Spotify & The Economics of the Music Industry | In Practise

Spotify & The Economics of the Music Industry

Former CEO at EMI Group & Board Member at Pandora Media

Learning outcomes

  • Fundamentals of a music artist deal with a record label
  • Potential pressure on the economics of the record label business
  • Spotify's strategic options to increase gross margin
  • How Spotify can replace services that A&R houses traditionally offered artists
  • Strategic rationale of the Spotify Joe Rogan deal versus Pandora's Howard Stern deal
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Executive Bio

Roger Faxon

Former CEO at EMI Group & Board Member at Pandora Media

Roger has over 30 years experience in the music and publishing industry. In 1994, he joined EMI, one of the four largest record labels globally, and spent 5 years as CEO of EMI from 2007-12 just as the industry was rapidly shifting digitally. Roger has led A&R investments, negotiated deals with the largest streaming platforms, and is on the board of Pandora Media and ITV. Previously to working in the music industry, he was CEO of Sotheby’s Europe and EVP at Lucasfilm. Read more

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Roger, great to have you with us today. I think a good place to start would be if you could provide some context as to when you first joined EMI and how you’ve seen the major changes in the music industry?

I was fortunate and unfortunate in joining the music industry. I was fortunate that I got in in 1994, where the music business was soaring. I remember the CEO who hired me said, the one thing you need to know is, you have to be stupid not to make money in the music business. But fearfully, we have a lot of stupid people in the music industry. People did lose money but, largely, the market was driven in a way that people probably don’t understand. At that time, there were four major music businesses and they’d grown up by buying independent labels but, mostly, by consolidating distribution. In that period, the CD was driving meaningful growth, in sales. Music retail, music stores, were expanding at a rapid rate.

What you had was, four businesses, whose business model was, basically, shipping as much music into stores and leaving it there, as long as possible, until it sold. So the inventories started to go way up. But the businesses looked as if they were doing fantastically, because they’d get 8% to 10% growth a year, which is astounding. By 1996, 1997, you started to see the world be very different. It didn’t show at the top line, but it showed in the bottom line, within the P&L, where you saw huge amounts of inventory that was stuffed out into stores. Over time, that started to become more and more evident.

Guess what was happening at the same time? First of all, I was hired, effectively, to drive a digital change, for EMI, amongst other things. We did all sorts of things; we were very aggressive in partnering with new digital groups. Digital then is nothing like it is today. It’s like the Dark Ages and we were learning how to build fires, as opposed to other things. There were a lot of ways of thinking about how you would use the digital world, to distribute music. That was true of all major players, to one extent or another. EMI was at the forefront of it, because it was part of a conglomerate that had very large interests in digital kinds of technologies. As I say, in those two years, the underlying economics of it was starting to dissipate. Then you get to 1998 and something happens, and that’s Napster.

Napster was the first time that digital really became understood as a mortal attack on the music industry. It made absolutely clear that music could be transferred indiscriminately. That the availability of one CD, in a marketplace, could mean that the entire world could have access to the music. That’s a pretty awesome and disturbing thought. Some people, like Bertelsmann, what they thought is, what we’ll do is, we’ll grab hold of Napster and we’ll tame it; we’ll make it work for us. That was probably the most idiotic view that I could ever imagine because its whole model was free. When they tried to get them to create a business model that was related to revenue, all that happened was that they just lost their place in the market, because the market had so many others that were pirating music.

The music industry had no experience with technology. It had no experience with digital activity. They just went to the law and started to try to solve this issue by attacking every digital use that was being pirated – that was impossible – as opposed to trying to build an alternative world, an alternative that was more conducive to consumer wants and was much more as what we’re seeing today.

Music businesses, at that time and, to some extent, even today, are run by A&R people; people who choose music, in effect and help develop it. They’re not strategists, in the broader business sense. The management of the music business was aging. These were guys that made their mark in the sixties and the seventies and here we were, in the late nineties and into the 2000s. They were frozen; they didn’t know what to do, other than to just try and fight the hurricane that was coming at them, with the law. What it took for us to come out of that, which was a very long time, by the way, was for others to find a different model, to try and create a different model. It wasn’t the record companies that did that. The record companies resisted. So you first had Steve Jobs, who said, I’m going to solve your problem. Apple is going to be your digital music. The old guard didn’t understand what they were about to do with him, was to give him the keys to the business, which probably wasn’t a bad thing. I’m speaking as though I wasn’t in favor of it. But what happened was, the old guard were at a level where if Steve Jobs wanted to do something, they would just agree to what it was that he wanted to do and not create a different kind of alternative.

Essentially, the music business, which continued to sell physical goods and it even does today, gave over the digital answer to Apple. What was happening with the physical goods? The physical goods were declining at an astronomical rate, of between 7% and 12% a year, which is devastating for a business. The CD and all of the infrastructure to service physical goods had huge margins. But once the volume drops down, you can’t make it work. Every year, you try and close down pieces; you try and lose pieces of what you’re doing, so that you’re shrinking the business as fast as you can. Every music business had that same issue. There was no one who was immune. Size made the issue even more difficult. But music continued to be sold and the pirates, in many ways, created a greater level for music. The volume of participation in listening to music expanded at as much of a rate as the decline in the physical goods.

The existential question was, how do you move to a different basis on which you are going to connect with your consumers?

What was the strategy of EMI then, when you’re seeing this physical distribution decline, the market expand, because more people have access to the music, but now the profit pool is, in effect, unknown or questionable?

At EMI, it goes in layers here. As I was saying earlier, in the latter half of the nineties, EMI was very aggressive, in terms of the way in which it looked at the digital opportunities. But by the time it was 2002, the lawsuits associated with the business were so great that investing in those things was impossible. I’m not overstating how distressing the entirety of the industry felt about where things were and how to fix them. My role changed across the industry too. Consolidate, so let’s get bigger so we’ll be less small, going forward. EMI tried to do that with Warner Music. It was turned down by the European Union. But others did happen. There was consolidation. Bertelsmann and Sony got together and there were smaller consolidations that went on, as well. That gave you more scope, as long as you could continue to reduce your costs.

What does that all mean for the people who make music? The artists and the songwriters and the producers? What happens is, they have, historically, been completely dependent on major record companies and publishers for their income. Now, the opportunity for income is declining and declining and so how do you fix that? The record companies took the lion’s share of any of the revenue and that’s largely because their business model wasn’t about optimizing the value of each song or each recording, but was, let’s find the ones that are going to break out and those are the ones we are going to pay attention to. A lot of music got created, but a lot also got dumped into a junk pile. That cost meant that, in order for the economics of the music business to work, you had to make a lot of money on the things that worked. The more failure you have, the more your successes have to be greater.

That model had been the way in which the business had worked for decades. The deals for music creators, even in successes, the majority of their revenue related to their works, go to the record companies. Otherwise, the business model doesn’t work. You had distress among the artists and you had distress among the record companies themselves. You had distress among the retailers, who are getting hammered, closing their stores as fast as they possibly can. In the United States, the malls had a lot of small, odd shops, for records and people weren’t buying, so in every mall in America, you had a shop that went out of business. In the United Kingdom, in this period, you had the same kind of phenomenon. It was a little less dire there, because the US tends to be more adoptive of new technologies. But nonetheless, pretty dire.

Getting back to the middle of the decade, 2005, 2006. That’s the point at which new models start to come forward and have something. They come from places that you don’t really expect them to. The one that is most prominent here, is Spotify. Spotify would not have happened in the same way if it had been started in the UK or the US or even in France as they’re basically conservative, in terms of their way of thinking. But Scandinavia, they thought, okay. It’s Sweden; it’s meaningless, in terms of the amount of records we sell. Let’s give it a try.

Sweden also subsidized bandwidth and had the infrastructure required.

Precisely. They had the structural elements that allowed Spotify to exist and they had managed the piracy to a greater extent than most territories. The heads of each of the major labels, in those territories, led by EMI, decided that they wanted to do it. They wanted to give them the ability to do it. The key way that was accepted, was that there was control over the actual distribution. It wasn’t simply an open book and that there was an economic model which was, we’ll give it to you free, with advertising and limited options, but we’ll have a subscription model that gives consumers the music in ways that are more satisfying and that is the basic model, at the end of the day. It’s a funnel. We have a funnel and we’re going to get a lot of people to listen and come in and then we’re going to get them to come through the funnel and start to pay.

What was driving the music business was the presumption that this would reduce piracy. You would see changes in piracy. That was what the proposition was. It was not seen as the future, so much as it was a way to fight piracy.

So the labels were just thinking of ways of capturing some margin from this piracy and the explosion in people listening to music online?

Right; get it out of the way. Even in that time, CDs were what we did. If we can get the piracy to go down, maybe the markets will start to stabilize and we can make money again.

You thought the CDs and the physical distribution may stop declining or even come back?

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Spotify & The Economics of the Music Industry

June 5, 2020

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