R ELATIONSHIP I MPERIAL C OLLEGE

M ARKETING MS C S TRATEGIC M ARKETING

Digital music distribution:

Business models and the role of recommendations
You are the CEO of an investment firm that specializes in digital content companies.
You are familiar with companies in the realm of movies such as Netflix and have been
interested in diversifying your portfolio. One promising new area appears to be digital
music services. You have identified two potential candidates that follow distinct business
models: Pandora and Spotify. Using your knowledge of movie streaming services, you are
trying to evaluate their business strategies. Which of the two companies do you decide to
invest in?

Recent Developments in the Music Industry

The worldwide market for music generates around $15 billion in revenue annually. The
music industry was dominated by physical record sales up until the early 2000s, but over
time, revenues from digital channels (digital record sales and streaming) have increased in
importance and surpassed physical format sales in 2014.
A crucial event for the industry was the emergence of file-sharing services which fa-
cilitated piracy. In 1999 the file-sharing service Napster became a platform for the illegal
exchange of music. Although Napster was shut down in 2001 (after being sued by record
labels), other file-sharing services sprung up in the aftermath and piracy has become an
important factor in the music industry. In 2014 BitTorrent facilitated about 4 billion music
downloads, the bulk of them illegal. Largely as a result of piracy, music sales dropped by
71% (see Figure 1), between 2000 and 2014.
However, the revenue figures for recorded music hide the fact that a large fraction of
music consumption occurs through free and ad-support channels. In 2015 terrestrial radio
captured a 50% market share of all daily minutes of music in the US (see Figure 2). Owned
music and internet radio each have a market share of about 15%.
Artists are typically under contract at a record label where they sign multi-year, multi-
album contracts. Artists tend to be paid an advance to cover living expenses and other
costs. The labels also take care of distribution and promoting the artist. In return, labels
obtain copyrights of the artist’s records. Artists are paid royalties which are set at around
15% of sales revenues (20% for superstar artists), but are only paid out after the advance
payment is recouped. Music distribution is a very concentrated industry with three major

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labels dominating: Universal Music Group, Sony Music Entertainment and Warner Music
Group. Together they have a market share of roughly 80%.
Labels pay royalties to artists from recorded music sales based on the royalty rates
described in the previous paragraph. For radio (terrestrial and internet) and streaming
services, payment to artists is more indirect. Labels first collect payments from radio sta-
tions and streaming services. Artist are then paid royalties by the labels as a fraction of the
payments they receive from the radio stations and streaming services.
Two key emerging players in the digital music realm are Spotify and Pandora. Both
companies have experienced a tremendous increase in their user base over time and both
have over 80 million active users (see Figure 3). Both services rely to a great extent on rec-
ommendation systems to provide a better experience to their users than is available from
more traditional formats of music consumption. While there are some similarities between
the two companies, their business strategies and the integration of recommendations into
those strategies are fundamentally different.

Spotify
Spotify was launched in 2008 in Sweden by co-founder and CEO Daniel Ek. Ek was in-
spired by the user-friendly experience of the file-sharing platform Napster and wanted
to re-create this experience on a paid service. He believed that consumers would value
convenience in music delivery and would be willing to pay for such a service instead of
consuming pirated music. Spotify gives consumers access to a large library of music (over
30 million song as of 2016) which users can listen to, but consumers cannot copy music files
and use them outside of the app. Currently, Spotify has approximately 100 million active
monthly users and 50 million subscribers to its paid service. The service has grown rapidly
since its inception and has helped launch careers of individual artists such Ed Sheeran and
Hozier.

Revenues
Spotify operates a “freemium” model with a two-tier structure. Their basic service is avail-
able at no cost, but advertising is aired between songs and some functionality is restricted
(lower sound quality, limited mobile play, no offline playlists). Consumers pay $9.99 to ac-
cess the premium version, which is ad-free. Spotify’s website claims that based on a total
annual fee of $120, “a Spotify Premium customer spends 1.6x more per year compared to
the average spending of a U.S. music consumer who buys music (not including those who
spend $0 on music)”.
Spotify obtains revenue from two sources: advertising that is aired on the free service
and subscription fees for the premium version. Advertising revenues make up only 9% of
revenue.

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 Spotify’s revenues have grown rapidly (see Figure 4) and almost doubled from 2014 to
2015. However, costs have increased substantially as well and Spotify has not yet turned a
profit. Spotify is planning to go public in 2017 or 2018.

Costs
Spotify pays 70% of its total streaming revenues to record labels in the form of royalties.
The royalty fee applies both to revenues from subscription fees and to advertising revenue
from its free service. Broadly speaking, royalties are paid in proportion to the market-share
of songs plays (e.g. if 30% of all songs played are from artists on Universal music, the label
will receive 0.7 * 0.3 * streaming revenue). There are minor adjustments for individual
artists and labels. The payment per song played lies between $0.006 and $0.008.
The structure of royalty payments is the result of negotiations between Spotify and the
various record labels. As such, the payment structure for royalties could potentially be
changed in the future.

Recommendations
Spotify was initially less focused on recommending music to its customers, but has added
various features over time that facilitate consumers’ music discovery process. Spotify
includes a radio feature which (similar to Pandora) learns about consumers’ tastes over
time due to thumbs up / down votes on each song. Spotify also provides links between
artists and songs by suggesting related artists to consumers listening to specific songs.
One of their most successful features is the personalized weekly discovery playlist that
was launched in July 2015. Discovery weekly has been used by 40 million users.
To further enhance their capabilities in the realm of recommendations Spotify acquired
The Echo Nest, a music intelligence company that develops tools for curation to drive
music discovery, and Sonalytic, an audio detection startup.

Additional reading:
The Verge: Tastemaker, How Spotify’s Discover Weekly cracked human curation at inter-
net scale

Pandora
Pandora was founded in 2000 by Wil Glaser, Jon Kraft and Tim Westergren and was ini-
tially called Savage Beast Technologies. In 2004 the company changed its name to Pandora
Media. The founders’ vision was to create a personalized radio station for each user that
would only play good music and filter out songs that the user did not like. A recommen-
dation system to guide the discovery process was at the heart of this effort.

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 Contrary to interactive streaming services, Pandora is considered an internet radio and
consumers cannot select which specific song they want to listen to. Instead, Pandora plays
songs based on its knowledge of users’ preferences. Users can signal their preferences by
skipping a song or giving it a thumbs up / thumbs down. There is a limit to the number
of song skips within a given time period.
Pandora has 80 million active users and a 70% market share in the internet radio market
(which does not include interactive services such as Spotify).

Revenues
The website began as a paid service but quickly changed to an advertising-based service
to make it available for free to users. Pandora now operates a “freemium” model with
a two-tier structure. Their basic service is available at no cost, but advertising is aired
between songs. The premium services also provide some functionality (ability to replay
tracks, listen to stations offline, higher quality audio). Consumers pay $4.99 to access the
premium version, which is ad-free. In March 2017, Pandora launched a new service priced
at $10, which allows users to listen to and create playlists of individual songs on-demand.
Pandora obtains revenue from two sources: advertising that is aired on the free ser-
vice and subscription fees for the premium version. Advertising makes up 80% of total
revenue. The remaining 20% originate from subscriptions for the premium service (which
does not air any ads). Pandora typically does not air more than 3 ads per hour for free
users.
Pandora’s revenues have been on an upward trend (see Figure 5), but Pandora has not
yet turned a profit (on an annual basis).

Costs
Pandora falls under regulations that were implemented for terrestrial radio and royalty
payments are not up for negotiation with labels or artists directly. Their content costs make
up about 50% of revenue and royalty payments per song are $.0014 for non-subscription
users and $.0025 for subscribers to the premium service.

Recommendations
Pandora’s recommendations are based on a recommender system called “The Music Genome
Project”. This recommender system was developed in its entirety by Pandora Media
and constitutes the core technology used to program its online radio stations. The Mu-
sic Genome Project assigns over 450 attributes to individual songs. Examples of such at-
tributes are genre, gender of the artist, rhythm syncopation, key tonality, vocal harmonies,
and displayed instrumental proficiency. Attributes are assigned manually by human be-
ings (rather than being extracted by an algorithm). Each song is analyzed by at least one
musician in a process that takes 20 to 30 minutes per song.

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 When users engage with the app by giving thumbs up / thumbs down to specific
songs, the app learns about the common traits of the songs a specific user like or dislikes.
For example, if a user that repeatedly dislikes country songs, Pandora will serve less songs
belonging to the country genre over time.

Additional reading:
The New York Times Magazine: The song decoders

Case questions
1. How does music consumption differ from movies? How do these differences impact
the nature of recommendations?

2. What are the key differences in the recommendation systems of Spotify and Pan-
dora? To what extent are these differences linked to other differences between the
two companies’ business models?

3. Which company will be more successful going forward?

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 Figure 1: Music Revenue over Time

Figure 2: Music Consumption: Market-share Across Channels

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Figure 3: User Pool and Usage on Pandora and Spotify

Figure 4: Evolution of Pandora’s Revenues and Profits

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Figure 5: Evolution of Spotify’s Revenues and Profits