Earlier this week, Macquarie Research analyst Ben Schachter issued a note regarding Apple (NASDAQ: AAPL), outlining the belief that Apple Music will help boost services revenue but not profits because the margin profile of music-streaming services is generally quite slim. The analyst believes that Apple Music has a gross margin of around 15%, an estimate that is notably lower than the 23% to 25% gross margin that market leader Spotify Technology (NYSE: SPOT) is forecasting for 2018.
Beyond profitability concerns, there's some good news. Schachter believes that Apple Music could grow to upwards of 110 million paid subscribers over the next three years.
Image source: Apple.
Apple plays catch-up
Schachter forecasts that Apple Music will grow 40% per year on average for the next three years. Apple Music is now up to 40 million paid subscribers. That compound annual growth rate (CAGR) would make it one of Apple's fastest-growing businesses, at least in terms of revenue. Schachter expects Apple to report services revenue of approximately $8.3 billion for its fiscal second quarter.
For reference, Spotify's full-year guidance calls for paid subscriber growth of 30% to 36%, which would put the Swedish company's paid subscriber base at 92 million to 96 million by year's end. Apple Music's paid subscriber disclosures over time have been irregular, making it difficult to derive accurate year-over-year growth rates. Additionally, the company has been growing off a relatively smaller base, which generally lends itself to more impressive growth rates. That being said, there have been signs that Apple Music's growth rate has been incrementally accelerating while Spotify's incrementally decelerates.
Spotify plays defense
The prospect of Apple catching up with Spotify is a looming risk. Fear of competing with the richest company on Earth could have even contributed to Spotify striking an onerous deal with private bond investors in 2016. That deal certainly influenced its decision to go public via a direct listing instead of a traditional IPO.
Spotify has a notable advantage over Apple, though: its free, ad-supported tier. While the free service draws ire from the music industry, it serves as an important way for Spotify to address emerging markets while converting many of those free users into paid subscribers over time. The company is expected to be unveiling a revamped version of its free tier next week that could accelerate growth of free users, effectively filling the pipeline of prospective paid subscribers.
Remember that the overall market for music streaming is growing, benefiting both Apple Music and Spotify. This isn't zero-sum competition we're talking about. It's the future of the music industry.
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Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.