Spotify UK Earns Revenue, But Will Spotify Ever Be Able to Turn a Profit?

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Image by Anne Thorniley (CC by 2.0)

Is this the good news that Spotify CEO Daniel Ek has been waiting for? Is this enough?

Spotify’s UK company seems to be turning things around for the company. In new filing at UK trading fund Companies House, Spotify Ltd in the UK posted £187.2 million, or $275.2 million, in total revenues for 2015. This is up 18% from 2014, when the UK wing of Spotify had posted £159.07 million, or $233.8 million in total revenues.

The biggest source of revenue for the UK company came in a surprising 44% surge in subscriptions. In 2014, Spotify UK had earned £119m, or $175.2m. This year, subscription revenue was £171m, or $251.6m. Speaking to The Guardian, Spotify UK said,

“This increase can be attributed to the transition from desktop to mobile as today the majority of new users signing up for Spotify are mobile. 2015 was a big year for Spotify and we had some very significant successes. In many ways, it was our best year ever.”

However, advertising revenue took a minor 2% dive from 2014’s £11.09m or $16.3m. This year, advertising revenue peaked at £10.8m, or $15.9m. Therefore, ad revenues were only able to make up 5.8% of Spotify UK’s revenue, down from 7% in 2014. It’s estimated that 90% of Spotify’s income comes from subscriptions, with advertising revenue filling up the rest. The drop in revenue may have come from more freemium users converting to premium.

In regards to its wages, Spotify UK spent £9.35m, or $13.7m. On average, this is around £51,944, or $76,350. Spotify UK staff members also grew from 167 to 180.

Things look absolutely solid until you take a look at royalty payments and distribution costs. The costs of sales surged 20% to £149m, or $181.6m. Thus, Spotify UK was only able to post a total profit of £1.25m, or $1.78m. The company also made a minimum pre-tax profit of £2m, or $2.85m.

There are two key takeaways from the 2015 report to keep in mind ahead of Spotify’s planned IPO.

1. Is Spotify’s freemium model actually hurting its business?

Spotify’s overall revenue improved and more and more users change from freemium models to premium models. Spotify reportedly counts with 100 million users, but less than half that number are actually paying for the service. The rest has to be made up from advertising revenue.

In the UK, 2015 advertising revenue was down, but globally, Spotify’s advertising revenues were actually up 98%. The company only earned $219m from ads.

Last year, Spotify earned more than $2 billion in revenue, notably led by paid subscriptions. Its advertising subscriptions only led to just a little over 10% of its overall revenue. According to some industry insiders, the reason why advertisements bring in so little money is because they’re incredibly cheap. Ads are basically only serving to “annoy” users into premium subscriptions. Spotify is also heavily dependent on the money that it earns from its subscriber base. The less users sign up per year, the less revenue the company earns, and the opportunity for Spotify to turn a profit minimalizes.

According to Business Insider, a successful freemium model has the following characteristics:

• A large free user base

Spotify counts with 100 million users, so there’s no problem with for the first characteristic.

• A low marginal cost to serve each new subscriber

This is one of Spotify’s most notorious problem. Music licensing deals won’t allow companies like Spotify to release how much they have to pay music companies for a single stream. What’s worse, Spotify has been rumored lately to have failed to close a deal with the Big 3 labels, presumably because they want to pay them less. Thus, we have no idea what the true cost for each new subscriber is for Spotify.

• A product whose value to the user increases over time.

With the rise of Apple Music, which has an established reputation, and now Amazon Music Unlimited, what advantage does Spotify offer the competition? Apple Music is aiming to score more paid users with exclusive timed albums. Amazon Music Unlimited is aiming to woo users with Alexa-enabled devices, and its $3.99 a month plan. Spotify has yet to dabble in any sort of exclusivity, though there are strong rumors that point to the contrary. I’ll quote DMN reader Anon.

“One of the strategies that i believe spotify is working on to pull in new subscribers is to add original content. it probably won’t be house of cards style dramatic tv shows,

but if they can offer something no one else can and make it available only on their premium tier, people may just be willing to fork over the monthly fees.

pandora is doing the same with the questlove program and i’m certain apple is on this road to especially considering their recent purchase of carpool karaoke”

2. Don’t expect huge Spotify profits (or any substantial profits at all) due to royalty payments

Now, while Spotify UK’s numbers may initially look good, operating costs and royalty payments actually take overall revenue down to. Despite this, the UK company was able to turn a profit. Last year, Spotify earned a few billion in revenue, yet it’s still posting a profit. Why?

There’s a very real power play going on in the music scene. Music streaming services have actually been a huge source of the music industry’s revenue. In fact, Spotify may be the #2 source of revenue. Take a look at the following quotes:

“Between the two, both iTunes and Spotify pay out roughly the same percentage of revenue to rights holders (iTunes pays out 70% of revenue to rights holders, while Spotify pays out roughly the same percentage of revenue in content costs.”

“Over 23 million people used Spotify last month alone and the service has already been a leading source of revenue for labels in several European countries”

Despite this, however, record labels still demand a huge share of the profits. 15-year veteran of the digital music industry Michael Robertson shared his insight. Once the CEO of MP3.com, he lists eight reasons as to why he believes Spotify will never be profitable.

1. General deal structure: Pay the largest of A) Pro-rata share of minimum of $X per subscriber, B) Per-play costs at $Y per play, C) Z percent of total company revenue, regardless of other business areas

According to Robertson, record labels set the retail price and actual cost per stream, not Spotify. This limits Spotify from actually making a profit, since they have no control over the price.

2. Labels receive equity stake.

Robertson is currently the CEO of now-bankrupt MP3Tunes (thanks to EMI) and radio recording service DAR.fm. He writes that not only do labels set the price, but they also receive partial ownership of the company they’re licensing to. The Swedish Wire backs this claim up, writing that Sony BMG with 5.8%, UMG at 4.8%, Warner Music at 3.8%, and even EMI at 1.9%.

3. Up front (and/or minimum) payments.

No pain, no gain here. As Paul Resnikoff on CNBC’s Closing Bell, a company needs to invest at least $1 billion. Robertson says that these payments actually stifle creativity and innovation in creating business models and services.

4. Detailed reporting, including monthly play counts.

There doesn’t seem to be anything wrong with detailed reports. After all, if you’re an artist, don’t you want to know how many people are listening to your tracks? The problem here, according to Robertson, is that labels make additional demands. They ask for reports unrelated to payment, like overall market share of sales in different categories. He writes,

“The labels effectively offload their business analysis (and the cost of such analysis) onto the music services. I can’t think of another industry where that is standard practice.”

5. Data normalization.

Music streaming services like Spotify have to normalize artist, track, and album names given by one label with those provided by another.

6. Publishing deals.

Did you land a deal with a major label? Great! Now you have to do the same for each publisher. Robertson writes how this process actually works.

“Although you may have the rights to stream from labels, you sometime can’t get the rights to stream from the publisher, or worse, even find the publisher.”

7. Most favored nation.

Robertson states that each major label demands the most favored nation clause to ensure other labels get the best agreement terms possible.

8. Non-disclosure.

Digital music companies are never permitted to disclose their licensing deals. Want to know why Spotify has terrible stream payouts? The legal writing won’t allow them to. If the company speaks about the licensing deal, say goodbye to the deal.