Music streaming has been the growth engine behind the music industry's resurgence over the last decade.
Last year, the number of songs U.S. consumers streamed topped one trillion for the first time, climbing around 30% from 2018, according to data from Nielsen Music.
That trend hasn't gone unnoticed by several big tech companies, including Apple, Alphabet's Google, and Amazon. All three have launched services to compete with one of the earliest entrants into the on-demand streaming space: Spotify (NYSE:SPOT).
But what separates services like Apple Music, YouTube Premium, and Amazon Music Unlimited from Spotify is their connection to much larger, more profitable companies. In other words, Spotify's competitors can afford to operate their music streaming services as loss leaders to support their core businesses; Spotify needs to make music streaming profitable.
But with big competitors willing to take losses, consistent profits may be a "pipe dream," says Evercore ISI analyst Benjamin Black.
While Spotify posted a surprise profit in its third quarter, management forecast a return to operating losses in the fourth quarter, despite proven operating leverage and expected paid listener growth.
Indeed, if Spotify intended to merely stream music, profitability will surely never come, as negotiations with labels would hit a wall, no matter how many listeners the streamer racks up.
Spotify's path to profits requires it to create products and services that take advantage of its massive network of creators and listeners. Here's what it's doing already.
Building the two-sided marketplace
At Spotify's investor day in March 2018, ahead of its IPO, management described its idea of a two-sided marketplace. Spotify intends to use its scale to drive greater artist discovery and enable artists to connect with more fans.
Spotify's main Marketplace offering is Spotify for Artists, which provides analytics, identity management, and promotion tools for musicians on its platform. Spotify reported 465,000 artists use the platform as of the end of the third quarter, up 365% year over year. Artists using the platform represent 80% of listening on Spotify.
Ultimately, Spotify for Artists could enable many musicians to find an audience without the need for a record label. The value record labels provide musicians is promotion and distribution, and Spotify for Artists makes it much easier to do that without a label thanks to its massive audience and ability to put new music in front of those listeners.
Spotify's curated playlists account for around 15% of total listening on its platform. The company could use those playlists as a platform to feature independent artists that use its Spotify for Artists platform without a traditional label. That should increase profitability for Spotify and for creators.
Other recent Marketplace products include Sponsored Recommendations, a cost-per-click ad product that relies on Spotify's targeting capabilities to get new music in front of listeners. Most notably, it's an ad product that works for both paid and free listeners.
Additionally, Spotify recently acquired SoundBetter, an audio production marketplace. SoundBetter connects studio musicians, producers, sound engineers, and other music professionals to collaborate.
Spotify is acquiring and building ancillary products that complement its existing user habits. Users love getting recommendations for new music -- Spotify for Artists and Sponsored Recommendations monetizes that behavior. That will lead to better margin expansion than renegotiating deals with record labels.
Don't forget about podcasting
Spotify became the No. 1 podcast-listening platform in 2019, surpassing Apple Podcasts and Google Podcasts. That said, podcasting remains a bigger cost to Spotify in the near term than a source of revenue. Investments in technology and original content have put pressure on gross margin over the past year.
CEO Daniel Ek said 2020 will be the year the company starts exploring ways to monetize podcast listening more directly. The company unveiled its first step toward that end at CES earlier this month, introducing Spotify Podcast Ads. The product programmatically inserts advertisements into podcast streams, similar to how it inserts ads in between songs.
Theoretically, the new product should enable improved monetization for podcast creators compared to the hard-coded ad copy included in most podcasts. Additionally, it should make it easier for smaller podcasters to monetize their product without the large audience requirements for direct sales.
Importantly, Podcast Ads, like Sponsored Recommendations, is an ad product that reaches both free and paid listeners, monetizing Spotify's full audience.
Spotify's business doesn't rely on squeezing better deals out of record labels in order to expand gross margin. The big tech companies it competes with will prevent that, as record labels now have several popular options to pit against the streaming leader.
Instead, Spotify's expanding its products to make content production, consumption, and monetization easier for everyone on its platform, and that's where it'll unlock profits.