Spotify’s Growth Comes At A High Cost [Mark Mulligan]

Alongside the news that Spotify now has more than 140 million active users, came word that it is also bleeding cash as a rate twice a fast as it did just the year before. Analyst Mark Mulligan of MIDiA digs deep into the numbers to learn more.

___________________________________________

By Mark Mulligan of MIDiA

Spotify has published its much anticipated 2016 revenues. Because the company is under so much analytical scrutiny, there is little that is particularly surprising but there is still plenty we can learn from the results:

Growth maintains momentum: Spotify recorded revenues of €2.9 billion in 2016, up 51% from €1.9 billion in 2015. Although that was a lower growth rate in % terms (80% for 14/15), it was a bigger net add in revenue terms (€989 million net new revenue in 2016 compared to €863 million in 2015). Spotify still has some way to go before it challenges Netflix’s $8.2 billion streaming revenue, but it is making clear progress.
Spotify is getting ready for public reporting: The 2016 accounts featured heavy restating of previous year figures and many line items from last year’s accounts were no longer reported. All of which points to an organization getting its reporting structures in place for a public listing of some kind.
ARPU is a mixed story: Spotify’s total monthly user ARPU increased from €1.82 in 2015 to €1.94, driven by a small increase in ad supported user APRU and, more importantly, a higher share of paid users (38% in 2016 compared to 31% in 2015). However, that increased paid conversion has come at the price of lower paid ARPU, with $1 for 3-month trials etc., pushing down paid ARPU from €5.16 in 2015 to €4.58 which in turn is more than an entire dollar a month less than the €5.85 paid ARPU figure Spotify enjoyed in 2014.
Losses are widening again: Spotify reported losses before tax of €539 million against revenues of €2.9 billion (i.e. 18% of revenue). This was up from 12% in 2015 although it had been as high as 17% in 2014. In order to keep up with the market, Spotify is having to spend heavily, and this is all without any major product or territory launch in 2016. You need deep pockets to play at streaming’s top table.
Rights costs may be on a positive trajectory: Spotify’s Cost of Sales (previously reported as Royalty Distribution and Other Costs) were €2.5 billion, or 84.6% of revenue, down slightly from 85.5% in 2015. The shrinking share of the loss-making ad supported user base is most likely the key contributor here. Though the new UMG and Merlin deals will help sustain this path.

In Search Of A MarginSo, what do Spotify’s results say about the economics that we didn’t already know. In truth, not much. The market has lots of growth in it yet; competing is expensive, growth has to be incentivized and rights are the main cost component.As Spotify nears a public listing or an acquisition by Alibaba or Tencent, it remains the benchmark for the health of the streaming economy. With the underlying fundamentals remaining largely unchanged in 2016 despite stellar growth, here are a few thoughts on how the economics of streaming might change:An often repeated argument from record labels is that streaming services will hit profitability when they reach scale. So, when does that happen? 48 million subscribers can lay a good claim to being ‘scale’, but it isn’t driving profit. While the market establishes itself, streaming services have to overspend on product innovation and marketing (and then, later, on user retention). So, these costs will likely rise in relative terms. Meanwhile, rights are always going to remain largely in line with revenue (though the UMG and Merlin deals reward growth with some discounting, which is a welcome innovation). But even these deals will not change the fact that rights will be large enough to challenge margins and will largely scale with growth. Which means no truly meaningful scale benefits. So here are a few alternative ways in which streaming margins might be improved:

Doing a Netflix: Because Netflix owns much of its own content, it is able to use its recommendation algorithms to ensure that content over-indexes, improving margin. It also amortizes costs against those content assets to help it register a profit. Spotify could do the same but is unlikely to do so anytime soon. It cannot afford to antagonize its major label partners, each of whom has a UN Security Council type power of veto (Spotify would falter if any one of them pulled out). Someday, Spotify probably will become a label, though not in the way most people would understand the term. However, it will wait for more scale and confidence before flicking the switch on that strategy.
Ecosystems: Apple has long demonstrated the value of competing right across value chains. Now Amazon is following suit (e.g. Amazon Video covers rights, infrastructure and distribution). Exercising control across the value chain gives a company more places to extract margin. Perhaps Alibaba or Tencent (or some other Chinese giant) could buy a major label and a streaming service? Access Industries is already on this path, wholly owning WMG and more than half of Deezer (though there doesn’t seem to be much in the way of dots being joined yet). And then the wildcard is a streaming service becoming so big that it can buy a major or a collection of big indies. Or of course Apple deciding to any of the above. Should this feel like wild conjecture, do not forget that it was not so long ago when an ISP (AOL) bought WMG, and a water and sewage conglomerate (Vivendi) went on a media company acquisition spree and bought UMG.
Ancillary revenue streams: The most pragmatic solution though is not a silver bullet, but instead a blended strategy of new revenue streams. These can range from B2B (e.g. Spotify selling its data to live companies like Live Nation and AEG to help them get more cost effective with better targeting), through premium user add-ons to new formats such as limited capacity, pay-per-view artist live streams.

Spotify played the starring role in streaming’s biggest year yet and looks well on track to do the same in 2017. But at some stage, the losses need to narrow. The industry needs to help ensure this happens, unless it wants the market to end up being dominated by companies that simply do not have to have streaming turn a profit because they are making money elsewhere.