Business Matters: Spotify's 2012 Revenues More Than Double, Net Losses Increase Indicating Workable Business Model

Spotify, the world's largest music subscription service, more than doubled revenue in 2012 to over $573 million. Although the company lost slightly more money than it did in 2011, there are signs its business model can be sustainable. Numbers from the company's financial statements, filed in Luxembourg, were reported Wednesday by the Financial Times.
Revenue grew 128% to $573.1 million (€434.7 million) in 2012 from $246.7 million (€190 million) in 2011. The company's growth continued to drag on the company, however, as net loss increased to $77.4 million (€58.7 million) from $58.8 million (€45.4 million).
The fact that Spotify's loss deepened as revenues grew mightily is sure to raise eyebrows. Critics say the company's business model is unsustainable. Some artists are unhappy with the royalties they receive from the company. The same complains are frequently levied against Internet radio service Pandora. Like Spotify, Pandora regularly loses money as it gains market share.
But the numbers indicate Spotify's business model could work. For this to happen, the company must be able to operate on whatever is left after paying rights holders. As Spotify generates more revenue, and as its business model takes shape, it will keep a greater share of its revenue. Indeed, cost of sales fell to 83.5% of revenue in 2012 from 97.7% in 2011. This means Spotify kept more of every dollar it generated last year to cover salaries, I.T., marketing and other corporate expenses.  
The improvement in cost of sales should come as no surprise. As I pointed out in October, Spotify U.K.'s cost of sales declined to 85.7% of revenue in 2011 from 102.6% of revenue in 2010. That's a sign the business model had evolved in one particular market and could evolve in other markets, too.
These new financial numbers show aggregate results and don't offer a clear picture of the service's success in any one market. Instead, they are a composite of many different markets in which Spotify launched at different times. Spotify is strong in Sweden and Norway, where it has been available for over five years, and the Netherlands, where it launched over three years ago. It is less mature in the U.S., where the service launched in July of 2011. Australia and New Zealand are included in these numbers even though they didn't get Spotify until May 2012.
It stands to reason that Spotify's business model will appear in better shape as the company spends more time in each market. Its freemium business model allows free listening in order to encourage paid subscriptions. Early years may not be profitable, but the model should gain momentum and, if consumer adoption is high enough, allow for profitable operations.

Expect even more growth in 2013. CEO Daniel Ek has publicly stated Spotify expected to pay out roughly $500 million to rights owners in 2013. If gross margin (sales minus cost of sales) improves five percentage points to 78%, $500 million paid to rights holders would imply total revenue of roughly $850 million, up 47% from 2012.