Spotify has grown to become the largest music-streaming service on Earth, thanks in part to its free, ad-supported tier that serves as a funnel to its premium business. The company estimates that 60% of all gross premium subscriber additions since early 2014 have come from its free tier. But ad-supported services face brutal economics, getting pinched between royalty costs and weak monetization through ads.
To that point, Spotify confirmed in its F-1 filing that its ad-supported business has long been a money-loser, only turning positive in 2017 after the company was able to negotiate more favorable licensing terms from record labels.
| Tier |
2015 Gross Profit |
2016 Gross Profit |
2017 Gross Profit |
|---|---|---|---|
|
Premium |
257 million euros |
436 million euros |
806 million euros |
|
Ad-supported |
(31 million euros) |
(35 million euros) |
43 million euros |
Data source: F-1.
That's not to suggest that the ad-supported business is a great business now that it's profitable. Ad-supported gross margin was still less than half of premium gross margin in 2017 (10% vs 22%). The good news is that it doesn't take Spotify very long to recoup user-specific losses after a free user converts to a premium subscription.
Image source: Spotify.
Ad-supported losses are almost like marketing expenses
During Spotify's investor day presentation last week, CFO Barry McCarthy told prospective investors that once a free user converts to a premium subscriber, it only takes about 12 months to break even, after which point the lifetime value of that user continues to rise.
Image source: Spotify.
That's especially true as Spotify continues to reduce premium churn, retaining a greater proportion of subscribers over time. The family plans in particular, which include up to six accounts for $15 per month, have been instrumental in driving down premium churn over time.
Image source: Spotify.
Once a family has signed up for a family plan and started personalizing the service, the switching costs for moving an entire family to a competing service are huge. With pricing mostly standardized across the industry thanks to competition, there's not really a strong incentive to switch anyway.
In fact, McCarthy said that historically Spotify has essentially considered its ad-supported segment to be a marketing expense, helping to give users a taste of the service knowing that there's a very good chance that free users will eventually open their wallets. When looked at from that angle, it makes even more sense. The ad-supported losses incurred in 2015 and 2016 are a fraction of what Spotify officially spent on sales and marketing (219 million euros in 2015 and 368 million euros in 2016), making it an extremely efficient user acquisition channel.
