Can Apple and Beats Fix the Economics of Streaming Music?

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(L-R) Jimmy Iovine and Dr. Dre attend the Beats by Dre Holiday 2011 product line up unveiling at CLVT on October 11, 2011 in New York City.
(L-R) Jimmy Iovine and Dr. Dre attend the Beats by Dre Holiday 2011 product line up unveiling at CLVT on October 11, 2011 in New York City. Photo: Paul Zimmerman/Getty Images

Prompted by Apple’s reported acquisition of Beats (and the rampant speculation that part of the logic behind the deal has to do with Beats Music, the company’s nascent streaming service), I just went back and read Pitchfork’s exhaustive, well-designed cover story on the streaming music industry. The magazine spends thousands of words covering the history of streaming music, its Web 1.0 purveyors, and more recent entrants like Spotify, Pandora, and yes, Beats Music. Its conclusion is definitive and convincing: The days of buying our own discrete, individually downloaded copies of songs are over. Streaming, in some form or another, is the future of music listening.

But the question Pitchfork mostly avoids answering is, to my mind, the most important one. Namely, how are any of these services ever going to make money?

It's no secret that streaming music is a money-losing business. Pandora, for example, has never had a profitable year and said in its most recent quarterly filing that it expects to continue losing money "in the near term." Spotify, which raised $250 million at a $4 billion valuation last year, has the same problem; according to Pitchfork, "the more Spotify expands in the U.S., the more money it loses." A recent report from Generator Research predicted that although streaming music services will grow massively (the report predicted 1.7 billion music-streamers by 2017), these services may never turn a profit.

Most of why it's hard to make money from streaming music comes down to royalties. Last quarter, on the way to losing $28.9 million, Pandora paid out about 56 cents of every dollar it made as royalties to record labels and artists. (When you count only mobile listeners, it was more like 67 cents of every dollar.) Spotify pays out even more — about 70 cents of every dollar it takes in. You have to sell a lot of ads and subscriptions to make up for those slim margins, and so far, nobody's doing it. (Pandora's coming the closest, but even it's a ways away from steady profitability.)

The world of streaming-music royalties is a dense thicket of seemingly arbitrary rules. For example, every time Pandora streams a song, it's required to pay a performance royalty to SoundExchange, an agency that collects money on behalf of artists and record labels, at rates that are set by a three-judge panel known as the Copyright Royalty Board every five years. It's also required to pay a separate publishing royalty to ASCAP, BMI, or another performance rights organization, at rates that it sets with those organizations on a one-by-one basis. (These rate fights often end up in court.) Spotify's on-demand model means it doesn't have to deal with the Copyright Royalty Board like Pandora does, but it has to negotiate its own royalty agreements directly with artists and labels — also an expensive and cumbersome task.

These are both dangerous business models. If you're Pandora, you're reduced to lobbying Congress and suing publishing organizations when negotiations don't go your way, and you're always one court ruling away from financial disaster. If you're Spotify, you're constantly forced into onerous agreements with labels, and you have to find venture capital investors willing to subsidize your operations while you sell more subscriptions. The music royalty and copyright systems need an overhaul for the digital age, but until those changes arrive, these companies are fighting battles they may not be able to win.

The streaming status quo isn't working for artists, either. Bette Midler famously took Pandora and Spotify to task over their stingy royalty rates, saying that 4.2 million plays of her songs on Pandora over three months netted her just $114.11. Other artists aren't much happier. (Thom Yorke, the lead singer of Radiohead, called Spotify "the last desperate fart of a dying corpse.")

So, with artists screaming about small payments, and labels and industry groups squeezing the bottom line, what's a streaming music service to do?

The basic problem streaming music companies face is a math challenge — in general, the more people who use your service, the harder it is to turn a profit. The only ways to increase your profits while growing are to (a) reduce your overhead costs, (b) bring in a lot more revenue through ads and subscriptions (ideally subscriptions, since ad revenue is notoriously fickle), or (c) use your negotiating leverage to force labels and/or artists to accept lower royalty rates.

To make the equation work, what you'd ideally want is a big, cash-rich company that already has deep connections to and leverage over the music industry, that has a solid platform and millions of easily converted subscribers, and that is willing to subsidize a money-losing service while it lobbies for more favorable royalty rates.

This is, more or less, what Apple could do with Beats Music.

As an independent service, Beats Music hasn't made much progress on the streaming business model. A leaked document shows that as of March, it had only about 110,000 subscribers (compared to 6 million for Spotify) and paid about 62 percent of its top-line revenue out as royalties, compared to about 70 percent for Spotify. (Those rates will almost certainly have to be renegotiated as part of the Apple deal.)

With Apple behind it, though, Beats Music will be in the best possible negotiating position. Apple has plenty of experience bossing around record labels, and it has millions of iTunes users who could be tapped as potential Beats Music subscribers. No label is going to want to hold its songs off an Apple-owned streaming service, especially if Dr. Dre and Jimmy Iovine are on Apple's side of the table. And the result of Apple's leverage could be a streaming service built largely with the music industry's cooperation, rather than fighting it tooth and nail.

This new model wouldn't necessarily be better for musicians. Even with millions of paid subscribers and bottom-line profits, Beats Music would still likely enrage artists and songwriters who pine for the days of bigger royalty checks. But that's a larger problem with the digital music paradigm shift, which has created a class of consumers who feel entitled to unlimited streaming for less than $10 a month.

To be clear: I don't think Apple is buying Beats because it wants to compete with Spotify and Pandora. (Or because, as some music blogs have speculated, Beats has already negotiated sub-average royalty rates that will make it competitive with those two.) As I wrote last week, I think Apple is mostly making a hardware acquisition here and attempting to capitalize on the enormous popularity of Beats headphones.

But if Apple used its heft and music-industry relationships to turn Beats Music into a sustainable streaming service that could make money while paying artists, it would be a nice side effect of the deal. After years of red ink and arduous negotiations, maybe Apple can finally make the streaming math work.