2 Ways Spotify Can Increase Profits
Audio streaming giant Spotify (NYSE: SPOT), has attracted much criticism from investors because its expenses eat away a large part of its income. Since the majority of its revenue costs are paid in royalties to major music labels, Spotify claims a meager gross margin of 25%. However, the platform is evolving, as is the influence of Spotify in negotiations with labels. In the beginning, Spotify needed users and the labels owned the music. Now the labels need to be distributed – and Spotify has the ears.
How much does he pay for the labels?
While the specific contractual terms are complicated and unspecified, record companies, music publishers, and music rights owners receive a royalty from Spotify for letting Spotify stream their content. It has been estimated that 52% of the income generated by each stream is distributed to the holders of specific rights.
This favorable payout rate likely reflects just how much Spotify needed label content when it started out. Without music, Spotify would have had no way of attracting users. But now, from the outside, Spotify’s reliance on label content is diminishing for two reasons: diverse revenue streams and continued growth in user numbers.
Diversified sources of income
Subscription business models can make it difficult to determine why customers are paying for a product. What does the customer really want? Most subscription companies find that answer in their user data – and for Spotify, that user data is moving away from music.
In Spotify’s last quarter, 70.4 million users listened to podcasts, more than double the 34.5 million podcast listeners last year. As investors, we can reasonably assume that Spotify’s recent investments in the podcast space are partly responsible for this 103% increase in podcast engagement.
Much like Netflix, Spotify started out by distributing other people’s content, but as Spotify grew it released its own original and exclusive podcasts. According to the most recent letter to the shareholders of the company, Michelle Obama’s podcast became its best podcast globla in July and August, a sign that the Spotify originals are winning over users. The Joe Rogan Experience Also becomes exclusive on Spotify at the end of this year, and judging by Rogan’s 2019 figures of over 190 million monthly downloads, which have likely increased since then, it should attract a large following with it.
Beyond exclusive content, Spotify is also becoming a major ad exchange for podcasts – this time by acquisition. On November 10, Spotify announced its acquisition of Megaphone, which distributes podcasts on all major platforms and connects podcasters with advertisers, who can insert their own ads into podcasts to better target their marketing. Podcasters have to pay to use Megaphone, creating recurring revenue for Spotify – and recurring revenue from podcasts should help Spotify less depend on costly deals with major music labels to further increase its overall revenue.
With these investments in the podcasting space and user adoption of podcasts as a whole, Spotify’s need for label content appears to be diminishing over time. In turn, its growing global audience should give Spotify greater leverage against labels entering future negotiations, which should help increase its profit margins.
Continuous user growth
Over the past three years, Spotify has increased the total number of monthly active users from 150 million to 320 million. Yet the sheer size of Spotify’s growth is still less impressive than its sustainability. Over the past 11 quarters – every quarter since Spotify went public – the company has seen total monthly growth in the number of active users between 26% and 31% year-over-year.
As Spotify continues to grow, it makes sense for an artist to stay on the platform and irresponsible to leave. Most artists derive the majority of their income from touring or performing. To get the most out of these concerts, artists want their music to be accessible to as many fans as possible. More exposure to listeners means more potential fans who will buy tickets to live events. Avoiding the over 300 million possible fans on Spotify’s platform would make artist income a little harder to find.
What to look for
While long-term margin expansion seems logical for Spotify, it has yet to happen. If Spotify is to keep more of its revenue to itself, it will need a massive user base that listens to more than just music. To see if it can meet that goal, keep an eye on the nominal monthly growth of active users and the percentage of active Spotify users listening to podcasts. While these metrics aren’t perfect, they should give investors at least some clues as to the true worth of the Spotify platform.
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.