Spotify’s Operational Playlist:
Ambiguous Profitability and Surging Popularity
Last month, Ed Sheeran’s new album (Divide) debuted on Spotify’s free music-streaming service. Aside from breaking and setting multiple streaming records (highest number of first-day streams, single-day streams, and most-streamed artist over the course of a single day), Divide also helped Spotify maintain its overwhelming popularity as a top on-demand music streaming service.

Spotify currently has over 100 million active users worldwide. Between March of 2016 and the same month in 2017, the Sweden-based service gained 20 million paying subscribers, nearly doubling its total subscriber base from 30 million to 50 million. In a business environment where other music streaming services like Soundcloud and Tidal are dropping like flies, Spotify seems infallible. Its popularity and revenues are increasing each year: in 2015, it reported $2 billion in revenue, its highest earnings ever. This is, of course, good news for its users, who are primarily students and young adults, as the service offers unlimited free streaming with ads.

Spotify’s surging popularity and earnings are belied by a mix of financial issues, however. For one, Spotify has never seen a profitable year. Although its top line (referring to the first line on a company’s income statement, the revenue line) has seen tremendous growth each year for the past few years, its bottom line (the last line on an income statement, the net income after costs and taxes) has been consistently negative since the company’s founding in 2008. As Spotify’s subscription fees and advertising income — its two main sources of revenue — have grown, its costs and spending have increased in greater measure. According to the Financial Times, Spotify’s 2015 revenues went mostly to paying labels and artists in the music industry for rights to stream their songs. The few hundred million dollars of remaining revenue went completely towards new aspects of Spotify’s service, such as the Discover Weekly feature.

Another issue Spotify faces relates to the royalties it must pay to artists and their labels for streaming their songs, as well as the distribution rights to albums and singles. While Spotify’s royalties — which currently operate on a per-stream basis — vary from artist to artist, the average royalty currently sits at $0.007 per stream. Even though some artists’ songs are streamed millions of times This doesn’t seem like very much in the first place, and for many artists, the portion of the royalty that actually ends up in their pockets is much smaller, since the royalty is paid to the label and the label is the actor that determines how much the artist ultimately receives.

The royalty rate, which despite being so low is Spotify’s biggest cost, is part of the reason high-profile artist Taylor Swift pulled all of her music from Spotify in late 2014. In an interview with Time, Swift indirectly cited the low royalty rate for her decision to sever business ties with Spotify’s platform: “I think there should be an inherent value placed on art. I didn't see that happening, perception-wise, when I put my music on Spotify. Everybody's complaining about how music sales are shrinking, but nobody's changing the way they're doing things. They keep running towards streaming, which is, for the most part, what has been shrinking the numbers of paid album sales.”

This creates quite a dilemma for Spotify, as partnering with high-profile artists such as Taylor Swift is what attracts users and subscribers to the service, as well as increases the number of profitability of ads played on Spotify’s service to free users. If Spotify attempts to win back Taylor Swift and attract more high-profile artists, it would have to increase the per-stream royalties it pays to music labels. This would heavily increase the total royalty costs, which already wipe out most of its yearly revenues. However, the cost-cutting option, which is to maintain or even lower royalty fees, would certainly conserve revenues at the risk of losing more artists to higher-paying services such as Apple Music or Rhapsody.

At the end of the day, profitability is Spotify’s primary goal. In an effort to increase revenues from paying subscribers, the music streaming service recently struck a deal with Universal Music Group (UMG) that would allow Spotify to delay the release of new albums by UMG artists on its platform to free users by two weeks. As Universal Music Group is the umbrella corporation that contains the labels of artists such as Kanye, Adele, and Coldplay, this deal would understandably entice free users to purchase Spotify’s premium subscription plan in order to gain instant access to new album releases, thus increasing Spotify’s revenues. This deal also allows Spotify to lower royalty rates for streaming material by UMG artists, thus saving some of Spotify’s costs.

The logical next step for Spotify to raise revenues and increase profits, however, would be to issue an initial public offering (IPO). This would allow public investors to buy shares of Spotify stock on the public stock market, thus giving Spotify more working capital. However, Spotify has not given any concrete indication that it is headed towards an IPO.

Instead, the service has hinted at a direct listing of public stock (a Direct Public Offering), which is not underwritten by investment banks. This means that the initial stock value and public valuation of the company will not be determined beforehand, as in the case of an IPO. In a direct listing, the stock price is determined organically by supply and demand after the company goes public, thereby eliminating the middleman and all of the associated costs of having its public offering underwritten.

However, even if Spotify opts to go the route of a direct listing as opposed to an IPO, when that may occur is still unclear. Spotify has the incentive to do it sooner than later: in order to fund its over-budget activities, Spotify raised over $1.5 billion in debt financing from investment firms Goldman Sachs, Dragonner, and TPG. Per the terms of this agreement, the interest Spotify will pay on this debt will start at 5% and increase by 1% each year until Spotify goes public. The longer the company waits to go public and remains in the private market, the greater the cost of the debt financing in the long run.

All of this paints a very ambiguous picture of Spotify’s financial situation and future. On the one hand, the company has never seen a profitable year, has gone into debt to fund its operations, and is far from going public. On the other hand, its popularity is exponentially increasing, with the number of both free and subscribing users rising, and investors continuing to purchase equity (shares of the company on the private market), resulting in an equity value of over $8.5 billion. This situation exists in a declining music streaming industry that is coming to be dominated by Spotify, along with Apple Music and Google’s Amazon Prime Music, with all other services either falling out of mainstream use or being acquired by other companies.

When asked why investors keep investing in Spotify, despite no sign of profitability in the near future, Chicago Booth School of Business professor and Princeton Financial Accounting professor Roman Weil cited Amazon’s early stages as a parallel for Spotify’s current situation. “Having negative income for 20 years in a row is not a barrier to big valuations,” Weil said. Amazon had its first profitable year in 2004, a full decade after it was first founded, and yet it was wildly successful even when it was losing more money than it was bringing in. “Meanwhile, it’s gotten to be almost as viable as Apple, because people like its business model.”

In other words, Spotify will continue to be viable, despite its negative profitability and the changing music streaming landscape, just because it is such a universally well-liked and user-friendly streaming platform. What this means for its users, most of whom are high school and college students and not gainfully employed, is that their favorite music streaming service will continue to exist, but that the free user experience may no longer be as satisfying as it once was. Premium subscriptions, which may become more appealing for all of their perks, are still a significant cost for those not earning income, and may turn users off from Spotify in favor of services with lower costs. For example, Amazon offers several different subscription plans that range from free for Amazon Prime users to $10 a month for non-Prime-account-holders, the same price as Spotify’s subscription.

At the end of the day, in Spotify’s quest for profitability, it’s lowering expenses by indirectly raising costs for free users. Whether this means more users will buy into this plan and purchase premium subscriptions or users will leave Spotify in favor of cheaper alternatives remains to be seen.

  • Richard

    I agree. A wise businessman in the Caribbean named Sir Kyffin Simpson always said that the key to success is progression and humility, and clearly he’s done very well for himself as a self made man!

  • John Andrews

    The Airgain IPO launches this week, and they’re a one-brand company.

    Some investors don’t think it’s a good stock though:

    http://seekingalpha.com/article/3997291-risky-signals-antenna-maker-airgain-launches-ipo

  • Cincinnati World Cinema

    Well said, Joe, and worth rereading on a regular basis! Another advantage of small-to-midsize city living is pace and competition. Living in NYC, LA and SF entailed a hectic pace, hallmarked by capital S striving, as one realized there were a ton of others doing what I do. Spending so much time in one’s car in SoCal meant much less time for quality pursuits and pleasures. A smaller pond with relaxed pace allows one to savor life and special moments.


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