How Much Do Spotify And Record Labels Still Need Each Other?

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Ryan Snook
                

Growth is great, but what else should Daniel Ek & Co. do in order to get in the black?

So far, Spotify's relationship with the recording business has resembled many marriages, says MIDiA Research managing director Mark Mulligan: A passionate honeymoon, followed by a series of arguments over which partner is in charge, and then a realization that both depend on each other.

From the outside, things look great. Spotify announced in January that it has 70 million subscribers worldwide, and the U.S. recorded music business grew 17 percent in the first half of 2017, compared to the same period of the previous year.

Does that mean they'll live happily ever after?

Not necessarily. Spotify's upcoming public listing -- the company filed on February 28 to list its shares directly on the New York Stock Exchange and investors expect shares to begin trading as soon as March 26 -- "is the moment when the kids leave home," says Mulligan. "Until now, they had to be together. Now they have to decide if they want to be."

Spotify depends on the major labels to supply most of the popular music that it streams, and it's hard to imagine that changing in the foreseeable future. But soon the company will no longer depend as much on the major label goodwill it needed to ensure its stock listing goes smoothly. (Spotify's direct listing won't generate the capital of a traditional public offering but it will allow investors -- including the three big record companies who each own about a 5 percent stake - to cash out.)  Now the scrutiny it will receive as a public company will give it an incentive to focus on profitability: The company's filing with the Securities and Exchange Commission shows that in 2017 it brought in $€4.1 billion ($5.1 billion) in revenue, with a loss of €1.2 billion ($1.5 billion). That could mean aggressive cost cutting ahead.

"The music streaming business is a tough business to make money in," says Gene Munster, a partner at venture capital firm Loup Ventures. "Most of the $10 a month consumers spend goes to the labels and artists." Although the long-term deals Spotify signed with the major labels last year improved this somewhat, the company's path to profitability still concerns investors.

Spotify will have a hard time raising prices while the streaming business is growing and it's competing for subscribers with Apple and Amazon, which can afford to lose money on music. "In order to find a path to profitability, Spotify needs to either cut its costs on music, by acting as a label, or find other sources of revenue, like ticketing or merch," says Duncan Davidson, a general partner at Bullpen Capital who previously worked at digital rights management firm Intertrust Technologies.

Spotify has been compared to Netflix, which faced similar pressure on margins from movie studios and improved its finances by creating its own content. Unlike Netflix, Spotify wouldn't even need to get exclusive rights to content, since it doesn't need to grow faster – just reduce costs. "Spotify just needs to show that it can break artists," Davidson says, in order to make its own music popular enough to reduce its costs and gain some negotiating leverage with labels.

Spotify may be hinting at this idea in a letter from chief executive Daniel Ek included in the company's filing. "Today, artists can produce and release their own music," Ek writes. "Labels, studios, and radio still matter, but in a cluttered landscape, artists' biggest challenge is navigating this to get heard. We believe Spotify empowers them to break through."

That's not the kind of talk labels have usually heard from Spotify. "Ek is sending slightly contradictory messages," Mulligan says. "He's saying that he's there as a trusted partner for the labels but potential investors aren't interested in that, and he has to try to persuade them that he can disrupt the music business."

Can he? Like Netflix, Spotify is a technology business darling, with enough market share to challenge established entities. But the music business is dominated by fewer large companies, and Spotify seems to be far more dependent on catalog than Netflix (which doesn't share viewership data). "If Spotify does create its own content," Mulligan says, "it will have to do it in a slow, almost sneaky way."

The company could be doing this already. Some of Spotify's popular relaxation playlists are already dominated by acts that can't be heard on other streaming services, although the service has said it has no direct involvement with this. But rather than risk alienating its major label partners, Spotify could instead focus more on other kinds of high-margin content, such as podcasts.          

"Everyone is focused on how music streaming platforms aren't profitable, but Spotify has a huge audience with a high level of customer satisfaction and engagement," says Russ Crupnick, managing partner for MusicWatch, a consultancy that provides syndicated research to labels and technology companies including Spotify. "So the question is, what can they add to the service that's a higher-margin product than music streaming as we know it? It could be a platform for podcasts, for audiobooks, or for video. Instead of focusing on what the business looks like today, the question should be, 'what does Spotify look like three to five years from now?"

This article originally appeared in the March 10 issue of Billboard.


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