Inside Spotify: can streaming be profitable?

Spotify’s revenues grew sharply in 2016, but so did its losses. The market leader’s financial statements show how difficult it is to turn a profit in the streaming industry.

By Felix Riesenberg

On Thursday, Spotify released its annual report in Luxembourg. After the first headlines and news stories appeared, the numbers are worth a closer look. The streaming company’s latest filings reveal that its 2016 revenues of €2.9 billion were up 52.1% from 2015’s €1.9 billion — but its operating losses rose 47.9% from €236.3 million in 2015 to €349.4 million in 2016. The company raised $1 billion in March 2016 to fund international expansion and to cover its widening losses. Spotify also corrected an error in accounting that understated losses in previous years.

The results bring up the question if and how Spotify and even other streaming services such as Apple Music, Deezer and Tidal can be a sustainable business? In its letter to the shareholders, Spotify repeated its answer to this question: “We believe our model supports profitability at scale,” it claims. It’s a strategy Spotify founder and CEO Daniel Ek explained back in 2012. “Our focus is entirely on growth,” he told the Swedish newspaper Dagens Industri: “That is priority one, two, three, four and five.”

Five years later, the strategy can be evaluated by looking at the revenue and cost drivers. Spotify generates revenue through two sources: advertising and subscriptions. In 2016, the Swedish streamer made €0.3 billion from advertising and €2.6 billion from subscriptions, up 50.3% and 52.3%, respectively, from a year ago. So it’s fair to say that the streaming business is mainly about the subscribers.

On the cost side, the company’s consolidated accounts reveal that its cost of revenue — primarily royalties paid out to record labels and other music rights holders — rose steadily over the years: €0.9 billion in 2014, €1.7 billion in 2015 and €2.5 billion in 2016. So Spotify paid out 83.9% of its revenue to rights holders, 86.3% and 84.6%, respectively. The simple rule here is: the more the users listen, the more the service must pay. The fact that Spotify pays the vast majority of its revenues back to the labels makes it hard to reach economies of scale.

It’s also insightful to take the user numbers into account. Spotify ended 2016 with 126 million active users, with 48 million of them paying subscribers, representing year-over-year rises of 38.5% and 71.4%, respectively. Cross-referencing that with the revenue figures suggests that in 2016, the minority of subscribers accounted for a 89.9% majority of the revenue.

This point becomes even more apparent when you look at the difference in average revenue per user (ARPU). By 2016, premium users spent €69.43 per year, free users €4.18. But there is also a side effect of Spotify’s growth story. Over the last three years, promotions such as the €0.99 for 3 months or the family bundle not only drove growth, but also reduced the subscriber ARPU. It’s down from €85.46 in 2014. This trend will put an extra economic burden on a business model with thin margins.

Also, it’s fair to mention that 80% of Spotify’s subscribers startet as free users. “Our free service drives our paid service,” wrote Ek in 2014. And so Spotify is willing to take a negative — but not widening — gross profit of about €33 million per year for its free segment.

So when will it be profitable? Since 2008, Spotify has grown fast, but also has struggled to make a profit. The perennial loss-making company has two levers to improve its margins: revenue-wise, the streamer has to win more premium users and cost-wise, to negotiate more favorable license deals with record labels. For example, the two recently signed agreements with Universal Music Group and Merlin Network Group include the flexibility to reduce Spotify’s royalty fees if it meets certain targets for user growth. In a more distant future, the IPO money could enable Spotify to exploit new revenue streams like concert ticketing, music production, services for businesses, expansion to China and India. The question around Spotify and its competitors — except Apple, Amazon and Google with their high-margin core businesses — is whether they can survive long enough to reach scale.