Spotify In the Black: What Would a Profitable '19 Mean for the Streaming Giant -- and Can It Keep It Up?

After a decade of chasing growth at the expense of profits, Spotify may have turned the corner in the third quarter of 2019.

For years, music and technology executives have wondered how a standalone streaming service can turn a profit. If so, how big must it become? In the case of Spotify, the answer is revenue of $1.92 billion in one quarter and $5.44 billion over nine months.

In the third quarter 2019, the music streaming giant turned a $60 million operating profit on $1.92 billion of revenue, and has eked out a $4.4 million operating profit over the first nine months of the year. Investors were impressed by financial gains, subscribers growing to 113 million and monthly active users reaching 248 million. Spotify's share price jumped 19% on Oct. 28, adding $4 billion of market capitalization -- even as its shares still trade 16% below the price at which it debuted on the New York Stock Exchange in April 2018.

The earnings release recalled The Smiths' song "How Soon is Now?": "When you say it's gonna happen now, when exactly do you mean? / See I've already waited too long." Both the industry and investors may feel profitability has come too slowly, but it has seemed inevitable. Spotify has improved its financials each year, one plodding step after another: in 2015, its operating loss was 12.1% of revenue. It improved to 11.8% in 2017, 9.2%; and 5.3% in 2018. Then, in the first nine months of 2019, Spotify's operating income -- not loss -- was 0.1% of revenue. That's a small win that shows what tech companies are supposed to do: scale the business until revenues cover both unavoidable costs (rent and content, for example) or more flexible spending (salaries, sales, marketing, office supplies, et al).

Spotify's income statement shows consistent improvements in three main expenses: sales & marketing; general & administrative; and research & development. Two years ago, those three buckets accounted for 36.6% of revenue. A company that pays content owners anywhere from 70%-75% of revenue can't spend another third on salaries, marketing, development and the like -- the numbers don't work. But by the third quarter of 2019, those three buckets accounted for 24.8% of revenue -- just enough to pay for recordings and songwriting and have some money left over.

Can Spotify maintain the momentum? Sustained profits would have major implications throughout the music industry. Spotify would have proven the business model of a scalable, global music streaming company. For a change, a streaming service wouldn't be buried in digital music's graveyard along with barely-known startups and admirable attempts by the likes of Samsung, Microsoft and Nokia. What's more, labels and publishers would have proven their "bend, don't break" strategy. Rights holders' royalty demands are financially draining. The few strongest companies, such as Spotify, survive by collectively pouring hundreds of dollars into developing a killer product and building a global infrastructure.

Over a decade after its 2008 launch -- even in its current profitability -- Spotify is still in growth mode, the phase when a streaming company spends more on expansion than it receives from a subscriber. Customer acquisition and market share are the main concerns here. Revenue growth is an important metric, too. But profit can be sacrificed in order to outgrow competitors and build a base of satisfied, long-term customers. While in growth mode, a company can generate only so little money from a customer. Licensing contracts with labels tend to have minimum guarantees -- a label receiving a fixed percent of revenue can let average revenue per user fall only so far.

There's a catch, of course. Spotify has spent billions of dollars just to get a whiff of a breakeven point. It has accumulated a deficit of $2.78 billion while spending hundreds of millions acquiring companies and talent. New features are rolled out at a steady rhythm. The marketing spend is enormous. Engineers -- which aren't cheap -- represented "a significant portion" of Spotify's roughly 3,700 full-time employees as of Dec. 31, 2018. And there's no guarantee Spotify can sustain profits.

When it comes to Spotify, Wall Street has more bulls than bears. Of the 22 analysts covering Spotify, 13 have "buy" ratings and only two have "sell" ratings, according to MarketBeat. After earnings were released Oct. 28, two analysts raised their price targets (one from $185 to $195, another from $160 to $170). In a report titled "Don't Call it a Comeback," Morgan Stanley analysts wrote that Spotify's potential to become the market leader "are not even close to being priced in." On the flip side, Evercore analyst Kevin Rippey called the quarter a "relief rally" and reiterated his belief that Spotify is a "loss-leader" facing competitors that lack an equal profit motive.

Some things Wall Street says about a company can have narrow interpretations. An analyst's price target is merely a benchmark for investors. A "sell" rating is relative to the current price. A company could be accurately and fairly valued at $80 per share. If the price sits at $90, a "sell" rating doesn't mean the company's in trouble; it simply suggests investors should sell shares sooner rather than later. The share price itself is the major statement. It carries expectations about continued user growth, revenue gains, market leadership, improved margins and future earnings. If Apple and Amazon grab more market share than expected, if Spotify revenues and earnings disappoint, then expectations falter and the share price will fall.

The coming holiday season will be a test. The same model that weeds out weaker companies also encourages business models that don't focus solely on music. Amazon's e-commerce dominance helps its music streaming services. Apple Music has the advantage of popular Apple phones and smartwatches. Google has the benefit of being ubiquitous. All three integrate music into the voice-activated smart speakers. Spotify has only short-lived partnerships and promotions.

The big question is what happens in 2020 and beyond. Streaming companies are riding a wave created by cultural and economic shifts. High-speed internet is turning traditional cable bundles into relics from legacy companies; in the U.S. AT&T's cable business lost 1.2 million accounts in the third quarter. Consumers want to choose what and when they watch. But it's a crowded market. Market leading Netflix already faces Amazon, Hulu. Disney, HBO and NBCUniversal are prepping their own video on demand services. In the same vein, on-demand music eats into radio's dominance. As Spotify CFO Barry McCarthy posited during the earnings call, "streaming wins and linear dies." Although Spotify enjoys market leadership today, can it defend its market share against able competitors? "It's our game to lose," McCarthy said.

Looking ahead to fourth-quarter earnings, will Spotify suffer from a sophomore slump? That's the name given to a second album whose sales disappoint after a successful debut. An operating profit in one quarter, and in a nine-month period, is a good start. But Spotify must deliver a meaningful follow-up. Given the trends, a string of good releases looks possible.

This article originally appeared in the Nov. 2 issue of Billboard.