99 million Spotify (NYSE:SPOT) listeners don't pay a dime to stream millions of songs on demand. Instead, they listen to intermittent advertisements Spotify sells in order to support its freemium model. Currently, those advertisements are just annoying enough to convince heavy listeners to subscribe to Spotify's premium ad-free service.
Spotify generated just 1.03 euros per free listener in the first quarter. Premium subscribers paid an average of 13.83 euros over the same period. Spotify is taking a hefty loss on free users in order to support the growth of its paid subscription service.
There's clear room for growth in ad revenue, as competitors like Pandora Media (NYSE:P) show. Even so, investors shouldn't bank on ad revenue growth in the near term for Spotify. Here's why.
Just as much listening as Pandora
Pandora reports a metric called revenue per thousand listener hours, abbreviated as RPM. In the first quarter, Pandora's RPM was $55.52.
Spotify doesn't report listener hours, but in its IPO registration form, it noted the average user listens to Spotify 25 hours per month. It also said premium subscribers listen threetimes as much as free listeners. Based on its first-quarter subscriber numbers, that implies free listeners average about 13.4 hours per month.
All told, Spotify's free listeners totaled about 4 billion hours of streaming in the first quarter. Pandora's free listeners totaled 3.85 billion hours.
Meanwhile, Pandora generated $223 million in ad revenue; Spotify generated 102 million euros (about $119 million). That's a big gap in monetization.
Pandora now operates exclusively in the United States, where advertising prices are relatively high compared to the rest of the world. Still, Pandora's results suggest there's still a lot of room for growth in Spotify's ad business.
Indeed, Spotify saw a 14% year-over-year increase in average ad revenue per listener in the first quarter. That outpaces the 11.5% growth in global digital advertising expected this year by Zenith, as well as the 9% year-over-year growth in RPM at Pandora. But there's still room for improvement.
Why Spotify might not max out its advertising potential
Generating additional advertising revenue means making more sales. And making more sales could mean hiring more sales representatives. Spotify is working on programmatic ad buying platforms for marketers to target digital ads with Spotify's listener data and, potentially, data licensed from third parties, but increasing ad sales will still require some increase in manpower. Spotify might find greater efficiencies in using its manpower to increase the number of paid subscribers by continually improving the service with better recommendation algorithms and curated playlists.
As long as Spotify continues to grow its paid subscribers at a faster rate than free listeners, it may be better off leaving ad-supported listeners under-monetized. Paid subscribers grew 44% year over year in the first quarter, compared to a 21% increase in free listeners. At this point, it makes a lot more sense for Spotify to focus on converting as many listeners to paid subscribers. Even if it doubled its ad revenue for free listeners (bringing its monetization in line with Pandora's), it would still generate less than 15% of the revenue per ad-supported listener compared to paid subscribers.
There's a much bigger payoff for converting listeners to paid subscribers. While seeing continued progress in ad revenue per user is nice, investors should pay more attention to what percentage of listeners pay for a subscription. That's where Spotify really makes its money. If paid subscriber growth slows, Spotify can always pull the lever and ramp up ad sales.