Netflix (NASDAQ:NFLX) was once a great partner for film and television studios. Media companies could lock in guaranteed high-margin revenue from licensing their shows and movies to the video-streaming service. But as Netflix streaming ate into time spent watching live television and fueled the rise of cord-cutting, Netflix became more of a frenemy.
Spotify Technology (NYSE:SPOT) could produce the same fate for record labels. As the music-streaming service's listener base climbs toward 200 million and streaming becomes the biggest source of revenue for the recording industry, Spotify holds a lot of leverage over the labels. It could become big enough that, like Netflix, it starts producing its own content -- i.e., signing deals with artists directly instead of working with labels.
But management says that's not the right way to think about its "two-sided marketplace" strategy. Spotify is a technology company, not a content company. Netflix, comparatively, has no qualms comparing itself to the biggest media companies in the world.
Content costs can't keep declining
Record labels have arguably been the biggest hindrance to Spotify producing a meaningful profit. Spotify's royalty payments to labels is, by far, the biggest factor impacting its cost of revenue, which totaled about 75% last quarter.
Spotify has dramatically improved its gross margin (up 3 percentage points year over year last quarter) as a result of renegotiating its contracts with record labels. It keeps those contracts short intentionally with the idea it can come back to the table two years later and have much more leverage due to its rapidly growing user base. Spotify can negotiate lower rates as a percentage of revenue while offering higher guaranteed payments thanks to its larger user base.
But Spotify can't continue to pressure labels like that forever. That's especially true as competitors have shown considerable strength in certain high-value markets like the United States.
Offering its strengths as services for labels
The key to Spotify reaching its long-term gross margin goal of 30% to 35% is developing services for artists and labels. Spotify currently collects revenue from the consumer side of its business, but it thinks it can monetize the supplier side of the business as well. That's what it means by "two-sided marketplace."
CEO Daniel Ek provides the example of helping labels improve their marketing and promotion efficiency. Spotify collects tons of data on listener preferences and behavior, so it could use those data and its algorithmically generated playlists -- which comprise about 17% of listening hours -- to get artists' songs in the ears of people most likely to enjoy them and become fans.
Ek noted that the company will follow the freemium model with labels and artists just as it does on the consumer side of the market. It's already developed ways for artists to upload songs directly to the platform and submit them to playlists for free. It could, however, charge labels for things like song positioning in a playlist or recommending certain playlists.
The marginal cost of supplying such services is considerably low, especially compared to the low-margin consumer business. As such services grow as a part of the company's business, it ought to show considerable lift in its overall profitability.
We've heard the "partner" rhetoric before
Spotify certainly doesn't want to do anything to perturb its only supply of content, especially when it's in the midst of another round of negotiations. So even suggesting the company might look into more direct deals with artists would be a bad strategic move.
Back in 2011, Netflix suggested that its service is a win-win for media companies as well.
"Netflix streaming has become a valuable additional profit stream for content owners. Some content owners fear that licensing to Netflix will undercut other, larger profit streams. The Starz example suggests otherwise," management wrote in its fourth-quarter letter to shareholders at the beginning of 2011. "The evidence is pretty clear that content that is also licensed to Netflix generates more money for its owners than content that is withheld from Netflix," they added.
A year after that letter, Netflix released its first co-production, Lilyhammer, and its first self-commissioned original, House of Cards, came out a year after that.
There's a good chance Spotify's management is engaging in a bit of poker playing with the labels, just as Netflix did with media companies eight years ago. It needs the labels' commitment right now, but it could quickly shift away from them at any moment.