Tuesday, June 28, 2011

Facebook Music Will Be a Transformative Event for Streaming and Mobile Services

Leaked information about a very elaborate integration of streaming music services into the Facebook platform has created quite a buzz in the music industry over the last few days and it's easy to see why. In the same way that Facebook embraced gaming to extend its social networking reach, it appears to be on the verge of adding a social networking element to the music listening experience and the implications for the industry are enormous.
One need only look to the impact Facebook has had on the gaming industry, where a company like Zynga (game developer that earns revenue almost exclusively through Facebook) went from startup to multi-billion dollar company in less than three years. The success of Zynga and other companies that develop social network inspired and distributed games has led to an enormous flow of capital into the companies that are operating in the social media gaming space, with over $1 billion in funding flowing into these companies in 2010. Facebook's embrace of gaming spawned the birth or rebirth of several companies with near half billion dollar or more valuations including Zynga, Playdom, PopCap, and now hundreds of other startups that took in a record $1.05 billion in funding last year.
Of course, the funding record set in 2010 will likely be exceeded by a substantial margin in 2011 if current trends continue. Facebook's social media gaming became an industry in itself and the companies that were early to the party are now worth hundreds of millions on the low end and as much as $10 billion (Zynga's reported valuation from recent $500 million funding) on the high end. When you consider the far reaching appeal of music generally and consider the fact that 46 of the top 100 pages on Facebook are music related, one gets the sense that music could rival gaming in its ability to get users to interact more and spend more time on the site. We believe such a move by Facebook management reflects this understanding, along with its recognition that an integrated music offering could substantially increase the value of Facebook prior to its IPO next year.
In his GigaOM article earlier this week, Om Malik listed several features that Facebook may be planning, based on its contacts with several music services -
* In the left-hand column, right where Facebook lists Photos, Friends, Places, Groups, Deals, Pages, and Games, you will find a new tab called Music. This tab will show up if a user has listened to music with one of Facebook’s partner music services.
* Clicking on this new tab will open a page called Music Dashboard.
* The Persistent Playback/Pause Button at the bottom of the Facebook page, where currently you have the chat icon. This button essentially is like a quick snapshot and controller of the music experience.
* A page with snapshot of all the songs you have listened to on any specific service and also your top tracks and the number of times you have listened to those tracks.
He also indicated that the music dashboard would offer notifications that show if your friends have listened to songs recommended by you or on your profile, a list of songs heard and recommended by your friends, a list of "Top Songs" from friends, Top Albums from friends, recent listens from your friends, and a "happening now" ticker that shows what is happening in your social and musical universe, including songs that your friends are playing.
While the discussions that have followed the Facebook Music revelations this week have usually included Pandora (NYSE: P), Last.fm and other popular internet radio type services, we believe that the features described necessarily would require "on demand" licensing that allows a listener to choose a specific song to be played, as distinct from Pandora style services' DMCA licensing that restricts the number of times a given song, artist or songs from a particular album can be played within a given time period. While there are certainly iterations of these projected Facebook Music features that could weave in a user's Pandora, SiriusXM (Nasdaq: SIRI) or Last.fm style listening, such features would be very limited in scope under their current licensing and would almost serve to highlight the advantages of using one of the "on demand" services.
Thus, we believe that a Facebook Music offering in any way similar to what is currently being discussed would require integration with the "on demand" streaming music services . This could be a windfall for the companies that already have the necessary US licenses to offer "on demand" music streaming from the Big Four music labels, as Facebook will almost overnight make their services a "must have" Facebook application that could achieve that status virally in a fraction of the time it took for Apple's (Nasdaq: AAPL) iTunes to achieve its lofty status. To say that this would be transformative for these companies would be an understatement and one need only look to the ascension of Zynga and the companies that were early participants of the Facebook gaming phenomenon to understand why.
Given the likely impact a Facebook Music offering will have on building the market for streaming music services, we could envision a scenario similar to what occurred with social media gaming companies evolving, where we begin to see an enormous flow of capital and a huge upward adjustment to the valuations accorded to the players in that space. The one major difference that makes this situation unique and potentially more of a blockbuster for the on demand streaming music companies is that there are currently only five of them and the barriers to entering that space are quite large.
The largest barrier to entering this space is obtaining the necessary "on demand" streaming licenses from the Big Four music labels. It has been widely reported that the European streaming music service Spotify has procured three of the four licenses necessary and that they are aiming for a July launch in the US, but it has taken Spotify almost 2 years past the original expected launch date to get the licensing deals done. Google (Nasdaq: GOOG) reportedly tried for over a year to work out a licensing deal with the labels before walking away and Amazon (Nasdaq: AMZN) found the process so daunting that they are tying to circumvent the process altogether. If some of the most creative minds (not to mention the best financed) in the American industry cannot easily obtain these licenses, it's quite unlikely that we will see a large crop of competitors emerge to fragment the market for "on demand" streaming music.
There are currently only five companies that are operating under US licenses that allow "on demand" streaming and Spotify will likely be the sixth. All of these companies should benefit tremendously as the "buzz" around a Facebook Music offering will likely be a rising tide that raises all ships and even makes consumers that are targeted through non Facebook channels more familiar with and likely to buy into the concept (renting access to all music vs. ownership of a small number of songs). Further, we believe this move by Facebook could create a market for streaming music services that is vastly different (particulary in terms of mass market consumer adoption) than what we see today, and in the process create billions in value for existing streaming music companies. Here is a quick breakdown of each of the six companies, ranked in order of US subscribers -
1) Rhapsody is a Joint Venture between Viacom's (VIA) MTV and RealNetworks (Nasdaq: RNWK) and is generally considered the grandfather of streaming music services because it has been operating a streaming music service for over a decade. Rhapsody is also the largest "on demand" streaming service in terms of subscribers with a reported 750,000, the majority of which it has acquired through more traditional marketing channels. Rhapsody has been slow to offer the more innovative social media integration features that the smaller players in the space have offered. Regardless, the company will be a huge beneficiary of the expansion of this market that we expect to occur with the introduction of Facebook Music and it could not come at a better time as the company is rumored to be preparing for an IPO in the first half of 2012.
2) Napster has the second largest base of users in the US and it is wholly owned by retail powerhouse Best Buy (BBY). Though it will certainly benefit from the industry's rising tide, the lack of social media features and conglomerate speed innovation will likely put Napster lower on the list of who will benefit the most from a Facebook Music service. It has also occurred to us that Napster may be only slightly more popular than the Winklevoss twins down at Facebook HQ (given the Sean Parker factor).
3) Kazaa has the third largest base of subscribers (80,000 range) and among the best social media integrations with features that allow you to follow your Facebook friends or other Kazaa users, see what they are listening to and play songs from their playlists. Kazaa's cutting edge social media offerings and its name recognition (we wonder how many of Facebooks' 750 million users were among the 800 million who downloaded the original Kazaa) give it the potential to be one of the biggest winners of the Facebook Music service.
Atrinsic (Nasdaq: ATRN) acqquired the Kazaa music service recently and it is expected to change its name to Kazaa in a few weeks. Additionally, the company just hired music industry veteran Stuart Goldfarb (CEO who guided the online transition of BMG Music Club and Columbia House) to be Kazaa's CEO and original Skype board member Mark Dyne is Kazaa's largest shareholder and a member of its BOD. Kazaa may benefit from being one of only two streaming music services to be publicly traded (Pandora is the other) and it is the only publicly traded "on demand" streaming music service.
4) MOG - With industry Rock Star David Hyman, a board stocked with industry heavy hitters and a service that offers very competitive social media interaction options, the tiny MOG should be a big beneficiary of Facebook Music. The company does not release its subscriber numbers, but we believe them to be a fraction of the size of Kazaa, Napster and Rhapsody due to the 20112 revenue projections given in its recent funding pitch and industry scuttlebutt that puts its subscriber count at about 20,000. MOG has been front and center as an innovator and is making an aggressive push with auto manufacturers.
5) Rdio - RDIO is like MOG in many respects, though it is perhaps even a step ahead in terms of social media features. Rdio offers all of the social media interaction features of Kazaa, but is even more user friendly for certain aspects (like creating playlists). Rdio has been one of the leading innovators in the space and its highly regarded leadership (CEO Drew Lerner) and backers (Skype Founders Friis and Zennstrom) should push Rdio to the front of any significant industry developments (like Facebook Music) and we expect Rdio to be among the biggest winners.
6) Spotify - last on this last only because it has no paying US subscribers as of this writing, we fully expect Spotify to quickly ascend this list and see it as the most likely to be the "Zynga" of the group, if one such dominant player is to emerge. Spotify already has the largest base of subscribers (1 million as of the last report) of any of the services, though it has only been offered in Europe. Spotify already has significant integration with Facebook for its European subscribers and more importantly, key executives of Facebook have invested in Spotify and many of the early reports about Facebook Music suggested that Spotify might be the only service offered. With its recent round of funding ($100 million) by several very high profile venture capitalists and the media's love affair with the service, we would not be surprised to see Spotify take a disproportionate share of the streaming music market we expect to evolve around Facebook.
Those wishing to invest in this space have very few options. Venture capital funding of the two smaller players MOG and Rdio have already pushed their valuations to the $20 - $30 million range, these valuations are dated and the recent flow of money into the media space generally (ie Pandora's $2 billion+ IPO) suggest that the valuations would be much higher IF there were a public market price available to price the shares. Investors may have an opportunity to get exposure to this space later this year, or early next year, if Spotify and/or Rhapsody move forward with an initial offering, but these will likely be at valuations that fully reflect the value that Facebook Music is creating, although a sub $10 billion Spotify IPO valuation would arguably leave a little left on the table for retail investors (at least according to Daniel Ek's "tens of billions" valuation).
Kazaa is currently the only publicly traded company in the on demand mobile/streaming music space. It is very closely held (the Big 4 Music Labels, insiders and affiliated hedge funds own over 80% of the shares) and there are only 1.1 million shares in its public float. Its currrent market cap ($15m as of the close on Friday) has not grown to match the others in the space, likely due to its lack of recognition (its name change to Kazaa is likely still several weeks away), lack of Wall Street analyst coverage and the fact that it is so small and so closely held that it would be difficult for an institutional investor to build a position that would be meaningful. Thus, the investing options to take advantage of this move by Facebook are few, but it could be quite rewarding tor those who are able to get equity in one of these five players before their valuations reflect it.
In summary, we believe the launch of Facebook Music will be a transformative event for the nascent mobile/streaming music services sector and we expect the existing "on demand" streaming music companies to be the biggest winners. If Facebook indeed takes these steps, it will likely catapult the existing streaming music services like Spotify, Rhapsody, Napster, Kazaa, MOG and Rdio from their current music buff/early adopter user base to a mainstream "must have" application used by millions that could rival Facebook's game offerings as the most used apps on the Facebook platform.
We believe that a Facebook Music dashboard that incorporates the "on demand" streaming music companies will result in a staggering increase in the number of subscribers to those services and possibly make all of them worth a multiple of their pre-Facebook Music valuation, possibly creating the next Zynga or at least several new billion dollar companies.source
Disclosure: I am long ATRN.
Additional disclosure: Author is registered as an accredited investor with Second Market and has made bids to acquire stakes in Rdio and MOG.

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