Spotify's Road to Profitability
June 9th 2020
(Note: this was written before Spotify's acquisition of the exclusive rights to Joe Rogan's podcast. As you'll read through this piece, you'll realize we weren't surprised by this bit of news at all.)
Overview
The music streaming platform, trying to go toe to toe with industry veterans seems to be maimed by its only deliverable, music. With industry cuts for labels and artists ballooning, this leaves little to no room for Spotify to take a piece of this massive pie.
Here's the fundamental problem: when you solely derive value from an end product you have no control over, it leaves little to no room for innovation as a company, which eventually leaves no room for growth. Podcasting, a new entity in media streaming has taken the globe by storm with massive surges in popularity whilst being an end product companies have control over.
This leads to a couple of questions. If Spotify was to focus on podcasting as a deliverable can Spotify grow podcasting as it has done with music streaming? Will a move towards podcasting help Spotify compete with the industry giants threatening its space? If podcasting is not the answer, what alternatives are there to make Spotify profitable?
Spotify's Business Model
One of Spotify’s major problems is not knowing how to extract the value from its clever business model. The music streaming platform uses a freemium business model by luring in users to utilize basic features of the platform. Once users are lured in and use the platform actively they are bombarded with interruptions such as advertisements and are provided the option to update to avoid these disturbances.
The problem that Spotify faces is they are sitting on a treasure trove of users they don’t know how to extract value from. The company has over 286 million active users as of March 2020 but less than half of them are paid users. For Spotify, the company makes virtually no money from free users and the conversion of Free to Paid is crucial.
For us at Dark Horse, this was the fundamental question. How can we design strategies that will increase Spotify’s conversion rate while maintaining the integrity and values of the company?
Our Recommendation
Spotify needs to double down on its podcast investments and introduce new payment structures that benefit both creators and podcast listeners. In the short-term, this would bring the company into profitability. Longer term, it would solidify Spotify’s position as the premier music and podcast content company.
Figure 1 shows the current trajectory of Spotify's cash flows if it does not implement any coherent strategy to move towards newer and more efficient deliverables. Figure 2 shows the projected path to profitability if Spotify moves towards a conversion heavy strategy that focuses on podcasts as per our recommendations.
Figure 1. Company will continue to lose money without increasing ratio of Premium users or adding new revenue streams
Figure 2. Projected Income with our strategy.
In the next few sections, we'll break down our recommendation, starting with the Market Analysis.
Market Analysis
The music streaming business is characterized by low margins and few dominant players with deep pockets. The record labels and creative artists on average absorb 70% of the music streaming revenue. This leaves platforms like Spotify with exceedingly narrow margins. Any price increases or cost-cutting efforts must contemplate market share losses to giants like Apple, Google and Amazon Prime.
Optimizing its product mix to enhance its overall profitability makes sense for Spotify. This means further developing its podcasting assets and helping to grow the podcasting market where it already has an important presence. Spotify is an early entrant in a relatively underdeveloped podcasting market where margins are not hampered by the middleman. This is a major opportunity for Spotify to become profitable.
We at Dark Horse used Michael Porter's five forces model as shown in Figure 3, to further break down the industry to understand its intricacies and entry points. Based on this model, we concluded that the music streaming industry is saturated with innovation being stopped at a screeching halt due to the razor thin margins provided by record labels. This leaves Spotify with little to no room to grow or to provide any value to its customers.
Figure 3. Porter's 5 Forces Analysis of the Music Industry.
Dissecting Spotify
At first glance, Spotify’s financial statements may seem healthy. This is far from the truth. Although revenue increases year-over-year, Spotify remains unprofitable. Spotify’s revenue is driven by premium users but the company’s ratio of paid to unpaid users is unsustainably low. Spotify’s freemium business model entices potential listeners to join for free and gradually attempts to convert them to paying users.
Spotify’s financial woes are rooted in a high customer acquisition cost and an inability to grow its paying customer base. This is further aggravated by Spotify’s inflexibly high product and delivery costs that are determined by long-term contractual obligations.
Based on our analysis of Spotify, we can understand its unique predicament, through our SWOT analysis (Figure 4). In order for it to reach a positive net profit it needs to deliver a product that has better margins.
In the current music streaming space, there is an ever-growing value gap (Figure 5). 61% of the value is taken by large record companies leaving the streaming companies no room to profit or grow. The podcasting market does not have this problem. Without large suppliers taking a portion of the cash flows, it allows for more room to grow and innovate in a space that does not have a dominating leader. This is illustrated in Figure 6, which shows that the “Value Gap” is largely absent with more money going to both the creators and the streaming companies. The podcasting market, though similar in medium has seen substantial growth in-terms of average advertising revenue, growing at 65% CAGR for the past 6 years. It's expected to continue growing as the audience for podcasts increases, making it an attractive opportunity for a company whose values are focused on growth and creator empowerment.
Figure 4. S.W.O.T analysis on Spotify.
The Dark Horse Approach
Spotify needs to take a two-pronged approach to address its profitability issue.
First and foremost it needs to place smarter efforts to convert free users into full-paying members. Simultaneously, higher margin products such as podcasting need to be pursued to add new profitable revenue streams. Based on our analysis, Spotify is already geared for this shift in media given its portfolio of acquisitions.
Figure 6. Spotify's acquisitions.
The podcasting market has traditionally been dominated by creators having free podcasts, used as a medium to express opinions. We at Dark Horse believe that monetizing this platform in the right way can allow for Spotify to be a linchpin in this industry.
Two Spotify acquisitions stand out:
Gimlet Creative: a podcasting veteran that has an in-house creative agency that deeply understands brand partnerships for podcasts.
Anchor: An app that allows anyone to easily make and distribute a podcast. Its technology allows creators to overcome initial startup hurdles and makes ad placement easy.
By fully utilizing the hidden potential of these two acquisitions, Spotify can become the top-of-mind name in the podcasting industry.
Action Plan
Dark Horse Consulting Group’s two-phase strategy focuses on acquiring and maintaining high quality content that customers actually WANT to experience. This in turn, should help increase the number of paid subscriptions.
Phase I focuses on acquiring two types of talent, celebrity and indie podcasters.
Phase II aims at making Spotify’s tools more streamlined for creators to encourage new indie podcasters to the platform.
Phase I - Content is King!
To improve as a platform and expand that profitable premium membership, Spotify needs to develop and expand its podcast market position. Its product differentiation will largely depend on the quality of talent it is able to attract. To attract top talent the company should continue to push "Spotify Originals" (content that is exclusive to Spotify) and aim to bring both celebrity and indie podcasters to the platform.
Spotify needs to create a slate of premium content that it has logistical control over. Signing talent on a contractual basis allows spotify to be the only platform that hosts the media. This creates a competitive advantage for the company, by hosting content that is unavailable on competing platforms. Spotify needs to strategically gauge its talent acquisitions, going for talent that has higher influence and lower cost that also works with its current line up (Figure 9). An example would be 'Mom’s basement' which is hosted on Spotify Originals.
A potential acquisition that could work would be Cody Ko and Noel Miller's podcast (currently being hosted on YouTube). These creators have a significant social following which could help with converting freemium users to premium whilst keeping cost of acquisition low.
Figure 9. The Influence/Cost of Acquisition Matrix.
Phase II - Great Tools mean Great Results
In Phase I we said that Spotify must acquire both celebrity and indie podcasters onto their platform. Now in Phase II, Spotify must aim to bring great tools to them so that they stay.
Spotify already has a host of great technical acquisitions under its belt, and we recommend streamlining them to make a 'creator-first' platform. Right now most of the acquisitions are fragmented, and so a 'Spotify for Creators' app would be most beneficial to creators, and make an instant incentive for them to join the platform. Figure 10 showcases what that app could look like:
Figure 10. A potential 'Spotify for Creators' app design, integrated with the main app with added tools.
The app would be built on top of the infrastructure of Anchor (a podcasting app that Spotify recently acquired), with added features, allowing users to see their shows – record instantly – and have the key numbers available to them at a glance. The app would come built-in with additional tools best suited for creators, allowing them to access everything in one place. Spotify wants to give creators more control, and this unified experience would definitely give it to them.
Our core belief is that with its suite of tools that will allow creators almost granular control of their content production (see Figures 11 and 12), Spotify will be able to attract a lot of celebrity and independent talent. This will undoubtedly boost their conversion of Free users to Paid users.
Figure 11. The new app could have a subscription management system to allow granular control of payments.
Figure 12. In the main app, users could have an option to support their favourite podcasters in the form of monthly or one-time donations.
Let's recap.
Phase I was about ACQUISITIONS. Getting new podcasting talent onto the platform (mostly exclusively) so that the audience for these shows shifts towards Spotify.
Phase II was about RETENTION. Making sure that these new podcasters are incentivized to stay on the platform, by providing them with great tools. These tools would create a strong podcasting ecosystem around Spotify.
Why this works
Our recommendations hits all four elements of Bain's 'Elements of Value' framework. It's functional since it simplifies and integrates the podcasting system. It's emotional since it allows anyone to create and launch a podcast, and rewards them (through our creator-support mechanisms). It's life-changing since Spotify's algorithms have the ability to bring creator's works to the masses. It also has a strong social impact component, allowing millions of artists and creators to realize their potential and start something big.
Potential Outcomes
We see Spotify becoming a premiere podcasting network, with exclusive shows bringing in recurrent monthly listeners that will add to Spotify's revenue streams.
Don't be surprised if Spotify makes a major content push and acquires some brand-name celebrities to become Spotify exclusives. It would be a natural extension of their current strategy.
By tackling both the acquisition and the retention, Spotify will have a strong chance of finally becoming profitable.