Spotify's Uphill Battle Against Royalty Costs

Despite reporting third quarter results that were largely in line with or even ahead of expectations, Spotify’s share price dropped by more than 6 percent in the aftermath of its earnings release on Thursday. The drop was largely driven by fears of slowing user growth and the company’s plans to “accelerate the pace of investment in R&D and Content in 2019”, which would likely reduce operating margins for the “foreseeable future”.

Like all streaming companies, Spotify is facing an uphill climb towards profitability as it needs to find a way of maximizing revenue while keeping content acquisition costs at bay. For every song a user streams on Spotify, the company must pay a certain amount to the record company owning the rights to that song. While the rate per individual stream is very small (so small that many artists feel treated unfairly), the costs quickly pile up when millions of users stream billions and billions of songs. In the first nine months of 2018, Spotify’s cost of revenue, consisting primarily of royalty payments to record companies, amounted to $2.8 billion or roughly 75 percent of the company’s revenue. While that is already a significant improvement over past years, it still leaves just 25 percent of revenues to cover all other expenses (including sales and marketing, research and development as well as general and administrative costs), making it incredibly hard to turn a profit.

Netflix has solved that riddle by producing more and more original content and bowing out of unprofitable licensing agreements with movie studios in order to improve its margins. The world’s leading video streaming company had a gross margin of 40 percent through the first three quarters of 2018, up from 24 percent five years earlier. Unfortunately for Spotify, this model isn’t easily converted to the music streaming business, where users expect to find all music past and present instead of a selection of original content to choose from. Instead, Spotify needs to constantly negotiate with record labels in order to improve its licensing terms and bring down content costs. The company reached new agreements with Universal Music Group, Sony Music Entertainment, Warner Music Group and others last year, but it remains to be seen whether these agreements will be good enough for Spotify to actually turn a profit anytime soon.