Streaming music companies have a significant problem that could ultimately sink the entire industry.
As streaming services, including Pandora Media (NYSE:P) and Spotify, grow in popularity they actually lose more money. Both companies significantly raised their revenue in 2013 while also growing their losses, as detailed on the chart below.
In most businesses adding sales means increasing profitability (or at least smaller losses) since fixed costs can be split up across more sales. Larger sales may require more of everything, but a company that grows from $243 million to $575 million, as Spotify did, likely does not need twice as many employees, twice as much office space, or, in most cases, twice as much of anything. That is not true for streaming music services -- here, more users (and revenue) means more licensing fees.
And while it does look like both companies are at least narrowing the percentage increase of their losses in relation to the revenue line, a report published by Generator Research last year concluded that the streaming business in its current state was "inherently unprofitable" and that "no current music subscription service — including marquee brands like Pandora, Spotify, and Rhapsody — can ever be profitable, even if they execute perfectly."
That's a pretty dire prediction and bad news for the records business, which has been counting on streaming revenues to make up for their collapsed CD business and the slightly declining digital download market.
How streaming services work
Spotify and Pandora take different approaches to streaming music. Pandora creates what are essentially personalized radio station for its customers. Start by telling the service a band you like -- perhaps Tom Pettty and The Heartbreakers -- and it will give you songs by them as well as songs other people who like that group enjoy. Listeners can give a thumbs up or a thumbs down and Pandora adjusts future song selections using that info.
Spotify has two versions of its service -- a free model that works somewhat like Pandora, though it allows users to listen to specific artists but only on shuffle mode. Basically, if you like The Replacements and Celine Dion, you can pick those two disparate choices and hear a random selection of their songs. Spend $9.99 a month to upgrade to the Spotify Premium and you can listen to whatever song you want, on whatever device you want including mobile phones and tablets.
Pandora has a premium service as well, which sells customers an ad-free experience for $4.99 a month, but it does not allow people to select specific songs or determine exactly which artists will be played.
Both companies support their free models with ad revenue.
Competition makes it hard to raise prices
While neither company shares the details of the deals it has with record labels, Spotify CEO Daniel Ek once said that his company paid 70% of its income back to the music industry. That's a very tight margin especially for a company that requires heavy bandwidth, a large infrastructure, and pressure to constantly improve the platform. Both Pandora and Spotify -- which just announced it has crossed 10 million paying customers -- risk losing users if they do the logical thing and raise prices to a point where the revenue at least sustains the business.
The key problem in raising prices is that Pandora and Spotify are not the only players in the space. Charging more would likely send customers to the smaller Rhapsody or newer services like Beats Music.
Will Apple or Amazon crush Spotify and Pandora?
Pandora and Spotify have the small problem that ultimately they need to make money. Two potential new entrants to the streaming space may not need to.
Apple (NASDAQ:AAPL) has reportedly made a deal to buy Beats Electronics, which owns the Beats Music streaming service. While that deal has not been officially announced, if it happens Apple could conceivably operate Beats at a loss to entice people into buying its devices. Apple would have the ability to either lower subscription prices, forcing its competitors out, or not charge at all, rolling the cost of the service into the price of iPhones, iPods, and other devices.
Another potential entrant into streaming music is Amazon (NASDAQ:AMZN), which has shown that it's willing to spend lavishly on video content that it then offers as part of Amazon Prime for no additional charge. The online retailer is always looking for ways to entice users into paying for Prime and with the cost of the membership rising from $79 to $99 recently, adding free streaming music may be a way to keep more people from dropping the service.
Keeping customers as Prime members might be worth giving away a streaming music service. In 2013 Consumer Intelligence Research Partners estimated Prime members spend more than twice as much — $1,340 per year – than non-Prime members using Amazon.
Spotify and Pandora may fail
As currently constituted Spotify and Pandora seem likely to fail -- a fall that would be hastened by Apple or Amazon getting into the game. Streaming revenue has been a rare bright spot for the music industry, so it seems likely that subscription-based streaming will remain in existence. That may happen due to Apple or Amazon subsidizing it or it may require concessions from music publishers to create a revenue structure that works.
Pandora and Spotify however appear to be following the old retail axiom of selling a $20 bill for $19 and hoping to make up the difference on volume. Even without the looming specter of two much larger companies offering music streaming as a throw-in, both Pandora and Spotify clearly need to adjust their strategies. That may mean higher prices, more ads, better label deals, or finding other ways to monetize. But growth without profit -- or at least profit being in sight -- is not sustainable.
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Daniel Kline has no position in any stocks mentioned. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple and Pandora Media. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.