Spotify’s next challenge: how to turn a profit

In just a few years Spotify has evolved from bete noir of the world’s recording artists to perhaps their greatest benefactor.

Daniel Ek, chief executive officer and co-founder of Spotify. Picture: Bloomberg.

In just a few years Spotify has evolved from bete noir of the world’s recording artists to perhaps their greatest benefactor. The Swedish company transformed the way people listen to music, and got them used to paying for it again after digital piracy had crippled sales. Global revenues from music streaming, which Spotify dominates with 70 million subscribers, more than tripled in three years, to about $US10.8 billion ($13.6bn) last year, for the first time surpassing digital and physical sales of songs and albums.

But if it is earning billions for others, Spotify is losing money for itself — with an operating loss of nearly $US400 million in 2016 — because it pays out at least 70 per cent of its revenues to the industry, mostly in royalties. As it prepares for a listing on the New York Stock Exchange it must convince investors that it has a path to profitability. Some reckon it can find one, but only at the expense of the labels it has enriched: by paying them less in royalties; by getting them (and others) to pay for promotions and data services; and even by competing with them directly, by making its own deals with artists. In other words, Spotify may only be able to make money by reshaping the industry yet again.

The economics of recorded music had shifted twice in the internet era before streaming came along, first owing to illegal file-sharing services such as Napster, then because of iTunes. Retail music sales in America plunged by almost half, from a peak of $US14.6bn in 1999 to $US6.7bn in 2014. Spotify, which launched its streaming application in 2008, was only a minor source of revenue but a major target of artists who believed they would never make money earning a fraction of a penny per song streamed.

But Daniel Ek, the founder of Spotify, has long argued that the virtues of streaming would be manifest only when it achieved scale. That has begun to happen. In addition to Spotify’s subscribers who pay $US10 a month (at least 70 million more use its ad-supported free service), Apple Music has 30 million subscribers and other music services have at least 70 million more. Songs from the most popular artists routinely surpass 1 billion streams on subscription services. On average a billion streams on subscription services brings in about $US7m for big labels, with perhaps $US1m of that going to the artists. Another pot of money goes to songwriters and composers.

With a big lead over its competitors, Spotify has become the industry’s most important distributor. One research firm estimates in the first quarter of 2017 Spotify accounted for 17 per cent of the $US5bn in revenues taken by record labels. That gives it several points of leverage that could help it turn around its losses.

Spotify’s most obvious power is its ability to make stars via its playlists and recommendation algorithms. Spotify has more than 2 billion playlists; most of them are made by users themselves, but Spotify’s own curated lists attract millions of followers. Redburn reckons that up to 20 per cent of streams are via one of Spotify’s own playlists. AWAL, an independent label, says getting on a Spotify playlist boosts a music act’s streams by 50-100 per cent. Spotify would have to be careful how to monetise this clout, lest it be suspected of charging for a place on its playlists.

Another source of power for Spotify is its data, ranging from where songs are listened to most and at what times, to what other acts a song’s listeners will tend to like. Spotify provides a lot of data at no charge to industry players, some of which either it must do (for calculating royalties) or considers wise to do.

Mr Ek says making data freely available helps artists use the platform better, which in turn benefits Spotify. Its data is used by labels, artists and promoters in planning album releases, artist collaborations and concert tours. But analysts believe that, as Spotify gets bigger, it can do far more with its data and extract a good price — from promoters of live events, say, as well as ticket sellers.

The streaming service’s most intriguing point of leverage is that it could use these advantages to become a music label itself, working directly with artists.

Becoming a label will not happen soon, partly because it would infuriate the incumbents who supply most music. But the growth of Spotify’s core business has come at a cost that is hard to ignore. Its royalty payments are a built-in, large expense, and some rights-holders are clamouring for even more. Competition from other paid streaming services mean it is hard for it to raise its own prices. To fund itself, Spotify raised $US1bn in 2016 under terms that allowed two of the lenders, TPG, a private-equity group, and Dragoneer, a hedge fund, to convert to equity at a discount that increased with time, making an early public listing desirable. As long as its losses mount, it will seek other ways to turn a profit.

That threat gives the labels an incentive to accept lower royalty payments from Spotify. They have another reason: Alphabet’s YouTube, which generates far less in royalties than subscription streaming. By helping Spotify, the industry helps itself.

Spotify has indeed negotiated reductions in royalties in the past year, beginning with Universal Music, the largest supplier of music to the service, which reportedly agreed to be paid 52 per cent of revenues, down from 55 per cent. Spotify struck similar deals with the other two big labels, Warner and Sony.

Still, big-label bosses have long been conflicted about the company that changed their industry. Early on they were sceptical about whether Spotify would make them much money. Now they may worry they are creating a future rival, much as the Hollywood studios licensed their content to Netflix. For the first time in 20 years the music industry is growing strongly. The fight for who comes out on top may have only just begun.

The Economist