Spotify Is Evolving
Spotify sees the writing on the wall: It’s going to remain difficult to make a profit from streaming music. Despite years of remarkably strong user growth, the high variable costs found with music streaming continue to serve as a financial headwind. Spotify co-founder and CEO Daniel Ek isn’t standing still, however. Spotify is evolving, partly out of necessity, with the long-term goal of becoming the largest audio platform in the world. While the transition includes its fair share of challenges, Spotify has a few things going for it that should force competitors like Apple to take notice.
Spotify Earnings
Spotify's quarterly results have become predictable. Strong subscriber trends are offset by nonexistent profit and mediocre operating cash flow. Last week, Spotify reported 4Q19 earnings, and the results mostly fit the pattern. The company grew its subscriber total by 23 million in just three months (a very good number). Spotify’s cash flow showed a little bit of improvement although the numbers still don’t seem to reflect a company that grew its subscriber base by a whopping 65 million people in 2019.
As shown in Exhibit 1, the growth of Spotify’s ad-supported monthly active users (those on the free tier) and premium subscribers (those on the paid tier) is not showing any signs of slowing. Although ad-supported MAU growth had underperformed premium subscriber growth, that dynamic has reversed. This reflects that Spotify is seeing success in growing the streaming music pie by attracting new people into the fold. These new customers are more likely to enter through the ad-supported tier and then possibly migrate to the paid tier over time.
Exhibit 1: Spotify Subscriber Growth Trends
In taking a closer look at Spotify’s subscriber base, it becomes evident that the company continues to see much of its growth in geographies where Apple has little to no presence. This suggests that recent subscriber growth has resulted from Spotify becoming a preferred choice for Android users looking to free, ad-supported music.
The Music Streaming War Has Quieted Down
For years, the music streaming war between Spotify and Apple Music was fought over subscriber totals. The back-and-forth subscriber disclosures between Spotify and Apple Music were closely monitored. At first, consensus thought Spotify had received too large of a first mover advantage for Apple Music to find any traction. Once that theory was busted, attention turned to the pace of new subscriber growth.
In 2019, Spotify grew its premium subscriber total by a little more than 2.0 million per month while Apple’s paid subscriber growth figure for Apple Music was closer to 1.3 million per month. Given how Apple Music now has more than 60 million paying subscribers, we can confidently say that both Apple Music and Spotify have “won” in music streaming. Each company has enough scale to matter.
Spotify’s Problem
Even though Spotify continues to see strong subscriber growth, the additional scale hasn’t resulted in dramatically improved financials. The problem is found with the high variable costs associated with music streaming. For every dollar that Spotify brings in the door, only 25 cents is left to cover the costs of running the business after accounting for music rights and other cost of goods sold. For context, here are the most recent gross margins (on an annual basis) for the big five:
Facebook: 82%
Microsoft: 66%
Alphabet: 56%
Apple: 38%
Amazon: 20%* (estimated)
*Although Amazon may have a lower stated gross margin than Spotify, the numbers are misleading as the company is generating close to $40 billion of operating cash flow per year. The underlying business is kicking off cash although much of it has to be put back into the business to keep things running.
When considering the amount of R&D and marketing that is required to stay competitive with the giants, Spotify’s gross profit picture isn’t encouraging. As for attempts to improve its gross margins, Spotify has stressed items like charging content creators for various tools and trying to negotiate content cost savings. However, the elephant in the room is Apple Music. By having a successful alternative in the paid music streaming space, music rights holders are in a better position to retain their negotiation power when up against Spotify.
Music rights holders have been the big winners in the current music streaming landscape. Nearly 200M people are now paying somewhere between $5 and $10 per month for music between Spotify and Apple Music. Unfortunately, it has become harder than ever for music artists to find financial sustainability. Expectations regarding how music as an art form will be valued likely need to be reassessed.
An Evolution
In early 2019, Spotify began betting big on podcasts. Since the start of 2019, Spotify has spent more than $600 million buying Gimlet Media, Anchor, Parcast, and most recently, The Ringer. By getting into podcasts in a big way, Spotify is trying to evolve from a dedicated music streaming service dependent on music rights holders for achieving profitability to an audio company with a platform delivering audio entertainment to as many people as possible.
Spotify’s financial picture stands to improve if the company can better monetize its 280M subscribers. One of the primary goals in developing an audio platform consisting of podcasts is to generate higher gross margins by having subscribers spend time listening to something other than music. With a captive audience of hundreds of millions of people, Spotify is in an interesting position to be more of an advertising company. In the future, Spotify’s long-term strategy may include having third-party developers create new kinds of audio experiences.
The timing for such an evolution looks good for Spotify as we are in the midst of a headphones renaissance set within a wearables revolution. With the removal of wires, headphones are being transformed. We see Apple expand its wireless headphones portfolio to include various AirPods models and Beats headphones. According to my estimates, Apple is bringing in $9 billion of revenue per year from headphones. That is 25% higher than Spotify’s annual revenue. Apple’s $3 billion acquisition of Beats in 2014 is looking smarter by the day when thinking about the headphones piece of the acquisition. Beats headphones are now bringing in approximately $2 billion of revenue per year for Apple.
Roadblocks
Spotify faces an uphill battle while evolving into an audio company. The biggest obstacle is the lack of first-party hardware and other services like video streaming. The never-ending rumors that Spotify has been tinkering with hardware likely have merit. The company is at a severe disadvantage by not having first-party hardware solutions including stationary speakers, and more importantly, wearable devices.
Last year, Spotify declared war on Apple. Instead of fighting the battle in the marketplace over exclusive songs and albums, Daniel Ek wants to go after Apple in the courts and regulator backrooms with the goal of weakening Apple’s grip on the App Store and the broader Apple ecosystem. If successful in its pursuit, Spotify would find itself in a better position to leverage Apple’s ecosystem for its own ambitions versus the other way around, which is currently the case.
In the event of video and music bundling taking off, Spotify will find itself at another disadvantage as the company has limited financial resources that would allow it to get into video ($1.9 billion of cash, cash equivalents, and short-term investments). The company would need to continue relying on partnerships for bundling opportunities, which is far from ideal. Although Spotify has easy access to capital, the amount of cash flying around for original video content is daunting. This is another reason why Spotify hasn't been shy running into podcasting. While some of the valuations that Spotify has been willing to pay for podcast startups and talent may make people in the industry blush ($250M for The Ringer), on a relative basis to the video space, Spotify is able to make its cash go further with podcasts. Much of this is due to the podcast industry not being as developed a video from a monetization standpoint.
Advantages
Instead of cash or video, Spotify has something else going for it in its evolution: the ability to focus. Audio is commanding all of Spotify management’s attention as it represents everything for the company. Spotify is likely betting that the giants will continue to treat audio (not the same as voice) as a money-losing ancillary business.
Another way of thinking about this dynamic is that Apple’s $1.4 trillion market cap is 56x larger than Spotify’s $25 billion market cap. A doubling or tripling in Spotify’s market cap would be considered a huge validation in the company’s evolution strategy while Apple’s market cap fluctuates $25B to $50B on any given day.
Apple’s Perspective
In its current form, Spotify doesn’t pose much of a long-term threat to Apple. Spotify is a service that is consumed by a small percentage of Apple users mostly on Apple’s platform. However, Apple can’t and shouldn’t ignore Spotify’s evolution. One of the more effective ways for Apple to compete with Spotify over the long run is to figure out where the company is headed and get there first.
Success at building an audio platform with millions of engaged developers could give Spotify a beachhead in audio apps and make it an App Store alternative in a wearables world. In such an environment, audio stands to be a key ingredient capable of augmenting our surroundings.
It is in Apple’s best interest to recognize the threat that Spotify could pose and beat the company in establishing an audio platform. Apple can empower iOS developers to come up with new forms of content and workflows designed to be consumed on a range of wearables (along with mobile devices). Along with music and podcasts, there could be room for new mediums and experiences, many that can’t even be envisioned yet. In such a dynamic, Apple could then leverage its biggest advantage over Spotify: hardware and a broader platform with various services.
If consumers end up viewing an evolved Spotify as something consumed on Apple’s platform instead of looking at Spotify as a platform in of itself, Apple will have successfully countered Spotify’s evolution.
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AirPods Are Becoming a Platform
If AirPods were magical, AirPods Pro are supernatural. Apple’s newest pair of AirPods continues to make waves with “augmented hearing” entering people’s vocabulary. However, the broader implications found with Apple’s AirPods strategy are just as impressive. Apple is quickly removing all available oxygen from the wireless headphone market, and competitors find themselves at a severe disadvantage. In just three years, AirPods have evolved from an iPhone accessory into the early stages of a platform well positioned to reshape the current app paradigm for the wearables era.
Another “Quiet” Launch
One of the more fascinating aspects found with AirPods Pro was how the product was unveiled. Instead of receiving stage time at Apple’s big product event at Steve Jobs Theater one month earlier, AirPods Pro received the press release treatment. When contemplating potential sales, AirPods Pro may end up being the best-selling Apple product that has ever been unveiled with just a press release.
The subdued unveiling given to AirPods Pro is consistent with Apple’s prior approach to AirPods. Instead of receiving the red carpet treatment as the Apple Watch did two years earlier, AirPods were unveiled to the world over the course of just five minutes at Apple’s iPhone and Apple Watch event at Bill Graham Civic Auditorium in San Francisco. In a sign of just how nonchalant Apple was with the unveiling, AirPods were positioned merely as an iPhone 7 and 7 Plus feature. The product was said to be an additional option that consumers had for handling the transition away from dedicated headphone jacks. (Remember those?)
Earlier this year, AirPods with wireless charging case was unveiled via press release as well.
AirPods Pro
It’s easy to gloss over many of the selling points found with AirPods Pro given the familiarity with AirPods. Items such as seamless pairing and the carrying case that doubles as a charging station play crucial roles in giving AirPods Pro such a high-quality and enjoyable user experience.
However, the features that have gained the most attention, and rightly so, are Active Noise Cancellation (ANC) and Transparency mode. For many people, AirPods Pro will be their first pair of ANC headphones. Those users are in for a treat as Transparency mode addresses the largest negative found with ANC headphones - the user is seemingly removed from his or her surroundings. A press and hold on one AirPod stem switches between ANC and Transparency mode. The functionality is a great example of how Apple’s engineering and design teams, through collaboration, can produce a great user experience.
Sales
In FY2019, Apple sold 35 million pairs of AirPods at an average selling price (ASP) of $162 (both are my estimates). On a revenue basis, the AirPods business is on a $6 billion per year run rate that is doubling year-over-year.
One way to put those sales numbers into context is to compare AirPods to other Apple products at the same point in time after launch. As shown in Exhibit 1, AirPods are trending similarly to iPhone sales when looking at unit sales out of the gate. After three years of sales, Apple has sold 61 million pairs of AirPods on a cumulative basis. During the first three years of sales, Apple sold 60 million iPhones.
Exhibit 1: Unit Sales out of the Gate
Apple likely crossed an important AirPods sales milestone last quarter. For the first time, Apple sold more than 10 million pairs of AirPods during a three-month stretch. While the preceding observation came from my earnings model (access to my Apple earnings model is a benefit associated with Above Avalon membership at no additional cost), the math checks out with Apple management’s commentary and clues provided on the 4Q19 earnings conference call. It’s likely that AirPods sales will exceed 10 million per quarter for the foreseeable future.
When contemplating AirPods unit sales trends going forward, too many people are stuck in a mobile mindset. Instead of seeing someone buy and use just one pair of AirPods, we may see a new kind of usage pattern develop in which a growing percentage of AirPods owners will use more than one pair of AirPods. This will help boost AirPods unit sales.
On Apple’s 4Q19 earnings conference call, Tim Cook was asked about the potential upgrade trajectory for AirPods. Cook commented that he thought current AirPods owners would be in the market for AirPods Pro to “have a pair for the times that they need noise cancellation.” The clear implication found in Cook’s comment was that Apple expects some AirPods owners to use multiple pairs of AirPods with differing levels of functionality.
After just three years of sales, we are already starting to see the early stages of this trend develop with people upgrading their AirPods but keeping their old pair as a backup.
In an unscientific poll conducted via Twitter poll through my account, 30% of respondents said they use more than one pair of AirPods. Interestingly, 41% of people who said they purchased a pair of AirPods with wireless charging case claim to still be using their older pair of AirPods as well. It helps that AirPods last years before poor battery life takes its toll. My initial pair of AirPods from 2016 are still used daily. It's early, but it looks like people using more than one pair of AirPods is a thing.
Platform Building
The current app paradigm primarily consists of downloading an app to our smartphone, tablet, smartwatch, smart TV, or laptop / desktop. We then interact with the app to “pull” information and context at a time of our choosing. App notifications are not very smart and instead represent mostly useless distractions more than anything else.
The Apple Watch was the first device to genuinely begin questioning the current app paradigm. The Siri watch face on Apple Watch is all about providing the wearer glanceable amounts of information, data, and context in the form of cards chosen by a digital assistant. These cards are personalized to the wearer based on the time of day and schedule. In essence, we are moving away from pulling data from various apps to receiving a curated feed of data that is dynamic - always changing and tailored to our needs.
Apple is turning AirPods into the second platform built for what comes after the App Store. Instead of being about pushed snippets of information and data via a digital voice assistant, something that will likely remain ideal for mobile screens, AirPods will be all about augmenting our environment by pushing intelligent sound.
AirPods Pro wearers are able to experience the early days of this dynamic with Transparency mode. Switching between Transparency mode and ANC is equivalent to augmenting our environment. We are receiving two different experiences despite being in the same location.
This dynamic could be extended so that a simple tap of an AirPod or a quick voice command can take us to a different location via sound. Utilizing HomePods as sound receivers, an AirPods wearer would be able to “move” from the kitchen to family room. A quick tap of one AirPods, or Siri voice command could bring the wearer from the family room to kitchen to answer a family member’s question or simply to be “in” the room.
App developers would be able to take part in this revolution by building experiences that further augment people’s hearing. “Apps” would amount to tools capable of adding context to our hearing. Fitness can be rethought by adjusting the AirPods wearer’s hearing during workouts and exercise based on his or her activity. As an example, AirPods music playbook can be adjusted based on the users’ heart rate obtained by an Apple Watch. Such adjustment would amount to the AirPods wearer being “removed” from his or her environment when close to reaching a maximum heart rate during a run or track workout. Of course, such health tracking and monitoring may one day be brought directly to AirPods in subsequent editions.
Another example involves utilizing AirPods to deliver different sound experiences to different people despite being in the same location and looking at the same thing. As an example, a single presentation shown in a school or office setting can end up delivering a dozen different experiences to those in attendance.
Platform Power
AirPods will derive its platform power from three sources:
Technology advantage
Design focus
Massive adoption
Apple is pulling away from the competition when it comes to building mini computers worn on the body. AirPods are computers for the ears. Years of learning how to manufacture 2.1 billion iPhones and iPads is now helping Apple to build nearly 70 million wearable devices per year.
This technology prowess and manufacturing acumen goes to waste if people don’t actually want to be seen wearing the devices. Apple’s success at redefining luxury, combined with the company’s design-led culture, gives the company a large advantage in the area of understanding what people will want to wear on the body.
The final source of platform power will come from massive adoption. There are currently 45 million people wearing AirPods. At the current rate, more than 100 million people will be wearing AirPods at some point in 2021. As to how Apple is able to see such strong AirPods adoption, Apple is busy removing all available oxygen from the wireless headphone market.
The company is utilizing a masterful combination of price and features to establish multiple beachheads in the market.
AirPods Pro do not replace AirPods in the product line. Apple is instead embracing a strategy of expanding the product line according to functionality. AirPods Pro represent the expansion of the AirPods line into a higher-end segment that places value with ANC. The end result is that Apple now has three different AirPods model, each targeting a different price segment of the wireless headphone market. It is certainly reasonable to expect Apple to continue pushing this strategy in the coming years so that we see a pair of AirPods go for as low as $99 and as high as $500.
We see similar product strategies with the iPad and Mac lines. With these, Apple sells a range of flagship products with varying degrees of functionality, and of course, price.
There are some unique attributes seen in Apple’s campaign to remove oxygen from the wireless headphone market. Unlike what they did with the iPhone or iPad playbook, Apple didn’t launch AirPods at one price and then begin to lower pricing once all of the profit had been sucked from that initial market segment. Instead, Apple has been doing the opposite. Apple unveiled AirPods at a very aggressive $159 price, which sent shockwaves across the industry as the competition was priced closer to $300. Three years later, competitors are still struggling to match AirPods' $159 entry-level price.
Something Big
This AirPods evolution into a platform does not come as a surprise. Here was the opening paragraph from my initial Above Avalon article on AirPods shortly after being unveiled in September 2016:
“AirPods will turn out to be one of the more strategically important hardware products Apple has released this decade. However, you would never know it judging from the way Apple unveiled the device last week. I suspect that was intentional. While the press remains focused on the short-term debate surrounding the iPhone's lack of a 3.5mm headphone jack, few have realized that Apple just unveiled its second wearables platform.”
Three years later and that paragraph still rings true. AirPods have turned into a cultural phenomenon while dedicated headphone jacks on smartphones have become relics. Meanwhile, Apple’s wearables train continues to gain momentum as the company grabs real estate on our wrists and in our ears by bringing a new level of personal computing to the masses.
Listen to the corresponding Above Avalon podcast episode for this article here.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.