Streaming Music Has a Problem—It’s a Huge Success

Pandora, Spotify and others need revenue—and where they want to get it from is ruffling feathers

In late September, Spotify CEO Daniel Ek was the first guest Mark Zuckerberg introduced on stage during his keynote speech at the f8 developer conference, which introduced the network’s new media consumption features.

That night, Sean Parker—Napster founder, early Facebook executive and Spotify investor—threw a lavish warehouse party for conference attendees, serving roast pig and lobster during performances by Snoop Dogg, The Killers, Jane’s Addiction and Kaskade. The next-day posts declaring which users were listening to what bands on Spotify trickled into Facebook’s feeds.

The integration helped earn Spotify an additional 4 million U.S. users over the next six weeks, notable because the Stockholm, Sweden-based company had launched its free music streaming service in the U.S. only a month prior. Until then, it felt as though music fans had largely conceded to paying for music on iTunes. But Spotify’s hotly anticipated—and most importantly, free—arrival electrified the digital music ecosystem.

It was likely no coincidence that the month Spotify landed, digital DJ site launched, also gratis—and with no clear business model—and, soon after, MOG and Rdio, which also participated in the Facebook integration, launched free versions of their subscription-based services. Around that time, Myxer, known for its mobile ringtones, apps and wallpapers, announced Myxer Social Radio, a free music-streaming service. Clear Channel unveiled an amped-up version of iHeartRadio, its previously quiet three-year-old digital service, also free. Even Pandora, the reigning Internet radio champ fresh off its IPO, got into the act, increasing its limit on free streaming from 40 hours per month to 320. It was a free-streaming free-for-all.

But nothing online is ever really free.

The online music industry is in a unique, catch-22 situation: The more successful it is, the more money flies out the door. Digital music companies pay dearly for the rights to stream music. Pandora, for example, turned a profit for the first time this past November—10 years since its launch—thanks to onerous licensing agreements requiring it to pay a fee each time a song is streamed. The firm’s peers, including the smaller players, also pay a hefty rate each time a song is played. The services will never outgrow their costs, an unfortunate arrangement commentators have dubbed a “suicide pact.”

And subscription revenue, a much smaller business, is not enough. The streaming services need advertising dollars, and they have monies previously allotted to broadcast budgets in their crosshairs. It is, in general, a well-trod story: New medium goes after old ad dollars. But in this case, the stakes are unusually high. Online radio’s very survival depends on stealing ad dollars from its traditional counterpart, and it needs to do it fast.

“When [streaming services] look at the pool of radio dollars, which is immense, and ask if there’s a logic to joining that category, it’s impossible not to be seduced by the opportunity,” says Mark Ramsey, president of consultancy Mark Ramsey Media.

EMarketer has estimated online radio would secure $800 million in advertising in the U.S. by the end of 2011, compared with traditional radio’s behemoth $15.7 billion. (The Radio Advertising Bureau’s official 2010 number, which includes off-air ads, is $17.3 billion.) It’s a small but growing sum that increases by 20 percent each year, and eMarketer expects it to hit $1.6 billion by 2015. (All numbers exclude Pandora and Spotify.)

Nine of the top 10 auto brands including Ford, Chevrolet and Toyota were running online radio ads as of September 2011, according to IAB’s Digital Audio Advertising Overview. The same goes for nine of the top 10 retail marketers like Target, Macy’s and Walmart; nine of the top 10 restaurant marketers such as Wendy’s, Taco Bell and McDonald’s; eight of the top 10 financial services marketers, including American Express, Bank of America and Chase; and seven of the top 10 telecom marketers, including AT&T (which was the top spender on traditional radio advertising, according to the RAB). Thus far, the money they’re spending mostly comes from digital campaign allocations, not the radio side.

But streaming music user growth is outpacing ad growth. Online listening is on par with streaming video and playing games as one of the most widely adopted Internet activities in mature markets (France, Germany, Japan and the U.S.), according to a 2010 Accenture study. In the U.S., 89 million people listen to online radio each month, and 57 million each week, according to Arbitron and Edison Research, a number that’s doubled every five years since 2001. Pandora alone has captured 4.3 percent of the U.S. radio market share; its 100 million users streamed 2.1 billion hours of music in Q3 2011, more than doubling what it streamed in 2010, it says.

The availability of streaming music on smartphones, which are increasingly car connected, is notable for the ability to displace both private collections (once stored on iPods) and radio. Importantly, the vast majority—estimates of 80 percent—of traditional radio listening is done in a car. Pandora and MOG have negotiated deals for their apps to arrive preinstalled in the control panels of a number of vehicles. Mercedes, Cadillac, Hyundai, General Motors and Toyota work with Pandora and MOG, which hired veteran Nissan engineer Martin Zacharias to lead its auto efforts, is available in new BMWs and Minis. The digital streaming players are quickly outgrowing niche status.

Their advertising is racing to catch up. Pandora has always derived the majority of its income from ads—sales for last quarter accounted for $66 million of its $75 million in revenue (only $668,000 of which counted as profits). Once entirely focused on digital ad dollars, Pandora is now making a concerted effort to dip into traditional allocations, putting together a hybrid sales team consisting of digital sellers and traditional radio sales people in local markets, says John Trimble, the company’s chief revenue officer.

“We’re certainly going heavier and harder into the traditional broadcast marketplace, advertising-wise,” Trimble says. With the disproportionate user-to-ad sales growth leaving Pandora sitting on unsold inventory, filling it, he says, requires “converting an entire marketplace and convincing them of the value of where the consumer is going.”

As for Spotify, around the time of its Facebook partnership, the company hired AOL alum Jeff Levick to run its U.S. sales operations. Of its 10 million global users, only 2.5 million shell out $4.99 per month for ad-free streaming. While traditional radio ilk (and even Pandora execs on occasion) claim that on-demand services exist to convert users to subscriptions, Levick argues that Spotify’s free, ad-supported product is “a huge part of the company strategy.” Once a free user’s six-month trial runs out, they’ll face listening caps and increased ads, but the service will never cut off entirely. “Free has to remain free, and that’s where the advertising lives,” says Levick. It’s going to be an uphill battle. In 2010, Spotify earned some $99 million, around $71 million of which came from subscriptions. The company paid out slightly more than its earnings in royalty fees.

Dave Marsey, Digitas’ group media director, says as consumption habits shift, Digitas has been making the case to use dollars from traditional radio allocations on streaming music sites. The targeting ability of digital is a key selling point, he says, as it goes beyond traditional radio’s location and time-of-day targeting. Listeners control the music they hear, so advertisers can target based on mind-set, something experiential marketers (like travel or financial services) benefit most from, he says. A genre, station, artist or playlist that’s explicitly chosen by the user tells advertisers what mood he or she is in—Nirvana in the afternoon, or Beatles in the morning, for example. That helps shape the advertiser’s approach, Marsey says.

But there are challenges for marketers and buyers that consider dipping into their traditional buckets. Foremost among them is one of definition: Are Pandora, Spotify and their peers digital, or are they radio?

“When people don’t understand what bucket you’re in, they can’t buy you,” Ramsey says.

A rise in streaming audio spots is also muddying the picture. As streaming usage migrates to mobile (70 percent of Pandora’s listening is via smartphones, for example) and vehicles (which utilize smartphones), the ads need to look and feel a lot more like traditional broadcast spots than display ads. While advertisers like the less cluttered feel of a single audio ad on Pandora or Spotify compared with a pod of ads on broadcast, they don’t believe mobile display ads command the attention that a desktop ad might, says Gaye Sussman, president of agency ID Media, which does traditional and digital buys for the likes of Verizon and Nationwide Insurance. Filling that mobile inventory with audio spots, supported by broadcast-allocated ad dollars, requires that streaming services are defined as radio, not digital.

Providing audience data that traditional radio advertisers understand would go a long way in helping to convince advertisers that their traditional ad money is in good hands online. Last fall, Pandora presented audience and listening data in terms similar to those reported by Arbitron, the industry standard for radio metrics. The ostensible move to introduce an “apples-to-apples” comparison of digital to traditional caused a panic among broadcasters (one called the comparison “worse than apples to oranges, more like grapefruits to footballs”), and has left advertisers in the lurch.

Jeff Haley, CEO of the RAB, notes that the streaming services and broadcast stations are measured by two very distinct methodologies. But Pandora isn’t backing down. “Broadcast radio companies are clearly afraid of what an accurate apples-to-apples measurement with Internet radio will show to radio,” a Pandora spokesperson wrote in an email to Adweek.

It’s a prickly situation. “You have to make sure that . . . while you make the traditional market comfortable with how they look at digital media, you don’t end up reverse engineering the measurement of our new market into the old market,” warns Eyal Goldwerger, CEO of digital audio ad platform TargetSpot.

Meanwhile, streaming services continue to rustle up new money from marketers’ digital allocations. Marsey says 30 percent to 40 percent of Digitas’ clients advertise on digital streaming services, and that many of the buys have, in the last year, graduated from the “test budget” into a regular spot on the digital buying plan.

And as with digital publishing, the streaming services are doing their best to make buys attractive to traditional radio marketers, racing to out-innovate each other with even more compelling, engaging and elaborate ad formats. MOG’s free streaming, for instance, is supported by interactive advertising. Users accumulate credit by, say, watching a movie trailer or streaming a playlist created by a brand. Grooveshark, which unlike its peers doesn’t even bother with audio, is betting its future on elaborate display ad packages. Paul Geller, Grooveshark’s senior vice president of external affairs, says these packages boast a clickthrough rate of 1 percent to 1.5 percent, a slight bump from the paltry U.S. average of 0.08 percent. The company makes 70 percent of its revenue through advertising, supplemented by music marketing data it sells to artists, labels and managers. Similar to MOG, users can exchange their time—here in the form of surveys about music—to earn points toward ad-free listening.

Pandora’s menu of ad options includes mobile Tap to Call and Add to Calendar functions, and special content packages like Pepsi’s sponsorship of Grammy-related mixtapes, artist videos and genre stations.

In November, Spotify opened its API to third-party app developers. The launch group consisted of publications like Rolling Stone and music-related services like concert tracker Songkick, but in the future, advertisers will be able to interact with users through the apps as well. “It’s early days, and the possibilities are endless,” a Spotify spokesperson says.

Regardless of how users experience the ads, the rich variety of listening options has certainly made a dent in the time users spend on radio’s onetime listening monopoly. Digital’s ability to displace broadcast radio is unclear; broadcast executives, of course, deny a threat—while simultaneously entering the medium themselves.

“As much as [Pandora and Spotify] would like to dress it up as something else, it’s a playlist. It’s a music collection and a jukebox,” says John Hogan, CEO of radio at Clear Channel. (Music collections and jukeboxes have never had advertising before.) And while Clear Channel, which owns 800 broadcast stations, has sunk several million dollars into a glitzy, star-studded relaunch of iHeartRadio—now more Pandora-like than its predecessor, with customization functionality and 150 digital-only channels—Hogan says, “[iHeartRadio] is not a business. It’s a feature, one part of what we can do.”

Streaming music services are “not radio substitutes any more than your Walkman, CD collection or iPod ever was,” adds Lew Dickey, CEO, president and chairman of Cumulus Media, the second-largest radio operator in the country with 570 stations. They are threats to CDs and downloads, and not free local radio, which 93 percent of Americans listen to each week, he says.

Still, that has not stopped Dickey from wading into digital streaming, with Cumulus attaching itself to radio behemoth Clear Channel to do so. In December, the companies announced an alliance where Cumulus’ stations will stream digitally through Clear Channel’s iHeartRadio service. (In return, Clear Channel’s terrestrial radio stations will promote sales from Cumulus’ daily deals arm, SweetJack.) The partnership’s news bulletin made no effort to pussyfoot around its intention: “Clear Channel Radio and Cumulus Media Announce Partnership to Compete With Pandora in Digital Radio and Groupon in Daily Deals.”

As consumption of all media shifts online, both sides—their respective diss wars aside—will likely need to act more like the other in order to sell their ad inventory.

“Broadcast versus digital is a misconception,” says TargetSpot’s Goldwerger. In fact, a study from the firm shows that when an advertiser adds digital audio ads to an existing broadcast campaign, it increases the average response by 3.5 times, and the reverse equation—adding traditional radio to an Internet campaign—increases response rates twofold. Meanwhile, the groundwork for cooperation is being laid. The 62-year-old RAB is working with the IAB to spread awareness of digital radio with the hope of also spreading the spending ad love, Haley says.

Advertisers will have no choice but to go where the listeners are, digital or terrestrial. The problem for the streaming services is that they need to stick around long enough for that eventuality. The cost of failure is high. Spotify has more than $237 million in venture investments, the latest round valuing the company at $1 billion. Pandora’s market cap, which spiked at $4.2 billion on its first day of trading, now hovers around $1.65 billion. And Rdio, MOG, Slacker, Grooveshark, Myxer and Turntable have gathered $130 million—no small feat—in investments among them.

In the same way online video and search created entirely new streams of ad revenue, the industry hopes—even needs—online radio to do the same thing. It’s a common—and catchy—refrain.