Everybody get on your feet: Apple got the beat?
It might be too early for Apple to break out into the 1980s song by the The Go-Go’s “We got the Beat,” but last week, news emerged that Apple was interested in acquiring Beats, the company that has taken a category dominated by cheap, pale-colored earphones and transformed it into a “premium” category. The NPD Group, a market research company that tracks the sales of a multitude of consumer products, reported that U.S. sales of headphones costing $100 or more increased 73% in 2012, a markedly larger increase than for the headphone market overall. Premium headphones now make up 43% of all headphone sales with Beats hogging a 64% share of that market. Upscaling an entire category is no easy task and is rarely achieved (notable exceptions include Starbucks (coffee) and Haagen-Dazs (ice cream)) yet Beats has managed to successfully leverage the public nature of earphone “consumption” to make Beats headphones the must-have accessory for one’s MP3 player – be it an iPhone, iPod or Android device.
Although Beats’ headphones are a potential complement to Apple’s iX line, that may not have been the primary reason for the acquisition. Rather, most believe that the twinkle in Apple’s eye came from Beats’ fledgling subscription service for music consumption– Beats Music. After years of heady growth, sales of song downloads – the business model made popular by Apple’s iTunes – have leveled off; some reports from Nielsen SoundScan have even projected that sales of song downloads declined by 6% last year. Apple’s situation is akin to that of Peter Parker (Andrew Garfield in the The Amazing Spider-Man 2) who notes “Every day I wake up knowing that no matter how many lives I protect, no matter how many people call me a hero, someone even more powerful could change everything.”
On the other hand, subscription services for music such as Spotify – a pioneer in the category – have begun to take off. Charging consumers a fixed monthly (or annual) fee for unlimited song streaming, these services have begun to record significant revenues, some in excess of $1B worldwide last year (see recent NY Times article). History buffs may remember that an early advocate of music subscription was the artist Prince whose NPG Music Club ran from 2001 to 2006; ironically the year that Spotify was founded, although the service took another few years to launch. Spotify currently has over a million paid subscribers, with around half a billion dollars in revenue according to some estimates. For example, one estimate puts the number of paying subscribers at 6 million; if these customers contribute revenues of $9.99 / month, this would lead to annual revenues of $720 million.
Beats Music has far fewer subscribers and charges $9.99 per month after a one-month free trial, and allows consumers to stream on up to 3 devices. The company also has a family plan administered by AT&T that charges $14.99 per month for up to 5 family members and 10 devices. From overall general business perspective, given the rumored price of $3.2B, if one assumes that 50% can be attributed to the music service, one can do the back-of the envelope calculation as to how many paying subscribers would be needed to justify a $1.6B price tag. From my previous post about Netflix, the formula for customer lifetime value is:
CLV formula: M/(1 – R + I) – A
Recall the M refers to the annual margin generated by the customer, R is the retention rate and I is the rate at which the firm discounts future revenues. A is the acquisition rate that we will assume to be 0 for now. We don’t know margins but we know annual revenues are $120 / paying customer. If we assume a 10% discount rate and a 70% annual retention rate (note Netflix has around a 90% retention rate ), the Customer Lifetime Revenue for a Beats Music customer would amount to $300. Supporting the purchase price would require the company to have over 5 million paying customers, although this does not take into account the costs of providing the 20 million songs catalog the firm offers or the cost of acquiring new customers. Thus the question arises: what are the benefits of subscription services for customers and are we likely to see a gradual shift in this direction?
Most subscription services work on what is called a “freemium” model. The idea, in the context of music services, is that new customers can use the service for free for a period of time (say a month) to experience the full range of benefits that can be obtained from the service. After this period, the customer needs to pay the subscription fee in order to continue receiving the benefits (as in Beats Music). Alternatively, in the case of services like Spotify, it is possible to continue receiving the service so long as the customer is willing to be subject to advertising. (Such a freemium model is slightly different from that used by services such as Dropbox where the limited sampling is not duration bound but rather bound by things like the amount of free storage; for more details on freemium models, please see Vineet Kumar’s article in HBR). Success with the freemium model depends critically on (a) getting a large number of potential customers to sample the service; and (b) converting a significant proportion of free users to paid subscribers.
One can contrast subscription services to paid music downloads (e.g., iTunes) to understand their relative popularity. With iTunes, one can sample a song as well, but only a portion of it. This type of service works well for songs that the customer may be familiar with, has experienced previously, or has been recommended by a friend. Nevertheless, it requires some level of involvement to search, identify and pay for the song. Further, since payment has to be made for each track or album downloaded, the price being paid is a salient factor that is constantly on the consumer’s mind.
In contrast to iTunes, during the free trial period for a subscription service, the consumer has the flexibility to explore all kinds of music, in its entirety, without having to be conscious of the cost. For consumers with less established listening habits or evolving preferences, such services provide a superior platform for experimenting, learning, refining, or perhaps even redefining one’s tastes. So what can the subscription platform do to facilitate better matching of music and mind? First, it can provide appropriate recommendations given the customer’s tastes – at this, Beats Music’s algorithm is considered stellar. Another way would be to leverage consumers’ social network – if one believes in homophily – since consumers befriend others with similar tastes, thus this would be an appropriate way of getting listeners to experience music they are more likely to want to listen to, and possibly pay for. Spotify’s service helps facilitate such learning.
At the end of the free trial, consumers need to decide whether the service is worth the monthly subscription fee. In what situations would a subscription service make more sense?
- For customers who consume large amounts of music – say more than 8 new songs a month ($9.99 for monthly subscription on Beats Music versus $1.29 for each song downloaded on iTunes)
- If consumers are still uncertain about their tastes or would like to explore brave new worlds of music and boldly go where their ears have not gone before (to paraphrase the opening credits of Star Trek).
- For customers who do not want to be constantly reminded of their spending on music, since a monthly charge on the credit card will ease that burden
- For those aiming to spend a fixed amount on music. The subscription service, especially in its “family plan” incarnation at AT&T, provides a means for a family to restrict spending on music to a fixed amount each month and lowers potential variability in such expenditures.
As for downloading, this option is best for customers whose musical tastes are already well established, or for occasional consumers of music (see number 1 above).
The main challenge for the subscription service is how to migrate the free customers to paying ones. While I have discussed some of the benefits above, a major concern could be the $120 annual price tag that does not allow one to actually own anything. Companies are utilizing a variety of strategies to address this issue. One approach is the advertising supported free service. Success would depend on leveraging free music to get consumers to make purchases in other categories, such as clothing or accessories. Another approach is bundling the service with a cellphone service (e.g., Spotify and Sprint) – not only does offering such a service add value to Sprint in its battles with AT&T and Verizon, it also helps Spotify exploit the base of Sprint customers to expand its service. Nevertheless, concerns with subscription services have led others to take different approaches such as “hard bundling” – building the cost of the music into the purchase price of the hardware used to play it (e.g., Yonder and HTC).
To me, the clues to what companies should be doing to manage the transition from free to fee lies in the data they are likely generating. Company data should reveal who the paying customers of the subscription services are, and understanding these data better will help the firm target those customers who are more likely to switch to the paid service once they sign on to the platform via the free option. Additionally, companies can selectively target the social networks of the customers that do transition to the paid service by creating social rewards for getting others to sign on to the service as well (see my earlier post on Punchh). Ultimately, Apple has several options it can explore – its strong relationship with carriers will help it with the bundling approach, and its hardware products allow it to explore “hard” bundling. Furthermore, having access to both iTunes and a subscription service will help Apple to guide its customers to the most appropriate option for them; in this case they may even want to consider having an ad-supported free service that expands the pool of potential customers for either of these revenue generating options.