Business

Spotify Saved Music. Can It Save Itself?

Investors are about to decide whether it matters that the most popular music streaming service doesn’t make any money.
Photographer: SCOTT GELBER FOR BLOOMBERG BUSINESSWEEK

Daniel Ek, Spotify Technology SA’s co-founder and chief executive officer, was in a celebratory mood on Feb. 28, the day his streaming music company filed to go public on the New York Stock Exchange. And like any modern CEO with faith in technology to reorganize the world, he celebrated by threatening anyone who stands in his way. Spotify, he wrote to investors, will render record labels and publishers obsolete by connecting artists directly to fans. “The old model favored certain gatekeepers,” he said, but today “artists can produce and release their own music.”

Ek, 35, started Spotify in 2006 because he thought he could stamp out the piracy that had ravaged the music business. He was right. Total global music sales have grown three straight years after a 15-year decline. More than 70 million people now pay Spotify an average of about $5 a month to access 35 million songs, plus playlists and podcasts. In private transactions, investors have valued the company at more than $20 billion, a market cap many analysts expect Spotify to justify when it lists its shares on April 3.

There’s only one small flaw in the business model: Spotify doesn’t make any money. The service has reported higher losses in three consecutive years despite quadrupling sales. It’s hard to be profitable when music-rights holders collect more than 75¢ on every dollar that comes in.

Daniel Ek, chief executive officer and co-founder of Spotify.
Photographer: Akio Kon/Bloomberg

Investors weighing whether to bet on Spotify need only look at the chorus of predecessors that tried and failed to meet the same challenges. Pandora Media Inc. hasn’t been profitable in six years as a public company. Deezer SA, a European service once seen as a Spotify rival, called off an initial public offering in 2015. If you don’t remember Grooveshark, MOG, Songza, or Rdio, it’s because they shut down or were bought by larger companies. Meanwhile, the tech giants don’t mind losing money on music if it helps sell other stuff: Apple Inc. doesn’t care what it pays the industry as long as Apple Music moves iPhones.

Ek has to improve gross margins for Spotify to survive on its own. With the scrutiny of public markets a couple of weeks away, he’s been visiting executives at the three major music companies—Sony Music Entertainment, Universal Music Group, and Warner Music Group—to propose more Spotify-friendly arrangements, say executives at those companies, who declined to be identified. But Ek may need to crank it up to 11. Matt Pincus, founder of Songs Music Publishing, says Spotify has to be “at such a scale that they can shove it down the music industry’s throat.”

The Stockholm-based company’s pitch to investors hinges on that word: “scale.” More than 1 billion people worldwide have their credit card information on their smartphones, and many are just waking up to the appeal of paid music services. Spotify is the dominant player, with as many subscribers as all its competitors combined. “We’re just in the second inning of this game,” Ek said at an investor presentation on March 15. “Spotify is a lot bigger than you thought, and the opportunity ahead is much, much greater than you realized.”

To convince Wall Street, Ek hired Barry McCarthy, the finance whiz who taught investors to love another subscription service. McCarthy was chief financial officer of Netflix Inc. when it went public in 2002. He’s also the chief advocate for Spotify’s unorthodox path to public markets. The music service is eschewing a conventional IPO, in which companies issue stock to raise money, and instead is letting existing investors sell their shares directly to the public. The unusual approach has led to much debate about whether others will follow. The way McCarthy sees it, Netflix was a fledgling DVD-by-mail business when it went public, and it needed an IPO to raise enough capital to fight the Establishment (Blockbuster, R.I.P.). Spotify is an international brand and already generates enough cash to keep the lights on.

If Pandora is the worst-case example for Spotify, Netflix is the best case and the comparison McCarthy is eagerly making. Investors have overcome concerns about Netflix’s spending—it budgeted at least $8 billion for programming in 2018—because more than 100 million people around the world pay about $9 a month to be part of the binge-watching revolution. The company is valued at more than $120 billion.

Like Netflix, Spotify has created an on-demand alternative universe. It knows what you listen to, when, and for how long. It processes that data to churn out custom mixes such as Discover Weekly, a collection of songs from bands you haven’t heard and deeper cuts from those you have. Spotify’s premade playlists account for about 30 percent of listening on the service, which gives them the power to make careers. Irish singer-songwriter Dermot Kennedy was playing the streets of Dublin until he got on more than 500,000 personalized Discover Weekly playlists. Now he tours the world.

Yet unlike Netflix, which produces original TV shows and movies, Spotify insists it doesn’t want to make music. It seeks to emulate another tech giant, Facebook Inc., and serve as a platform for content others create. McCarthy was brought in because he’s one of the only CFOs to successfully guide a subscription service to the market. He left Netflix before it started making original series.

Record labels, of course, would revolt if Spotify competed for talent. As it is, the company’s last round of negotiations with the industry dragged on for two years, the same length as the compromise deals eventually signed, which expire in 2019. Spotify gave labels more control over what music was offered free to the 90 million users who don’t sign up for the paid service, and the labels agreed to take a smaller cut of sales. These terms have improved Spotify’s margins, but rate cuts accomplish only so much.

So the company is looking for alternative ways to cash in. Artists use its data to plan album releases and its marketing to reach new fans. In his visits with music executives, Ek has floated the idea of charging for this service or asking for a share of the dollars the acts make that Spotify can link directly to its promotions. This might be a hard sell. Dozens of artists, including Taylor Swift and Radiohead’s Thom Yorke, have criticized the service for devaluing music—though Swift made her latest album, Reputation, available. Representatives for Tom Petty and Neil Young are suing the company for not paying them. Spotify acknowledges not compensating some artists and is working to settle outstanding disputes ahead of its public debut.

Spotify has also dabbled in new businesses, such as podcasts and videos, that labels don’t get a cut of. And it encourages artists to sign with publishers, including Kobalt Music Group Ltd., which collect a smaller share of royalties. “Spotify is a good thing for the music industry,” says Willard Ahdritz, CEO of Kobalt, which represents acts such as Beck and De La Soul. “I’m embarrassed by how badly the music industry has treated Spotify.”

In 2012 the Red Hot Chili Peppers signed an exclusive distribution deal with the company. It’s since stopped pursuing such arrangements and has focused instead on creating tools and services that enable musicians to bypass labels altogether. In Spotify’s thinking, the cost of production is so low that artists don’t need record labels, whose marketing and distribution support isn’t as important in today’s decentralized model as it used to be.

The bigger Spotify gets, the more critical it becomes to the music industry’s bottom line—and the more leverage it has. It’s so important to artists that only a couple, including Jay-Z, still avoid Spotify (they don’t like that it has a free tier). Concern about the service’s growing power is pushing the industry into alliances with the tech giants that the labels normally distrust because they want a battle royal: The more rivals, the less power any one of them has.

Ek is optimistic. “The music industry today is quite inefficient when it comes to breaking artists, when it comes to promoting and marketing artists,” he said at the investor presentation. “There is a tremendous opportunity in connecting these 3 million artists we have today with these 160 million-plus users that we have.” The question now is whether investors think he can do that and how much profit he can wring out each time he does.
 

 

    BOTTOM LINE - Spotify sees itself as the next Netflix, but unless it finds a way to improve margins, it could wind up as the next Pandora.
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