transformative transactions. Consider the $19 billion price tag placed on WhatsApp, which reportedly generated only about $20 million in 2013 revenue — a multiple of 950x revenue! In fact, applying traditional valuation approaches may cause companies to overlook acquisitions that can transform their business by propelling growth in new markets or industries.

This whole time, I was looking at these acquisitions through my traditional accounting and finance education, which preaches metrics like book value, net income, and simple year over year growth. While these are still solid metrics to gauge most businesses by, they begin to break down for unprofitable companies that are experiencing rapid growth, which defines most social media startups. The truth is, there is no fundamental metric that can precisely predict the future growth, profitability, and success of companies in this industry. Social media, startups, the other companies that we associate with Silicon Valley all fall into an extremely young industry that has not been studied in enough detail yet. Everything in this business is an estimate, at best. And while new metrics to value these companies have emerged, they are not battle-tested enough to spend billions of dollars based on their results. I bet a large part of the WhatsApp purchase was Zuckerberg's gut. 

iTunes or Beats?

It's been roughly half a year since Apple purchased Beats, and apart from a few updates to the Beats app, not much has been done that is visible from the outside. To be fair, integrating a huge team into an even larger company with a unique way doing things isn't easy. Apple had to let go 200 of the 700 person team, likely because teams at Apple tend to be small. 

Recently, however, it's been reported that the Beats brand will be subsumed into the iTunes brand, presumably as the iTunes music streaming service. If Apple goes this route, I think they will be forfeiting a lot of goodwill from the Beats brand. 

iTunes is a dinosaur, and it is seen as such by many music listeners. At University, I know very few people who still use iTunes, instead opting for streaming services like Spotify, Pandora, and Rdio. iTunes has an ancient business model, requiring you to buy and own songs and albums individually. People have long been transitioning away from owning music to leasing it, and iTunes is associated with the old world. Rebranding the new Beats music streaming service as iTunes streaming, or something similar, will diminish the goodwill the Beats purchase brought. It must be difficult for Apple to let go of the product that started the whole music revolution, but every product has a definite life span and should at times be euthanized. 

When the Beats purchase was announced, I was looking forward to it being the new iTunes. I still think this would be the best strategy for Apple. Rebrand iTunes as Beats, and make the new service primarily a music streaming service, while also offering music purchases for those who want it. Although Beats headphones are looked down upon within the tech community, most consumers love them because they look great and are represented by Dr. Dre (who is not an actual doctor). Similarly, the music streaming service should be pitched as the cool streaming service - one that has ties to the music industry. Apple has many contacts in the music business, and striking deals with musicians and labels to promote their music on Beats would be a winning strategy. Of course, the music industry doesn't want to bow to Apple as it did with iTunes, but Apple has the leverage to negotiate favorable contracts (Apple had 800 million accounts registered in April, most of which have credit cards attached).

Apple probably did this cost benefit analysis, and it still decided to go with iTunes as the brand for all of its music products. They decided to keep the iTunes name because it's such an established brand, which everybody has heard of. But this is precisely why iTunes should be rebranded to Beats. People know about iTunes, but it's no longer the cool new product from Apple. The brand can stick around for another few years, but this is a long term play, and Beats is a name that can possess the cool factor for the next decade. 

Don't Drop the Box, Dropbox

Not long ago, cloud storage was extremely expensive to purchase. There was Dropbox at first, but Google, Microsoft, and then Apple soon offered cloud storage. Other smaller cloud storage services like Box exist too, but I won't focus on them in this post (I think they're just waiting to be acquired, and simply offering cloud storage isn't a viable business model). 

So that leaves Dropbox, which is not in a good place right now. Cloud storage has become a commodity; it's already offered for free in small storage amounts (around 30GB is given for free), and I expect unlimited cloud storage will be provided for free within the next few years from huge tech giants (Google, Microsoft, Apple, Amazon) which can subsidize it through their other revenue generators. Amazon already offers unlimited cloud storage for photo's for Prime subscribers, free of charge. Similarly, Microsoft offers unlimited OneDrive storage for Office 365 subscribers. Apple is slow to catch up here, but they will undoubtedly offer unlimited cloud storage too (they likely don't have the infrastructure to do so currently, but it's being built). The data centers are a fixed cost investment, and once they are built it costs very little to provide the additional users with cloud storage. And since these tech giants make money through their other services, they can afford to subsidize cloud storage, and tout it as an additional feature. Dropbox can't afford to do so, since cloud storage is their main money maker. 

Although I believe Dropbox's management knows that cloud storage isn't a sustainable business by itself, they haven't done enough to differentiate themselves. When broken down, Dropbox the company is three distinct products: Dropbox cloud storage, Mailbox, and Carousel. Dropbox purchased Mailbox in 2013, and launched its photo service Carousel in 2014, but in terms of products, that is all they've got. In most recent news, Dropbox also partnered with Microsoft, allowing Microsoft Office users to access the Dropbox directly from the apps. Here's my breakdown of those three Dropbox products:

Dropbox the service is unquestionably the best cloud storage provider - it's beautifully designed, cross-platform, fast, and extremely stable. But it's also the most expensive option, and great design will not convince users to pay when they can get a slightly worse designed cloud storage service for free.

Mailbox is a Gmail client, and how Dropbox plans to monetize this product is unclear. They can put ads into the app, but its been over a year since the acquisition, and no ads have been added yet. Of course, it can simply be a value-add for Dropbox subscribers, but it's currently offered even to free users.

The last product under the Dropbox umbrella is Carousel, which is also their least successful product. It's a glorified photo viewer that integrates with your Dropbox account. Again, nobody would pay extra for this when free options exist that are not much worse.

None of these things scream sustainable businesses. For people to pay for Dropbox, it must add considerably more value to them than competitor services. At the moment, this is not even close to being true.

That leaves Dropbox with a few, difficult options.

1) Sell Itself. Steve Jobs infamously called Dropbox a feature, not a product, when in negotiations to purchase it. While it looked for a little while that he was dead wrong, as soon as cloud storage became a commodity, Steve's quote seemed to ring true, and it certainly rings true today. Dropbox could easily find a purchaser today, and cash in for a few billion dollars. I would put their value at around $2B, but more speculative investors value it much higher. Google, Microsoft, and Apple would definitely be interested in such a purchase, if only for the design and engineering talent. 

2) Go Public. This can be a terrible option, as Twitter is currently learning. Going public would infuse Dropbox with a lot of cash, which it could use to hire more people and develop a larger portfolio of products. But I doubt that would give them a new business model and ways to become profitable 

3) Release More Products. This is easier said than done. In essence, what I'm saying here is that Dropbox should create entirely new products that may generate them revenues for sustainable growth. They tried with the acquisition of Mailbox and the creation of Carousel, but both of those products generate no revenue (goodwill, maybe, revenue, no) and function as slight supplements to Dropbox the service.

Dropbox is one of my favorite companies, which is why I want them to start thinking of how they will differentiate themselves. Currently, their future looks bleak. It would be a shame if they were acquired, but that looks like their best and most lucrative option.

HBO Will Finally Unbundle Itself from Cable

Last month, HBO announced that in 2015 it will offer an unbundled tier, allowing customers to view HBO content without a subscription from cable TV companies. Basically, HBO plans to compete with Netflix, Hulu, Amazon Instant Video, and many other similar internet streaming services. This raises a few questions.
 
Will HBO offer all of its shows as part of this package? Currently, HBO subscribers have access to HGO Go, which allows them to stream almost the entire HBO catalogue. In addition, HBO allows subscribers to stream its latest episodes at the same time they are premiered on television. Will this new option only let customers access the back-catalogue of older HBO TV shows and movies? If so, that will reduce excitement for this news considerably. 

It's also worth exploring why HBO finally decided to unbundle now. Currently, if you want to subscribe to HBO, you have to do so through your cable TV provider. So you end up paying the provider, who then pays HBO. With an unbundled tier, you will pay HBO directly, eliminating the cable providers from the equation. HBO must know there is pent-up demand for their content from cable cutters, but they don't know if it will provide them with enough revenues to totally cut them off from cable providers. That's why they haven't said what the unbundled tier will include - it's a decision they haven't made yet. The question HBO needs to answer is will they make more money by going directly to consumers, or through cable companies as they do now? 

I wonder what HBO will charge for this unbundled tier. If it was my decision, I would price it in the $30-40 range, because cable TV cutters are desperate for the service, and would have no issues paying that much for their favorite channel. In addition, the quality of HBO shows is in a class of its own. Their closest competitor is Netflix, which charges $8.99 per month. But the common complaint with Netflix is the quality of its content. I have only found old TV shows and movies on it. Once in a while I will find some fairly new movie or show, but that is far from the norm. HBO, on the other hand, has the best TV shows in the business, and should charge accordingly.