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Apple Accepts the Worst Deal in Music Streaming – thanks to Taylor Swift

Taylor Swift vs. Apple MusicIt was a busy weekend. Yesterday, a Taylor Swift Tumblr post explained why she will withhold her 1989 album from the new Apple Music service. A few hours later Apple changed course, decided to incur higher operating costs in perpetuity and is back in Swift’s good graces. Everybody wins? Not likely.

The Fake Controversy

Apple Music is offering three months of free streaming starting on June 30th as part of its launch promotion. It had negotiated with the music labels that it would not pay music streaming royalties for this promotion period and in exchange would pay 71.5% of revenue or higher royalties beyond the first three months. This is 1.5% higher than the widely reported Spotify royalty rate set at 70% of revenue net of commissions.

This contract structure is not unusual. Lower initial revenue is offset by higher revenue over the long-term. Swift’s letter ignored this fact and instead focused on the need musicians have for money now. Granted, sacrificing three months of revenue for a 1.5% royalty uplift could be a long breakeven period.

However, that wasn’t the crux of the issue. It was about the appearance of paying artists for work. This is in itself interesting because very little of the streaming revenue reaches artists after labels take their cut. Music Business Worldwide research released this year showed that 73% of royalty proceeds are typically retained by the labels and only 11% reaches artists. In the end, this mini-controversy is about paying labels and not the artists. Taylor Swift is the rare artist that has her own label so she has much to gain from this ploy.

A Tale of Two Responses

You may recall that Swift had a well-reported tiff with Spotify last fall and pulled her music catalog from that service. The issue then was about reserving her music only to the higher royalty paying subscription Spotify service and not allowing it in the ad-supported service. Spotify refused to offer her special treatment, preferring to treat all artists equally and the parties went their separate ways. Since that time, Spotify’s growth has actually accelerated.

Apple didn’t want a public relations battle so close to the Apple Music launch and quickly capitulated to Swift’s demands. It will now pay royalties on the first three months and will retain the higher royalty rate of 71.5% of revenue. Apple seems to be getting the worst of both worlds, but is maintaining at least some decent artist relations which they may view as worth it.

However, it may not be over. Apple Music also has a little publicized ad-supported service that will presumably operate similarly to Spotify. Will Swift demand that her music only be played for subscribers and not for ad-supported listeners? What will Apple do then? Create two classes of musicians – those that can withhold their music to be played only for consumers paying the highest rates and another class of artists that have to take what they can get?

This doesn’t sound like the utopian vision of struggling artists getting their due. Alternatively, maybe Apple will pay the highest rates for both the subscription and ad-supported services even though the revenue generation is quite different. This seems like a bad deal for Apple on many levels, but maybe the company doesn’t care about the economics of music. Streaming will never compete effectively with the company’s revenue generation from smart mobile devices. The costs are simply too high.

Impact on Label Negotiations

record-labelsIt is hard to imagine that Apple’s actions won’t have a ripple effect. There are larger industry questions at play. Has Apple Music inadvertently set a new royalty threshold of 71.5%? Could higher royalty costs be a strategic advantage to Apple?

There was talk earlier this year of antitrust concerns related to Apple attempting to secure concessions from music rights holders that would allow them to set a lower subscription rate than competitors. Lower subscription rates would appear to be a good outcome for consumers, but it still can be construed at anti-competitive. De facto monopolistic power in one area, namely music downloads through iTunes, could be used to compete more advantageously in another area such as music streaming.

Similarly, voluntary acceptance of higher royalty rates could drive up costs for all streaming services that directly negotiate with music rights holders. Since Apple has robust revenue streams outside of music and the largest cash horde of any global company, it is best positioned to withstand the economic challenge of higher costs. Although this probably was not the strategy, it could have the same effect. This is the same complaint companies in numerous industries have every time Google introduces a new free product. Its revenue from advertising subsidizes zero-cost products in other areas.

Spotify, Rdio, Rhapsody, Slacker and others that negotiate directly with labels for music streaming rights may face a new reality. The market rate may no longer be 70%. Granted, there are other factors. The music rights holders need the services to be economically viable in order to generate revenue. However, Apple is a global service that could scoop up the customers of those services that fail and maintain the royalty payments. Music labels have a new precedent and a new point of leverage that they will no doubt attempt to exploit.

Aligning Interests

There is a great commentary on the Apple-Swift fiasco this morning in Seeking Alpha. Chris DuMuth Jr. of Rangeley Capital suggests that people always act in their own interests. Swift acted in her interests by insisting that she gets paid for streams during the three-month Apple Music promotional period. Apple acted in its interest by avoiding a PR firestorm that could undermine the Apple Music launch next week and risk alienating potential consumers and artists. Apple also maintained an “artist-friendly” posture that may help it secure exclusive content that could differentiate the service. Perversely, the company may also benefit inadvertently from higher costs associated with the industry.

One of the arguments before the Copyright Royalty Board (CRB) that sets Internet radio royalty rates outside of contracts is that music rights owners can exercise monopoly power. Whether it’s SoundExchange for non-interactive services or music labels negotiating directly with interactive services, if a streaming service wants a certain music catalog available to consumers there is typically a single entity that can hold it out as ransom. This monopoly power isn’t always in the best interest of the artists. In fact, artists with more favorable contracts that generate a higher royalty share for performers can be disadvantaged so labels can maximize their income from contracts where they share little with performers and songwriters.

Predicting the Next Demand

Spotify has a $0.99 promotional period and it pays standard rates to music rights holders for all streams according to TechCrunch. This fact surely made it harder for Apple to stick to its zero-compensation model for the three-month trial. Some have suggested that Apple simply give away more money to artists because, well, it has a lot of money and no one would miss it. I doubt this was the motivation in Mountain view.

Apple executives caved to Swift’s extortion because they believed the company’s interests were best served by avoiding a PR disaster and related consequences. The problem is that once you surrender to extortion, it tends to return.

I wonder about the next demand and how swift Apple’s reaction will be to keep the peace. I also wonder how one “weak” link will impact the entire industry’s negotiating position. One thing is for sure. Apple isn’t the first company to accept poor economic arrangements for the right to work with the music industry.

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