After driving streaming music's rise, Spotify cashes in

After driving streaming music's rise, Spotify cashes in

Back in Spotify's early days, when the company was just a dozen people in a small office in Stockholm, Daniel Ek, a co-founder, liked to compare it to Apple and Google. It was 2008, and the traditional music industry was collapsing. Yet as Spotify introduced its streaming service in a handful of European countries, it clung to what must have seemed an impossible ambition: challenging the titans of Silicon Valley to become the world's leading outlet for online music, with a hybrid free-and-paid model that made record companies nervous.

After a decade, the startup from Sweden has proved itself a worthy adversary, with 157 million users around the world, 71 million of whom pay for subscriptions. That is about twice the number of its closest competitor, Apple, which finally entered the subscription game three years ago.

In early April, in a ritual of success for any startup, Spotify's shares began trading on the New York Stock Exchange with a valuation of $26.5 billion. Underscoring the company's self-image as a disrupter, it shunned the usual circus of an initial public offering in favour of a rarely used - and potentially risky - process known as a direct listing, in which no new stock is issued and insiders can begin selling their stash on day one.

Spotify's path ahead, though, is far from clear. The company has never turned a profit. Its direct listing could backfire, spooking investors. Its competition is still a field of giants such as Apple, Amazon and Google. And Spotify's relationship with the music industry, which it relies on for the millions of songs it makes available for streaming, has been fraught since the beginning. "I don't believe the industry would have embraced subscription without Daniel's persistence," said Richard Greenfield, a media analyst at BTIG Research. "If it were up to the labels, he would have failed years ago."

In its defence, Spotify can point to its role in music's financial turnaround. After a 15-year decline that made the industry a cautionary tale for all legacy media in the internet age, revenues from recorded music began to improve sharply around 2015. Last year, revenues - which include sales from CDs, downloads and subscriptions to services such as Spotify - in the United States grew to $8.7 billion, their highest level in a decade, with streaming accounting for 65 % of the total, according to the Recording Industry Association of America.

Spotify predicts that by the end of 2018, it will have up to 96 million subscribers and $6.5 billion in revenue, according to a recent filing.But Spotify's revolution has been about more than numbers. Streaming has transformed the music industry's underlying financial model and rewritten the rules for how hits are made.

Ek and Martin Lorentzon, a Swedish investor, founded Spotify in 2006. Their service was built in part to mimic the experience of piracy - for years it used a peer-to-peer network to help songs play instantly - while operating legally and paying royalties. "Music was too important to me to let piracy take down the industry," Ek wrote in a letter included in Spotify's investor prospectus. The company declined to comment for this article, citing a quiet period before the public listing.

At first, Spotify was conceived of as a free, advertising-supported service. But realizing that record companies and music publishers would be more willing to grant licenses if Spotify also had a paid level, Ek and his team developed the so-called freemium model. Users can listen to any song free with advertising, or pay $10 a month to remove the ads and get perks such as offline listening. The free service is meant to lure customers to pay; according to Spotify, 60% of new subscribers begin as free users.

Music executives involved in Spotify's early licensing negotiations were impressed by the company's technology, and by its approach: Unlike other music tech startups at the time, most of which no longer exist, Spotify presented itself as a partner that could help the industry recover.

Still, the idea of simply giving music away was worrisome. So as a condition of granting licenses, the major record labels and Merlin, an organization that represents independent labels, received equity stakes in Spotify that are now worth billions of dollars. They have all said they will share with artists any profits from the sale of those stakes, although exactly how that will work remains unclear.

Unpredictable cycles

Once Spotify took hold - it came to the US in 2011, after protracted talks - record companies discovered that its subscriptions delivered steadily recurring income, a relief from the industry's seasonal ups and downs. "Once you get someone in, you take away the unpredictable cycles we used to see," said Ole Obermann, chief digital officer at the Warner Music Group. "For most of the year, we'd be behind and then count on a huge spike of sales around the holidays to make us profitable for the year."

With the cost barrier to listening removed, consumer behaviour began to change. Independent labels said their music was being listened to more. Playlists, programmed with a mixture of editorial supervision and machine learning, began to influence what people heard; according to Spotify, 31% of its listening now happens through its playlists.

Yet even Spotify's biggest champions in the music industry, such as Daniel Glass of the label Glassnote, notice that streaming and social media created a network effect that emphasised hit songs above all else. "I remember sitting down with managers and artists and explaining that they will get paid; streaming is the future, whether you like it or not," said Glass, whose label catalog includes Childish Gambino and Mumford & Sons. "But you've got to have hits." But can Spotify itself make money? It has had $2.8 billion in net losses in just the last five years, and pays most of its revenue to music rights holders. The company's freemium model means that it must subsidize the costs of the tens of millions of users who don't pay.

"Becoming the world's largest global music-streaming subscription service has been expensive," Barry McCarthy, Spotify's chief financial officer, said in the company's recent investor presentation. (McCarthy is a former finance chief of Netflix, an association he mentioned several times.) Spotify has a clear path to profitability, McCarthy said, pointing out that while it has continued to lose money, its operating losses have decreased as a percentage of revenue, and its free cash flow has grown to become positive for the last two years.

Still, he said that for the foreseeable future, Spotify would continue to make investments to promote growth - at the expense of profits. Spotify's stock price may depend on how long Wall Street will remain patient with that strategy.

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