Hit Streaming Service Spotify Eyes U.S. Music Fans

(By Antony Bruno, Reuters, November 2, 2009)

MTV Urge ... Yahoo Music Unlimited ... Virgin Digital ... Since 2003 -- when iTunes launched in the United States -- all of these digital music services have come and gone, without challenging Apple's market dominance, despite the backing of resource-rich parent companies.  Add in all the startups that have crashed and burned in the same time period and it starts to look as if no service could ever rival iTunes' traction with customers and critics.  Until now.

The Sweden-based startup Spotify, launched for public access in October 2008, has momentum like no other digital music service of the last six years. It offers on-demand music streaming, in both free and premium services, and now claims to have more than 6 million users in Sweden, Norway, Finland, the United Kingdom, France and Spain. At one point it reported signing up new members at a rate of 50,000 per day, although that figure has fallen since September, when the service restricted its free version to invited guests in the United Kingdom.

Spotify has won high marks from reviewers for the ease with which it provides access to a catalog of more than 6 million tracks from majors and indies alike and the unobtrusive way it delivers advertising.  Spotify's recently launched mobile version -- available for the iPhone and Android-powered devices in Europe to premium subscribers who pay the equivalent of around $15 per month -- has won similar praise. Although Spotify doesn't comment on its fund-raising activity, it has reportedly won $50 million worth of backing from investors -- at a valuation of $250 million, an almost unheard-of sum for a music venture in today's stingy venture capital environment. The European service also has the full support of the major labels, which reportedly negotiated a collective 18 percent stake in the company.

Yet this momentum will be tested severely as the company prepares to enter the United States -- the No. 1 music market in the world -- with a launch expected either late this year or early next, depending on how fast it completes its negotiations with the majors.  "It's been talked about so much I don't think it can meet everyone's expectations," says Forrester Research analyst Sonal Gandhi. "If the Spotify experience can be as good as hyped, it has a lot of potential."  With negotiations ongoing, U.S. labels are reluctant to comment on the service. According to music industry sources, the labels are impressed with Spotify's achievements but want the service to start generating real revenue. To do so, it must take care not to let the usage model outpace the business model.

There are certainly early signs of success. In August, Per Sundin, managing director of Universal Music Sweden, told the Swedish press that his company now earns more revenue from Spotify than iTunes. But that's in Sweden, where the service was born and where iTunes doesn't have the dominant hold on the digital music market it does elsewhere.  "We've seen income from Spotify follow a steep growth curve since launch," says Paul Smernicki, director of digital and direct-to-consumer at Universal U.K.'s Polydor Records. "Excluding mobile, they are pretty high up the list as a revenue stream for us. But we're certainly not in the same position as Sweden."  Scott Cohen, the London-based founder/VP of international at the digital distribution and marketing company the Orchard, says Spotify is already boosting income for labels in two ways.

"First, the more tracks are streamed on Spotify the more downloads occur on other services," he says. "We are not seeing any cannibalization. Second, revenue streams from advertising have been steadily increasing and have overtaken many niche stores in Europe."  But the ad-supported free service alone can't generate the revenue Spotify needs to pay for the music it plays. The company reported a net loss of $4 million last year, and its decision to limit its free service in the United Kingdom to invited guests implies a high burn rate.  That means Spotify has to increase the number of users for its premium service. So far, however, music subscription services like Rhapsody and Napster haven't been able to reach a mass audience. In its most recent quarterly earnings report, RealNetworks said Rhapsody has about 750,000 subscribers. Napster had 700,000 subscribers when Best Buy acquired the company last year, but hasn't released updated figures since.

While Spotify plans to make mobile access a key element of its conversion strategy, the mobile music market has also yet to take off. Spotify has confirmed it will launch in the United States with a "slightly different model" than in Europe, although it has yet to disclose details.

THE AD-FUNDED MODEL

Calling Spotify a free ad-funded music streaming service would be accurate but unfair. The company has paying customers, but they number less than 10 percent of its user base, according to comments from CEO Daniel Ek at a recent London conference. And company executives say that's unlikely to change.  "We expect the large majority of our users to stay with free," says Gustav Soderstrom, who left his job as director of business development at Yahoo to join Spotify as its head of mobile. "We're monetizing it through ads and through selling downloads (through its partnership with 7digital), so it's a significant revenue source."

So far, no ad-funded service has been able to turn a profit from advertising and download revenue alone. Which is why Spotify doesn't intend to. Using the "freemium" model, the company hopes to convert a portion of its free user base to the premium tier.  The free Spotify service could be seen as a customer acquisition play -- and perhaps not the most expensive one out there. Napster once estimated its customer acquisition cost at $100 per user, due to all the advertising needed to explain its subscription model.  "It makes the (customer acquisition) process easier than (it would be) if you start with no users," Soderstrom says. "You have to put a lot of marketing dollars into getting users' attention to even consider signing up. We don't have to do that."

Free access to any song on demand is powerful bait and Spotify offers what amounts to an indefinite trial period. Rhapsody and Napster usually limit their trial periods to about a week, after which users either need to pay or use only 30-second samples. (Rhapsody allows non-paying users to stream 25 free songs per month.) That may not be enough time to get users hooked on the access model.  Despite the popularity of Spotify's free tier in Europe, Rhapsody America VP of business management Neil Smith doubts it will roll out the same way stateside.

"The reason Spotify blew up so big and so fast was it was free," he says. "That model isn't going to happen in the U.S. anytime soon, maybe ever. The U.S. is the market where the labels make all their money. They can't afford to have a service that doesn't generate substantial revenue suck up all the usage. If it was $15 (per month) out of the gate, it wouldn't have a million users. Once you take the free piece away, we compete pretty well." So Spotify will have to ensure its ad-supported service remains worthwhile and not degrade it in order to push users to the paid version. Devaluing the free service would risk losing users, which in turn would threaten its function as a customer acquisition tool as well as limit any hopes of generating revenue from it.

THE SUBSCRIPTION MODEL

For all the hype Spotify gets for the popularity of its free tier, there's no guarantee it can match that success as a paid service.  Until its mobile option launched, Spotify's premium tier only offered the elimination of ads -- which weren't very intrusive to begin with -- and slightly better audio quality. The iPhone and Android apps add portability to that mix, but it's still not much different in price or function to portable subscription offers from Rhapsody and Napster.  "The value proposition of subscription has to change," Forrester's Gandhi says. "There has to be ownership. There has to be something besides just renting music."  Gandhi specifically points to subscription plans that allow users to keep a certain number of songs per month, such as the five tracks Napster gives away as part of its $5-per-month streaming plan and Zune's 10 free downloads.

Another option comes from Pali Capital analyst Richard Greenfield, who recently suggested that mobile operators and Internet service providers should bundle the Spotify premium service into their data plans. The idea of bundling is nothing new, but Spotify's ability to synch content across the different platforms makes it a more viable option.  Soderstrom says Spotify would consider such options, but only if they weren't exclusive.

THE MOBILE MODEL

Spotify is hanging its hopes of converting free users to paid users on the mobile application. But it doesn't want to position itself as a mobile service.  "I wouldn't say Spotify is a mobile service first," Soderstrom says. "You're going to do the majority of your browsing and discovery on your desktop, at least for some time. But if you want to use Spotify as your primary music service, then you're going to need the mobile option."  Previous portable subscription options required transferring tracks from desktop to portable device, which users needed to synch with an online service at least once per month to refresh the licenses. Services were based on digital rights management technology from Microsoft that had a reputation for being unreliable--and the dominance of the iPod had made them irrelevant.

Spotify gets around this by using mobile phones to stream the music rather than download it. Since mobile networks are notoriously unreliable, it created a way to temporarily cache more than 3,000 songs on supporting mobile phones, without using the 10 GB of storage normally required to do so--although users must still connect to Spotify every 30 days to verify their premium subscriber status.  

Mobile options have already paid huge dividends for music services like Slacker, Pandora and Clear Channel's iheartradio. Pandora, for example, says more than 45,000 of the 65,000 new registrations it gets every day come from its various mobile apps.  "Our future is going to be more mobile-centric than I had even thought, and sooner," Pandora founder Tim Westergren says.

But those are free applications. Rhapsody beat Spotify to the U.S. market with an iPhone app that lets users paying $15 per month stream any song from the service's catalog as well as their playlists and Internet radio stations, but to date it doesn't have a local caching option.  The U.S. mobile music market is also much tougher than that of Europe, where Spotify launched its mobile service in early September. According to a Forrester Research study, 27 percent of U.K. mobile subscribers with Internet access use their phone to play music at least monthly. In the United States, that figure is only 10 percent. U.S. mobile operators and labels alike hope Spotify will help goose these figures.  "There's definitely potential there," says one mobile operator. "I think we'll get the typical technology hype curve -- lots of hype going into market, pause and then either decline or hype again based on reality. Spotify has a chance to be a big deal."

THE EUROPEAN MODEL

Spotify's European success is impressive, but the U.S. market can be more competitive -- and more fickle.  "Spotify has a good chance of success in the States if they can make the right distribution partnerships," the Orchard's Cohen says. "But it will require a different strategy than in Europe."  And a win stateside would do much more than just cement Spotify as a legitimate player in the global digital music game. It will finally broaden the digital music market beyond iTunes and add a new usage model beyond track sales.  "Spotify is not the first streaming service in the world, just like iTunes wasn't the first digital download store," Cohen says. "What it does that is so special is make a fairly complex model seem easy to execute. They have a great team running the company and I wouldn't bet against them."

And while other U.S. music industry sources remain only cautiously optimistic, Spotify has confidence.  "There are certainly more music services in the U.S. than there are in Europe," Soderstrom says. "So, yes, it's more competitive. But I still think we have a better experience and a better offer. We wouldn't do it if we thought we were going to lose."