As a paying user and all-around tech nerd, I absolutely love Spotify. However, the investor in me also foresees some dark clouds on the horizon -- though that's not the full picture.
As we know now, Spotify is clearly gearing up for an IPO. There's just one problem: The fundamentals of its business model appear at odds with its massive $8 billion valuation. Worse yet, as emerged earlier this month, uncertainty surrounding Spotify's contracts with several major record labels could further crimp Spotify's already cumbersome cost structure.
Spotify's undone deals
According to a report from Music Business Worldwide, Spotify's long-term contracts with the three largest music companies -- Universal Music Group, Warner Music Group, and Sony Music Entertainment -- have all expired.
In a day-to-day sense, industry observers note this isn't particularly problematic. Spotify and the major labels continue to do business by rolling over their month-to-month contracts. Particularly, given the PR nightmare it would trigger, the odds of a major label pulling its catalog from Spotify seems remote.
However, it appears Spotify's promotional efforts to match rival Apple (NASDAQ:AAPL) Music have indeed created some consternation at the three major labels. In fact, a source for MBW's report described Spotify's promotional efforts without long-term deals in place as a "very grey area".
From an investor's perspective, Spotify's inability to strike a deal with any of the three major labels -- which combined control roughly 75% of the "global recordings market share" -- adds an element of significant risk, though remote, to the company's investment profile. Investors hate uncertainty, and the possibility that Spotify could see a major portion of its catalog disappear seemingly overnight will understandably matter to those considering picking up shares at its forthcoming IPO. However, in an unfortunate paradox for Spotify, securing the stability that comes with long-term deals could actually leave the Swedish streaming giant financially worse off.
A financial catch-22
Sadly, here Spotify faces a potential lose-lose situation. The company likely needs a deal with the major labels to successfully market its business to investors during the IPO roadshow. However, securing a deal seems likely to increase the royalty rates Spotify pays to the labels.
Though not a matter of public record, inside sources indicate that Spotify's current deals require it to pay about 55% of its revenue to labels, which doesn't include payments to music publishers. Either way, Spotify's royalty rate likely remains lower than those paid by Apple Music or Pandora's bankrupt Rdio subsidiary. For context, private sources state Apple pays the labels a royalty rate of 58% of its revenue, and Rdio, on which Pandora will base its own forthcoming on-demand streaming service, paid upward of 60% of its sales as label royalties.
For those unfamiliar with its financial situation, Spotify continues to bleed money. For its fiscal 2015, Spotify saw its losses widen from $177 million in 2014 to $188 million last year even as revenue jumped from $1.2 billion to $2.1 billion. Increasing the rates it will likely need to pay labels only further muddles the financial outlook for the world's favorite streaming service.
As the largest on-demand streaming service, Spotify is something of a grand experiment for tech investors. Accomplishing anything new often requires a fair degree of experimentation. Seen from this angle, Spotify's ongoing pursuit of a sustainable business model seems more than understandable. However, given Pandora's long history of losses and Apple's ability to run Apple Music at a loss indefinitely, the outlook for Spotify's eventual profitability remains a genuine concern. Here's hoping Spotify can successfully pull off this challenging balancing act.
Andrew Tonner owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Pandora Media. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.