SoundCloud was just recapitalized by investors in a dramatic down round after announcing that the company had only enough cash to last into the fourth quarter. Pandora just agreed to terms on a new investment that was also a down round and which resulted in a new controlling investor. Both companies have a new CEO. More broadly, there are bitter fights in the value chain between music streamers and music owners about royalty rates. All is not well in some parts of the music distribution business. Change is needed. As Jimmy Iovine puts it: “Not every industry was meant to last forever. The record industry needs to do something that artists can’t do for themselves. Or else there’s no reason for it to exist.”
This blog post will follow the Charlie Munger “inversion” approach. Instead of focusing on what is wrong with the finances of companies like SoundCloud, Spotify and Pandora (“SSP”), this post will focus on what they would have to do right to create a profitable business. The question that I want to answer in this blog post is: What would a healthy music streaming business look like for SSP? As my friend Bruce Dunlevie likes to say: “What can go right?”
In thinking about these issues it is important to remember that streaming is not a business, but rather a technology. Streaming is just one method of distributing music. Another point to keep in mind is that no business can be healthy if it does not have sound unit economics. There are zero exceptions to this rule.
The healthiest business that has somewhat similar characteristics to SSP is Sirius XM. It is a rough analogy, as we will see, but it is worth thinking about. How can music streaming by SSP be more like Sirius XM?
Let’s take a look at the unit economics of Sirius XM using a recent reports:
Subscriber Acquisition Cost (SAC) $31
Gross margin 62%
Churn: 1.7% a month
Assuming a 10% discount rate in this LTV calculation, the Sirius XM unit economics look like this:
Sirius XM has a very attractive business which is creating real value.
It is worth remembering that the deal Liberty struck to acquire the stake in Sirius XM was well timed. It was 2009 and due to the turbulence created by the financial crisis, cash was king and Sirius XM desperately needed it. Liberty loaned $530 million to Sirius XM in return for a ~40% equity interest just in time:
“Sirius XM, the embattled satellite radio company, said early Tuesday that it reached an 11th-hour deal with Liberty Media that will allow it to repay maturing debt and avoid a bankruptcy filing, at least for the moment.” https://dealbook.nytimes.com/2009/02/17/sirius-xm-reaches-loan-deal-with-liberty/
Liberty was buying into a company that had already done much of the really painful parts of creating a business that necessarily has huge upfront capital costs. For example, the $6 billion in accumulated net operating losses had been funded by other investors. In a recent earnings call Sirius said that these net operating losses mean no taxes will be paid until at least 2018. The free cash flow generated by the business has allowed them to do share buyback and pay dividends at a rate of about $2 billion a year.
As an aside, I ran into Liberty President and CEO Greg Maffei in Sun Valley at the bottom of a chair lift in the spring of 2009 shortly after they first bought a stake in Sirius XM. I remember telling Maffei that his purchase was an amazing bargain. I knew the satellite business well since I was an early Teledesic employee, was part of the negotiations with Rupert Murdoch over his Death Star satellite plans, did due diligence on Iridium, Globalstar and most importantly know about satellite radio since McCaw Cellular Communications had been a shareholder in American Mobile Satellite since its creation. I wish I had loaded up on more Sirius XM stock at that time. More recently, other investors have reached this same conclusion. For example, Berkshire Hathaway has invested in Sirius XM’s business both directly and through their equity investment in Liberty.
The beauty of the Sirius business model is obscured for some people by the fact that subscriber acquisition cost (SAC) is an upfront expense (see the number in red above in the spreadsheet screen shot). Current quarter GAAP “earnings” do not fully reflect the annuity-like value that is being created by a company like Sirius or Amazon. In other words, in a growing business that has up front SAC current quarter earnings are lower. The good news about that timing of the customer acquisition expense in a growing business that is creating annuity value is it defers taxes with further compounds the wealth that is being created.
The attributes of John Malone’s preferred business model have been consistent over the years and exist in the case of Sirius XM.
Many other companies like Amazon have adopted the financial model pioneered by cable television pioneers like John Malone and my friend Craig McCaw.
How can the SSP music streamers become more like Sirius XM? First and foremost, they must start working to improve each of the unit economics variables and become more like Sirius. These variables discussed below are all important, but nothing is more important for the SSP music streamers than improving gross margin (#2). Without a gross margin fix, nothing else matters.
- Subscriber Acquisition Cost:
At the time of the launch of the satellite radio business subscriber acquisition cost (SAC) was high. There were two separate satellite radio systems, Sirius and XM Satellite Radio and each was bidding against the other for distribution. They also signed expensive content deals that were not sustainable. For example, Sirius’ SAC during the first quarter of 2003 was $299. Ouch! The manufacturing volumes on the receivers were low and so unit cost were high. The adoption by car buyers of the service was also relatively low and brand awareness was still being created who was too often addressed via expensive advertising. Cars with radios were not yet in the used car channel where SAC can be lower. Both satellite radio providers did what they could to improve their sales funnels, improve retention and lower SAC but they had a long way to go. By 2007 Sirius’ SAC had dropped to $105, but it was still very financially painful. The merger of Sirius and XM in March of 2008 was a helpful event that caused SAC to drop further. With the help of Liberty SAC has continued to drop over the years until now it is $31 (which is an average figure that includes both higher SAC new car customers and lower SAC used car owners).
Sirius has acquired its more than 32 million subscribers in a number of ways. The biggest driver of SAC is the installation of new radios in cars on speculation that conversion rates will be high enough. When a new car leaves the dealer it typically comes with a free trial, which lasts three months. That free radio and trail is COGS that is really CAC but it works to get people hooked. Sirius XM is not a big advertiser and spends money instead on getting better content.
Sirius XM is in about 75% of cars and conversion is ~40% of that figure.
“conversion of new car buyers remains our largest single acquisition channel, in the second quarter these represented only 46% of all self-pay gross additions, compared to 48% a year ago and 49% the year before that. This means that 54% of our gross adds are coming from the existing fleet, either our used car efforts, win-back, self-pay activation or aftermarket additions. We only expect this share to climb higher in the future as our penetration rate in used car sales increases from about 34% in the second quarter to eventually match the approximately 75% penetration in the new car market.”
The bottom line is that Sirius XM’s SAC can be what it is because ARPU and gross margins are high and churn is low. Music streamers like SSP do not have that luxury. The ad supported ARPU for a SSP music streamers is tiny. Some reports indicates that SoundCloud ARPU is just 11 cents per user. XM has zero ads on its music channels. Total advertising revenue at Sirius XM is about 2%. It is not really a material part of the business of Sirius XM.
At a Morgan Stanley conference in 2015 Sirius XM’s CEO Jim Meyer said:
- “Economics on used cars are compelling, don’t pay a subsidy on second or third owner, only new car
- There’s not any technology that will go on the vehicle that SIRI won’t also be able to use
- We won’t have commercials on our music channels, never will
- Future of SIRI is based on subscriptions, not advertisement
- We don’t want to get into video delivery, or compete with Netflix (NFLX), we want an acquisition that will make subscriber base stronger, lower the churn, grow ARPU, etc. We don’t see the streaming business models right now as good businesses, not good economics.”
Sirius XM has been very opportunistic in working its sales funnels and churn management procedures and practices. It has partnerships with used car dealers, auto lube stores, insurance companies, banks and other businesses to generate leads.
There are other opportunities and challenges ahead. How do they sell more service to younger consumers? How do they sell service to people who do not own a car? How can they use music streaming to lower SAC for the paid service? Sirius’ CEO and President Greg Maffei made this comment about Liberty’s investment in Pandora recently:
“The $480 million we invested [in Pandora] will not move the needle at Sirius. It’s really there about figuring out is there a strategy in which we have a free offering that Pandora can be a part of that story that we can together figure out how to better monetize these 75 million to 80 million monthly users that they have in a more integrated fashion with the Sirius higher price offering.”
Maffei is talking about the value of an up-sell approach.
SSP music streamers have no choice but to be upselling first party premium content as will be explained next. The problem the music streamers face on SAC is that the amount of SAC that can be justified given their current gross margins and ARPU is miniscule. If SSP raise SAC then they will end up with a lot of customers who don’t really like the service that much. Not only are customers acquired organically cheaper to acquire but they are of higher quality and churn less. No one understands this better than Jeff Bezos:
“The balance of power is shifting toward consumers and away from companies…the individual is empowered… The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it. If I build a great product or service, my customers will tell each other….In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts.” “Your brand is formed primarily, not by what your company says about itself, but what the company does.”
2. Gross Margin:
The royalty paid by Sirius XM for music is favorable for historical reasons. The traditional business model for recorded music was based on the assumption that radio stations playing songs sold records that music labels created and the labels paid the musicians. Only song writers received a royalty from broadcasters since they could not sell records. But when music went digital, the music industry business model flipped on its head and there was no longer much of a business selling physical records. Musicians shifted to making their profit on concerts.
Sirius XM pays 11% of its gross revenue as a royalty to musicians as determined by a copyright board operated by the Library of Congress. What this royalty rate means is that even though it pays for its own content like Howard Stern Sirius XM is able to generate gross margins of ~62%. Barron’s explains:
Most of Sirius’ content, including Major League Baseball games and Fox News, is signed through the end of the decade. Howard Stern and the National Football League—admittedly costly programming—are up for renewal at the end of 2015. Music channels, which make up about half of Sirius XM’s content, generate an estimated 60% of the costs.
What does this say about what the SSP must do? Here is how one analyst looks at the comparison of Sirius XM to the SSP music streamers:
Pandora reported in the Earnings Conference Call on July 31, 2017:
Subscription ARPU was $4.82 up from $4.76 in 194 the prior quarter, reflecting a shift from Pandora Plus to Premium. For the quarter, licensing cost per subscriber (or LPU), was $3.11, an increase of 5% from Q1. Non-GAAP gross margin was 36%, compared to 38% in the year-ago quarter. The decline in margin year-over-year was primarily driven by higher statutory rates under direct-deals versus statutory rates.
$3.11/$4.82 means the royalty expense alone eats 64.5% of revenue. Ouch!
For Spotify the royalty payments also crush its gross margins. One estimate is:
“84% of Spotify’s total [revenue] last year went back out the door to the music industry, or to facilitate its payment to the music industry.”
“Cost of royalties and revenues paid: Spotify will pay at least $2 billion in payments to record labels, in addition to per-stream rates the company pays when users listen to songs. Dividing cost of revenue — which are primarily royalties paid — by total revenue, nearly 85% of Spotify’s revenues go toward royalty rates.”
Comparing the SSP music streaming gross margins to Sirius XM makes a clear point: the SSP music streamers must get their content costs under control. I like to say that all the LTV variables are interrelated. But the current gross margins are the clear business model killer in the case of the SSP music streamers. Bill Gurley describes my view below:
“a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.”
The SSP music streamers must find first party content that does not expose them to wholesale transfer pricing power of content owners to remedy the gross margin problem. Otherwise wholesale transfer pricing power of the record companies means that the SSP streamers will forever be unprofitable. Netflix and Amazon know this and that is why they create first party content.
The work of musicians is not substitutable. For example, Arctic Monkeys are not a substitute for Bob Dylan. The SSP’s music streamers will never have acceptable gross margins until they have their own content. Amazon know this and has a business model focused on generating cash flow only indirectly on music.
Sirius XM ARPU has risen slowly and gradually. This is the variable over which Sirius XM has the most control. In contrast, an advertising supported music streaming business the ARPU challenge is not a truly hard variable to control but not very significant in size. The price of an advertisement is so low due to exploding supply that the advertising-supported ARPU of a music streamer is inevitably tiny.
Contrast an advertising supported model to Sirius XM which makes clear that it is cash-money paying subscribers that drive the profit and cash flow train:
“We offer trials to car buyers and we even discount onboard or retained subscribers, but at the end of the day if you don’t want to pay for our service, we don’t have a place for you.”
Sirius XM put the comparison this way at a Merrill Lynch TMT Conference in June of 2005:
Pandora is monetizing at about $11 a user, Clear Channel at about $13, Spotify at about $30 and pays 2/3 of economics in royalties, and we monetize at $150 per subscriber.
The Sirious XM example show that the question for a music streaming company like SoundCloud is: what first party services would people be willing to pay a subscription fee for? What original content is valuable enough to get people to pay a fee? I don’t see any other choice than to do what Netflix did which is increase first party content. This means that SSP must shift from being only content distributors to being, at least in part, content creators/owners.
The news on churn has been increasingly good for Sirius XM in recent quarters. In the most recent earnings call the company reported:
“Churn was 1.7% in the quarter, down from 1.8% in the prior-year quarter. And reductions in voluntary churn rates more than offset pressure from an increasing rate of vehicle related churn. Healthy gross additions and this extremely good churn performance produced 466,000 net new self-pay subscriber additions in the second quarter which brought the self-pay subscriber base to nearly 26.7 million and total subscribers to just over 32 million.”
Churn is super important in any subscription business. Sirius XM said in an earnings call in 2015: “When you have subscriber base as big as SIRI, a 0.10% change in monthly self-pay churn is equal to the difference between 70,000 subs in a quarter or 280,000 net subs in a year.” Every single basis point of churn is important for anyone in the services business. The best way to grow is not to shrink.
Less than 3% churn for a consumer service can be a healthy phenomenon depending on the other variables. Lower than 2% churn is great and lower than 1% churn is outstanding. The level of churn is a product of a number of factors like high product/market fit and sound business execution on retention processes like automatic renewal.
What about churn at the SSP music streamers? One report is as follows:
“Apple Music have a subscriber churn rate of 6.4%, which is nearly three times higher than Spotify, whose churn rate is 2.2%.”
The best way to retain customers is always to have a fantastic product. Of course there are a range of operational excellence approaches like automatic renewal that can help, but in the end a great service is the most effective way to retain a subscriber. The best way to increase satisfaction is not, as Pandora has done, to increase ad loads. A far better approach would be to have content that is compelling enough that people do not leave. XM Sirius has this hook in the Howard Stern Show and other first party content. The SPP music streamers must find something similar that is first party. There is no other option.
I am going to stop this discussion here since the post is getting a bit long. Most people do not have the patience for an analysis like this which I could have made much longer. Getting the data needed to value a stock is like being a detective. You must find data from many places, figure out what is signal and what is noise and then put together an analysis despite inherent uncertainty. If you do not find this process fun or are unwilling to do the work, you should be buying shares in the form of a low cost index.