How Spotify Can Compete With Loss Leaders
Music streaming has been the growth engine behind the resurgence of the music industry over the past decade.
Last year, the number of songs streamed by U.S. consumers topped 1 billion for the first time, climbing about 30% from 2018, according to data from Nielsen Music.
This trend has not gone unnoticed by several large tech companies, including Apple, Alphabetis Google, and Amazon. All three have launched services to compete with one of the early entrants into the on-demand streaming space: Spotify (NYSE: SPOT).
But what separates services like Apple Music, YouTube Premium, and Amazon Music Unlimited from Spotify is their connection to much bigger, more profitable companies. In other words, Spotify’s competitors can afford to operate their music streaming services as premium products to support their core businesses; Spotify must make music streaming profitable.
But with big competitors poised to take losses, consistent profits can be a “pipe dream,” says Benjamin Black, analyst at Evercore ISI.
While Spotify recorded a surprise profit in the third quarter, management expects a return to operating losses in the fourth quarter, despite proven operating leverage and expected growth in paid listeners.
Indeed, if Spotify intended to simply stream music, profitability would surely never come, as negotiations with labels would hit a wall no matter how many listeners the streamer racked up.
Spotify’s path to profit requires it to create products and services that leverage its vast network of creators and listeners. Here’s what he’s already doing.
Building the two-sided market
On Spotify’s Investor Day in March 2018, before its IPO, management outlined their idea of a two-sided market. Spotify intends to use its scale to foster greater artist discovery and allow artists to connect with more fans.
Spotify’s main market offering is Spotify for Artists, which provides analytics, identity management, and promotion tools for musicians on its platform. Spotify said 465,000 artists were using the platform at the end of the third quarter, up 365% year-over-year. Artists using the platform represent 80% of listeners on Spotify.
Eventually, Spotify for Artists could allow many musicians to find an audience without needing a label. The value that record companies provide to musicians is promotion and distribution, and Spotify for Artists makes it much easier to do this without a label thanks to its massive audience and ability to bring new music to these listeners.
Playlists curated by Spotify account for around 15% of total listening on its platform. The company could use these playlists as a platform to feature independent artists who use its Spotify for Artists platform without a traditional label. This should increase the profitability of Spotify and the Creators.
Other recent products on the marketplace include Sponsored Recommendations, a cost-per-click advertising product that leverages Spotify’s targeting capabilities to present new music to listeners. Most notably, it is an advertising product that works for both paid and free listeners.
Additionally, Spotify recently acquired SoundBetter, an audio production market. SoundBetter connects studio musicians, producers, sound engineers and other music professionals to collaborate.
Spotify acquires and builds ancillary products that complement its existing user habits. Users love to receive recommendations for new music – Spotify for Artists and Sponsored Recommendations monetizes this behavior. This will lead to better margin expansion than renegotiating agreements with record companies.
Don’t forget podcasting
Spotify became the # 1 podcast listening platform in 2019, overtaking Apple podcasts and Google Podcasts. That said, podcasting remains a bigger cost to Spotify in the short term than a source of revenue. Investments in technology and original content have put pressure on gross margin over the past year.
CEO Daniel Ek said 2020 will be the year the company starts exploring ways to monetize podcast listening more directly. The company unveiled its first step toward that end at CES earlier this month, showcasing Spotify Podcast Ads. The product programmatically inserts advertisements into podcast feeds, in the same way that it inserts advertisements between songs.
Theoretically, the new product should provide better monetization for podcast creators compared to the hard-coded ad copy included in most podcasts. Additionally, it should make it easier for smaller podcasters to monetize their product without the demands of a large audience for direct sales.
It’s important to note that podcast ads, like Sponsored Referrals, are an advertising product that reaches both free and paid listeners, thereby monetizing the entire Spotify audience.
Spotify’s business is not based on getting better deals from record companies in order to increase gross margin. Great technology companies it’s competing to prevent that, as record companies now have several popular options to compete with the streaming leader.
Instead, Spotify is expanding its products to make it easier to produce, consume, and monetize content for everyone on its platform, and that’s where it will unlock profits.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.