Spotify (SPOT 1.69%) is looking to diversify its revenue beyond subscriptions and ad-supported music streaming. Its biggest endeavor so far has been its investments in podcasting. The streaming company has committed about $500 million to buying companies that do everything from producing podcast content to building the technology to deliver podcasts.
Spotify has also experimented with video as a source of higher-value ad inventory. Additionally, it's hinted at the long-term potential of cutting out intermediaries and working to distribute artists' works directly, acting more like a label itself.
There are a couple of big reasons Spotify is hungrier than most to develop alternative streams of revenue.
1. Spotify's ARPU is in decline and there's a reason behind it
Spotify's average revenue per premium user (ARPU) has fallen from 6 euros in the fourth quarter of 2016 to 4.86 euros in the second quarter of 2019.
Over the last three years, Spotify has greatly expanded its geographic presence. It's now available in 79 markets, adding 17 countries in 2018 and India earlier this year. All of the markets Spotify has entered recently may be considered "emerging." And in the company's second-quarter letter to shareholders, management said it saw "notable strength ... across our emerging markets."
Strength in emerging markets would explain a decline in ARPU: Consumers in less-wealthy countries can't afford to spend as much on discretionary services like Spotify, so it charges them less. But as those markets grow over time, Spotify should be able to see outsized growth in revenue and ARPU there.
But emerging markets aren't the biggest reason for declining ARPU.
2. Competition makes it hard to raise prices
Indeed, Spotify still sees approximately the same percentage of subscribers from North America and Europe as it did a year ago. "Approximately 75% of the impact to ARPU is attributable to product mix changes, and the remainder [is] a function of changes in geographic mix and other factors," management wrote in the letter. By that, it means more people are opting into its family plan, which allows up to six people to share a plan for one flat price, instead of each individual paying approximately $10 per month.
Spotify is currently experimenting with increasing the price of its family plan. The challenge, however, is that Spotify's competition consists of big tech companies, which already have multiple revenue streams that contribute a lot more than music streaming to their top and bottom lines.
Apple (AAPL 0.79%) and Amazon (AMZN -0.08%) are two of Spotify's biggest competitors. Apple will happily take a loss on Apple Music if that means selling more of its premium devices like iPhones, Apple Watches, and HomePods. Likewise, Amazon provides a subsidy to Prime members for its Music Unlimited service, and it provides an even greater discount if customers opt to listen exclusively on their Alexa-enabled smart speakers. That's because Amazon knows it can generate more revenue from those users in its main retail business than it can from standard subscribers.
Apple and Amazon have no incentives to budge on their low pricing. The incremental revenue they could generate from a modest price increase is nothing compared to the hundreds of billions they bring in every year from the rest of their businesses. If Spotify increased its pricing, it would be competing against companies offering nearly the same product at a lower price point.
Alternatives are needed
With family plans driving down Spotify's average revenue per user, and no clear way for Spotify to mitigate that impact, it needs to find a way to generate additional revenue from other sources. Podcasts are currently in the limelight for the company, but investors should pay attention to other sources of revenue Spotify may be working to develop. It will need them to keep growing and reduce the pressure on stabilizing ARPU.