As the largest music-streaming service on Earth, Spotify carries a disproportionate amount of weight in deciding the future of the music industry. Consumers have been rapidly shifting toward the subscription access model, which is music to record labels' ears (for now). However, Spotify pays an exorbitant amount of royalties to those record labels, which undermines the possibility of squeezing out a profit. Spotify has seen its net losses widen significantly over the past three years, losing $1.5 billion in 2017.

Royalty costs, considered cost of revenue, are Spotify's largest expense by far. The company has made some progress with reducing its royalty burden relative to revenue in recent years, but still paid out nearly 80% of revenue to record labels last year. That doesn't leave a lot to cover operating expenses. "Cost of revenue consists predominantly of royalty and distribution costs related to content streaming," Spotify notes in its F-1 Registration Statement. This is what Apple Music chief Jimmy Iovine was referring to when he said there are "no margins" in streaming services.

Chart analyzing Spotify cost structure over time

Data source: F-1. Chart by author.

What if Spotify could cut out the record labels?

"Building a Two-Sided Marketplace"

In a recent interview with Business Insider, early Spotify investor Par-Jorgen Parson highlights this idea as Spotify's truly disruptive potential. The platform has the scale to deliver meaningful analytics to artists, which can help them target and reach their most engaged listeners. One of the primary purposes of record labels is distribution, and if artists can distribute directly through Spotify, the value that record labels bring to the table is severely undermined. Spotify is a distribution platform for the digital age.

Sitting man with beard listening to music on his smartphone

Image source: Getty Images.

Parson points investors to a specific part of the filing entitled "Spotify -- Building a Two-Sided Marketplace" that prospective investors absolutely need to check out. In it, the Swedish company describes the tools and services that it provides to creators to help them grow their businesses. This includes things like Spotify's curation algorithm, which is designed to help users discover more content; access to the largest user base for distribution; promotional tools to target users; and analytics that allow creators to understand their listeners. Spotify is even working on creative tools, hiring Francios Pachet last year to lead Spotify's new Creator Technology Research Lab.

It's worth pointing out that many of the most successful distribution platforms over the past two decades have been built on cutting middle men out. YouTube was among the first of such platforms, and it similarly provides analytics and creative tools along with distribution. That's not to say that record labels will go away. They still provide value in other ways, such as marketing and representation, which still makes sense for more prominent artists.

Rather, Spotify could level the playing field, giving smaller artists a chance to reach a global audience at lower costs. "[Artists] can go directly to the most powerful distribution channel," Parson said.

Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.