Apple Music Chief Jimmy Iovine Suggests Spotify Is in Trouble

Apple (AAPL -0.81%) and Spotify are the dominant forces in music streaming today. The companies command over 90 million paid subscribers combined, which represents the vast majority of the industry's paid subscribers, which hit 100 million earlier nearly a year ago. The continued growth of paid streaming is helping the U.S. recording industry bounce back after years of malaise.

At the same time, Apple has grand ambitions with growing its services business to $50 billion by 2020, with Apple Music playing a meaningful role. Sadly, music streaming is not a great business, even for Apple. The Mac maker is fortunate enough to have a ridiculously profitable smartphone business, but the same cannot be said for larger rival Spotify.

Image source: Spotify.

That's what he said

Don't just take my word for it -- that's according to Apple Music chief Jimmy Iovine in a new interview with Billboard. Music streaming services simply aren't profitable, which could also help explain why Apple doesn't offer a free, ad-supported tier for Apple Music but instead only offers a paid subscription. Given Apple's deep ties with the music industry, it's tempting to think that Apple made that strategic decision out of the kindness of its iHeart, but the explanation could be more economic.

"The streaming services have a bad situation, there's no margins, they're not making any money," Iovine reportedly said. "Amazon sells Prime; Apple sells telephones and iPads; Spotify, they're going to have to figure out a way to get that audience to buy something else. If tomorrow morning [Amazon CEO] Jeff Bezos wakes up and says, 'You know what? I heard the word "$7.99" I don't know what it means, and someone says, 'Why don't we try $7.99 for music?' Woah, guess what happens?"

Data sources: Spotify and Apple. Chart by author.

Spotify's revenue jumped 40% during the first half of 2017, yet the company remains unprofitable even though gross margin expanded to 22%, according to The Information last month. It's not hard to imagine what would happen if Spotify was forced to cut subscription prices by 20% to compete, as Iovine hypothesizes.

"The streaming business is not a great business," Iovine added. "It's fine with the big companies: Amazon, Apple, Google... Of course it's a small piece of their business, very cool, but Spotify is the only stand-alone, right? So they have to figure out a way to show the road to making this a real business."

The pure plays could be in trouble

There aren't very many pure plays in music streaming, with Spotify and Pandora Media (P) being the most prominent examples. Spotify isn't public (yet) so we don't get to directly see its financials beyond the occasional leak.

Pandora's model has historically been focused on minimizing its cost structure through statutory licenses while monetizing hours streamed through ad revenue, which doesn't bring in as much as paid subscriptions. Spotify rose to prominence by inking direct licenses with record labels for its on-demand service and then charging a subscription fee that far exceeds the potential of ad monetization. At this point, both companies offer both free and paid tiers; Pandora's user base is predominantly ad-supported, while Spotify boasts the most paid subscribers even if the majority of its users are also ad-supported. Neither company is profitable (Pandora lost $61.5 million last quarter).

Data sources: Spotify and Pandora SEC filings.

I've touched on this in various contexts before, but certain sectors that have fundamentally unattractive economics (like local food delivery) are often better served as tangential segments of larger businesses. Music streaming is increasingly looking like one of those sectors, which is why it makes more sense for some of the aforementioned tech giants to lead the space. They don't need to make a profit thanks to their core businesses of e-commerce, consumer gadgets, or search advertising, and as such only really need to breakeven on operations provided that the segments can support the core businesses in some other strategic way (like buying more iPhones).

In Iovine's view, the biggest threat to the industry's economics are the free tiers as well as the free alternatives out there, including on video services like YouTube. By this rationale, Spotify's best chance at financial viability could be eliminating the tier that over half of its users prefer, but if that puts the broader industry on better financial footing, it could be worth what would be a massively controversial move that would spark intense user backlash.

Otherwise, pure plays will have to unsustainably continue relying on debt and equity capital raises to keep the lights on. Spotify raised $1 billion in debt last year, while Pandora had a $300 million convertible note offering at the end of 2015 and sold Ticketfly earlier this year to raise $200 million (after losing $250 million on the deal overall). Sustainable profits sound like a much better alternative.