Last year, 86% of the streams on Spotify (NYSE:SPOT) related to content licensed from the major music-rights holders. For that reason, many investors assume the labels dominate the discussions at the negotiating table over the royalties Spotify pays and other terms. There is a concern that its heavy dependence on the labels will prevent it from becoming much more profitable.

But the truth is much more nuanced. Certainly, Spotify depends on the music labels for most of its content, but the labels depend on it for distribution and a large and growing portion of their recorded music revenue. As a result, the bargaining power is more balanced than many investors appreciate.

Spotify needs the labels 

Universal Music Group (UMG), owned by Vivendi SA (OTC:VIVHY); Warner Music Group, and Sony (NYSE:SNE) Music Entertainment represent 29.8%, 22.6%, and 18.1% of the global recorded music market, respectively, according to the International Federation of the Phonographic Industry. These "big three" -- plus the Music and Entertainment Rights Licensing Independent Network (Merlin), which represents the digital rights of independent labels -- dominate listening on Spotify.

Spotify would face existential challenges if it lost access to this music. Its users would gravitate to Apple Music, Amazon Music, Alphabet's YouTube Music, Sirius XM-owned Pandora, or one of several international competitors. So Spotify's reliance on the labels is well understood, but is only part of the story.

A computer, a tablet, and two smartphones show Spotify being used.

Image source: Spotify Technology

But the labels need Spotify, too

Vivendi reports UMG's financial results, so we can see how important streaming music is to UMG. This year, through September, subscriptions and streaming music accounted for 61% of UMG's recorded music revenue, while physical, licensing, and downloading accounted for the remainder. That's up from 56% in the comparable period last year.

UMG's total recorded music revenue grew 21%, but 80% of that growth was subscriptions and streaming. Without streaming's growth, UMG's recorded music revenue would have grown by only 4%. And that 4% growth includes a surprisingly good year from physical music sales, which grew 18.7% due to a few unique big-name releases.

According to Vivendi's management: "Normally, the trend in physical should be to have a decline in this part of our business. We are very happy when we have very good surprises, but we believe that the trend is to go to the decline."

In other words, UMG's nonstreaming recorded-music sales should decline over time. So it's clear that UMG (and its signed artists) depend heavily on streaming -- and increasingly so over time as streaming music continues to grow and other formats shrink. And as the largest music streamer by far, Spotify is the largest contributor to streaming music revenue.

It is clear each side depends on the other, and both are benefiting from streaming's growth. On Vivendi's third-quarter 2019 conference call, CEO Arnaud Roy de Puyfontaine said:

And we do believe in the continued growth and success of both Spotify and the overall streaming market, which has now a number of strong companies. So at the end of the day, it's not about UMG versus Spotify or the labels versus the platforms, but more about working together, as I said previously, to accelerate growth in the market. And it is based on ongoing discussion and negotiation with our different partners.

Where the music industry is going

Today, the balance of power appears fairly even. The mutual dependence virtually assures reasonably healthy working partnerships. But as streaming music and Spotify continue to grow over the long term and other music formats continue to shrink, the labels' dependence on streaming and Spotify will only increase.

Streaming is already 61% of UMG's recorded music revenue and could be 70% or 80% (or higher) over the long term. In contrast, Spotify's aggressive push into podcasting and other non-music audio means it should become less reliant on the labels over the long term. Last year's 86% of streams represented by the Big 3 and Merlin should only decrease over time.

To the extent these trends continue, each label should become much more reliant on Spotify than the reverse. That could give Spotify the upper hand at the negotiating table and potentially allow it to win more favorable agreements over the long term.