Spotify Just Strengthened Its Best Weapon Against Apple

In line with prior rumors, Spotify Technology (SPOT 0.41%) unveiled a revamped version of its free service today at an event in New York City. Users of the free, ad-supported tier have long been unable to listen to on-demand tracks, instead being relegated to shuffled tracks and other limitations. Free users will now be able to enjoy 15 playlists that include on-demand tracks.

However, the user will not be able to create those playlists. They'll be algorithmically curated by Spotify and personalized based on the user's listening history. The new version of the app will allow new users to select preferred artists to immediately start personalizing the experience. This is the first overhaul of the free tier since 2014, as Spotify has mostly focused on growing its premium subscriber base by improving that tier in recent years.

Image source: Spotify.

Most of Spotify's users are ad-supported

While Apple (AAPL -0.28%) only offers a paid version of Apple Music, Spotify uses its free tier as its most effective marketing funnel. The Swedish company says that over 60% of gross premium subscriber additions since early 2014 came from the free tier, as users upgraded to paid subscriptions in order to enjoy a more full-featured experience. The ad-supported version also allows Spotify to better address emerging markets, where $10 per month may be out of reach for many consumers. Historically, it has taken about a year for Spotify to recoup its losses after free users convert to paid subscriptions.

It's worth noting that the majority of Spotify's total monthly active user (MAU) base is made up of ad-supported users, totaling approximately 95 million free MAUs, based on the midpoints of the company's guidance for the first quarter. By year's end, Spotify expects to have around 109 million free MAUs, again using the midpoints of its forecast.

Data source: SEC filings.

In comparison, Apple now has 40 million paid subscribers and no free users apart from those giving the service a test drive under the free trial.

Reinvesting newfound profits

There's another aspect for Spotify investors to consider: the costs. Offering tracks on-demand carries higher royalty costs than shuffled plays. In addition to performance royalties, on-demand streams also generate mechanical royalties for content owners. Spotify had renegotiated its licensing agreements with record labels in 2017, which allowed it to reduce its royalty burden and expand gross margin. That paved the way for Spotify to squeeze out a gross profit from its ad-supported tier for the first time.

Data source: SEC filings.

The gross profits from the ad-supported tier aren't too meaningful -- just 5% of consolidated gross profits for 2017 -- so reinvesting those modest profits back into improving the ad-supported service (in the form of higher royalties) is a smart strategy, especially as doing so could reinvigorate MAU growth at a time when Apple Music appears to be catching up.