by : Business, Featured Articles, June 2016

Gross Margin Blues

Gross Margin Blues

There has been a lot of excitement around streaming lately. At the end of last year, Apple launched their own service that amassed over ten million users in just three months. Despite the competition, Spotify was able to grow its user base at an even faster pace than usual and now boasts over thirty million users. Streaming now generates nearly $3 billion in revenue, which allowed for the first growth in recorded music sales in many years.

At the end of March, Spotify raised over $ 1 billion in convertible bonds that hold- ers can convert into a specified number of shares. The issue proves that the markets still consider Spotify a good investment, though the involvement of the equity firm TPG and hedge fund Dragoneer suggests that mostly high-risk takers are taking the bite. Spotify, like other streaming services, has yet to post a profit. In France, Deezer cancelled their plans to launch an initial public offering in the fall of last year at about the same time that talk about Spotify’s own IPO, for likely over $8 billion, was quelled.

One of the main reasons that streaming services like Spotify and Deezer can’t post a profit is that they have very low gross margins. Gross margins are defined as the difference between revenue and cost of goods sold. It is common to express the figure as a percentage of revenue. For example, if a car manufacturer can make a car for 4000 dollars and sell it for 10,000 dollars then they have a gross margin of 60%. The purpose of gross margins is to show the value of each incremental sale. Each time the manufacturer sells a car 60% of the selling price will go towards profit (before accounting for operating and financial expenses).

The year-end financial statements for Spotify and Deezer show that Spotify had a gross profit margin of 22% and Deezer was at 16%. Margins are small because of the high cost of paying rights’ holders, i.e. the record labels and the song publishers, for their music. Spotify’s CEO Daniel Ek insists that he wants to pay 70% of revenue to rights holders. This follows the iTunes model and older record label deals, where a third of every sale is allocated to distribution (before iTunes that money stayed in-house with the labels because the majors owned their distributors). If Spotify and Deezer were able to buy catalogue for a fixed fee they would benefit a lot from economies of scale. For now, the 70% payout means that gross margins will not improve much as the streaming services grow.

Naturally, a 20% gross margin makes it hard to make a profit once other expenses accrue: for marketing, operations, taxes, rent, legal, and interest payments. This is the structural problem for streaming services like Spotify and Deezer, and many analysts believe that getting ahead of their costs will prove difficult.

Even Pandora, not a profitable business, has gross margins of over 35%. The royalties for radio streaming are lower than for on-demand services due to the lower level of “control” exercised by the end user. On demand streaming has been growing its user base at a much faster rate but it won’t matter unless they can become more efficient in turning revenue into profit.

Deezer’s margins are so tight that they claim to only make money when their app is downloaded directly. And when consumers buy their app from the Apple store, Deezer gives up another fee, which undermines potential profit. In their financial statements they write that “app stores typically charge a percentage for billing up to 30% of revenues [and this] reduces our margins significantly.” The low gross margin means that they need perfect conditions to make money and have very little buffer for any other adverse factors that could weigh on their operation.

Legendary investor Warren Buffet says that the gross margin ratio is one of the first and most important things he looks for when analyzing the income statement of a company. He believes that you should only invest in businesses that have a gross profit margin of at least 40%. Those businesses may have a durable competitive advantage. Less than that and Buffett says that competition is too fierce.

One way for Spotify to improve their margins would be to try to negotiate lower royalty payments. This will be a difficult proposition though. The reason that Spotify has margins much lower than 40% is because of the reason that Buffett talks about: competition. It will be hard for Spotify to ask for a lower rate if the competition is Apple music, which may be willing to keep paying the current rates. If Apple pays a higher rate then they will end up being seen as more artist friendly and could have advantages with new releases.

In their financial statements Deezer talks about how they have negotiated licensing agreements with the three majors labels for an average term of two years. Even though they have the flexibility to negotiate better rates because the deals are done on a relatively short-term basis, they don’t have the bargaining power to do it. The market is very competitive and the path to better margins likely will not come from much lower licensing costs.

A better solution to the gross margin problem would be to look for ways to move into higher margin sectors. Spotify has a lot data it has collected on people’s listening habits and their favorite artists. Monetizing this information should be a higher priority item. Moody’s Analytics, a company that provides financial intelligence, has gross margins that are consistently above 70%. Putting data to good use is good business. Another way for Spotify to improve their margins would be to find synergy with another high margin business. Ultimately this could involve a merger or acquisition and the acceptance of a loss leading strategy on music sales – not ideal, however, for music makers. Short of that, Spotify might have to pin its hopes on the record labels accepting a smaller split than they are currently taking.

Steve Jobs was uncharacteristically wrong when he predicted that people would never want to rent music. The current juncture belies that. The problem hasn’t been so much that people don’t want to rent, or stream, music but rather that the businesses of streaming is weighed down by low gross margins.

 

By Ryan Stotland


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