How Spotify and Apple Music saved the musc industry

In November, Irving Azoff, the entertainment manager known for his dealmaking finesse on behalf of artists like The Eagles, gathered a host of music executives for a lavish charity event on the Santa Monica beach.

As he greeted his guests, which included managers to the world's biggest pop stars, Mr Azoff made a crack that spoke to their plight in recent years: "I'm happy to announce that all 20 of the people still making money from the music business are here tonight."

Glasses clinked and the crowd roared with laughter at Mr Azoff's gallows humour, perhaps reflecting that they had long ago accepted the ravaged state of their industry. It had been nearly 20 years since the music business became the first to bear the brunt of digital disruption, with file-sharing tearing apart its business model and destroying half its value in revenues.

Now it looks as though the internet may resurrect the business it almost killed.

Thanks to growth in Spotify and Apple Music, music streaming has passed the milestone of 100m paying subscribers worldwide, a feat few imagined possible a few years ago. The US music industry is on track to record a second consecutive year of growth - something that has not happened since 1999, the year Napster launched. Some analysts and executives are beginning to confidently predict a new golden age.

"For the first time in a long time, we're not just figuring out where to trim every year," one record label executive says. "This business has always been driven by hits. Now we're looking at a financial profile that recorded music has never had at this scale."

It has been hard to imagine how the music industry could ever match its pre-Napster performance in the 1990s, when compact disc sales ruled. But now one monthly payment zaps 30m songs into your smartphone, enabling artists like Drake to notch up streams by the billions. The Canadian rapper's music was streamed 4.7bn times on Spotify alone last year. Every hour, his songs are streamed more than 500,000 times on the service.

Few could be happier about these dizzying numbers than Universal Music, the record label that distributes Drake's music and collects royalties from Spotify each time someone streams one of his songs. Artists like Drake helped power Universal to profitability last year, earning the company $1.1bn in streaming revenues in the first nine months - enough to offset the fall in sales of digital downloads and CDs. Rival Warner Music, home of acts like Bruno Mars, generated its highest full-year revenues in eight years. This was also fuelled by streaming sales, which ballooned more than 50 per cent across the sector.

• Taylor Swift withdrew her music from Spotify in 2014 because of the level of royalties, but remains the 29th most popular artist there because of collaborations and soundtrack albums.

• Beyonce's latest album, Lemonade, was released as a streaming exclusive on Tidal, the subscription service launched by her husband Jay Z and other artists.

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Wall Street has turned bullish on the industry, which has been boosted by a revival in vinyl sales. In a research note, Music in the Air , Goldman Sachs projected that streaming will help revenues double to $104bn by 2030.

But music executives have held back from popping champagne corks.

"We're starting to see that optimism was justified," says Stephen Cooper, chief executive of Warner Music. "But it would be dangerous to get too carried away."

When Napster took on the music industry in 1999, record companies fought back in courtrooms but failed to come up with a viable model to combat the illicit music factory growing online.

But a small group of executives saw digital distribution as a possible cure to the industry's woes. The format's main virtue was that it could be controlled: if people were given digital access to the music they wanted, then they would pay for it. That year, Michael Nash, who now leads Universal Music's digital strategy, ran a secret trial with the big music labels and IBM, codenamed the Madison Project - their first real attempt to sell music online.

As the industry scrambled to respond to the piracy epidemic, "we were a handful of lone voices, crying out in the wilderness about streaming and digital transformation," he says.

Fast forward 18 years, and it is clear that Mr Nash and his comrades were on to something. Each year more people are buying access to digital music; Americans streamed 431bn songs on demand in 2016.

Some artists have been reluctant to join the streaming crusade - none louder than Taylor Swift, who abruptly pulled all her songs from Spotify in November 2014, later explaining she was "not willing to contribute my life's work to an experiment". Her work has still not returned to the site.

However as streaming revenues multiply, "you hear fewer dissenting voices," says Mark Mulligan, analyst at Midia research. "There is a clear momentum."

Despite the impressive numbers, there is still tension between the biggest music labels and the technology groups that pipe millions of songs into screens and devices.

The music groups hold the leverage. The source of their power is found in places like the dimly lit studios at Universal Music's offices in Manhattan, where master recordings are copied and then filtered into mobile phones, shopping malls and living rooms.

Through ownership of the rights to these master recordings, Vivendi-owned Universal, Warner Music and Sony together control 80 per cent of all recorded music, with Universal having a one-third share.

The negotiating power that this concentration provides is "the reason why the rules of disruption don't seem to apply to music", says Mr Mulligan.

Streaming is a high-margin business. The labels no longer face the costs of hauling truckloads of CDs to Walmart. Instead of ownership, they are selling access to a digital music fortress.

This compares well with television studios, which have lost some grip over content as video streaming services like Netflix make shows and offer a limited selection of programmes. Music fans, though, expect streaming services to offer more comprehensive digital back-catalogues, forcing them to cut deals with the labels. As one label executive puts it: "TV and film studios have to coexist with Netflix now. We haven't made that mistake."

Spotify pays 70 per cent of its revenues to content owners while Apple pays an even higher rate, according to analysts. Lingering paranoia from the Napster shakeout has made licensing negotiations with labels "slow and tough", says one streaming executive. "They could put us out of business very quickly if they chose to."

One large thorn in the labels' side is Google-owned YouTube, whose music draws more regular listeners than Spotify and Apple Music combined. Most music consumption on YouTube takes place on its free, ad-supported tier, a revenue stream vulnerable to the fortunes of the advertising market. While the number of people watching music videos on YouTube has grown hugely, royalties to artists have not kept pace, resulting in what critics call a "value gap".

YouTube points to the $1bn it paid back to the industry in advertising alone last year; in September the company enlisted Lyor Cohen, a music industry veteran who helped develop artists like Kanye West and Jay Z, to lead a charm offensive. His hire is a "recognition that music is an important part of YouTube," says a person close to the company.

Silicon Valley has also woken up to the power of streaming, with Amazon, Apple and YouTube launching subscription services in the past few years.

The record labels benefit from these new entrants but they also walk a tightrope, because they want to squeeze as much as they can from Spotify without killing it. The Stockholm-based company, which label executives liken to a rebellious teenager, brings in about 10 per cent of their revenues; perhaps more importantly, it keeps them from becoming entirely dependent on Silicon Valley.

Spotify continues to lure customers: more than 100m use the service and 40m pay about $10 a month for it. Founded in 2006, it has raised more than $1.5bn, with the latest funding round valuing it at $8.5bn.

The pioneer of streaming plans an initial public offering this year, which one label executive describes as "a big concern for everybody". Saddled with hefty royalty payments, Spotify has never turned a profit. The company's revenues grew 80 per cent to €1.95bn in 2015, but it still lost €173m as royalty fees soared - a business model that some analysts say is unsustainable.

Spotify also faces fierce competition from its larger rivals, for which music is "a rounding error," says Erik Huggers, chief executive of Vevo, the music video site. He likens Apple Music to Walmart, which discounted CDs to lure people into its stores in the 1990s. "People would buy the latest CD . . . and then they would buy cornflakes, toilet paper, a bit of shampoo, and the cart was full."

With the IPO looming, Spotify is trying to trim costs by negotiating lower royalty payments with the labels. Spotify made its latest offer before Christmas: it proposed cutting its royalty fees to about 52 per cent of sales from its current 58 per cent share - which at least one of the major record labels is warming to, according to people briefed on the negotiations.

In exchange for the margin relief, the music labels are considering a range of concessions from Spotify, including more equity in the company, upfront payments or moves to restrict its free, ad-supported tier.

Streaming may or may not be the start of a new boom time for the labels, but these are halcyon days for the music lover, with companies like Vevo and Pandora preparing to launch subscription services to compete with Google, Deezer, Apple, Amazon, Tidal and Spotify.

So far, Spotify has set itself apart by offering slick playlists and well-targeted song suggestions but the industry seems sufficiently self-aware to acknowledge that this will change. Given the number of rival services, consolidation is inevitable among the smaller players, says Mr Cooper.

And as streaming, still only a 10-year-old invention, grows into adolescence, "having the catalogue is not going to be enough", says Duncan Orrell-Jones, chief executive of Slacker Radio, a rival to Pandora. "Five years from now the space is going to look very different," he says, citing Silicon Valley-esque ambitions with virtual reality and "opportunities around the spoken word".

"People will say: 'holy cow, we never saw that coming'," he says.

Streaming is the industry's latest white knight but after decades of grappling with pirates, new technologies and evaporating sales, music executives know there will be twists to come.

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Copyright The Financial Times Limited 2017