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Spotify ‘scrapes barrel’ for subscribers as industry bets on streaming

"I don't care too much for money", sang the future billionaire Paul McCartney in his 1964 smash hit "Can't Buy Me Love".

Back when The Beatles ruled the airwaves, making a buck out of a popular song was a relatively straightforward process.

Music labels could collect cash from sales of records, touring revenue and sponsorship deals.

Daniel Ek, chief executive officer and co-founder of Spotify AB.
Akio Kon | Bloomberg | Getty Images
Daniel Ek, chief executive officer and co-founder of Spotify AB.

Fast forward half-a-century and McCartney's relaxed approach to the bottom line isn't likely to be shared among the executives of music streaming service, Spotify.

The Swedish company was born after the internet made digital music easy to share, causing music lovers to turn their back on physical formats such as vinyl and CDs.

It offers a model of "subscription streaming" which provides listeners with access to millions of songs for a monthly fee while Spotify pays royalties to music labels who pass on a cut to artists.

Spotify was a first mover in streaming and now manages a massive cloud-based distribution network that hosts the content from musicians.

For the first time in 2016, U.S. streaming revenues accounted for the majority of sales, registering $3.9 billion, according to the Recording Industry Association of America (RIAA).

So, a smash hit formula for the future of music then? Well, not quite.

In a telephone interview with CNBC, Kashif Sheikh, investment analyst at PrivCo, said while Spotify's paying growth looks "awesome", costs continue to rise and that's a problem.

"Revenues are growing incredibly fast but costs are growing a little faster so the gross margins are shrinking.

"Other operating costs such as marketing and R&D appears to be getting cut as well but they are not able to resolve their royalty issue," said Sheikh.

The analyst also said Spotify maybe "scraping the barrel" in order to raise the number of subscriptions.

"Imagine a family plan, six times as many songs to pay royalties on for the same flat rate membership.

"What they need to do is vastly reduce their costs. I don't think much of that is infrastructure. It is their royalty costs and I don't think that's possible," he said.

From left: Slash and Myles Kennedy play a Spotify Session at its London office on June 3, 2014.
David M. Benett | Getty Images for Spotify
From left: Slash and Myles Kennedy play a Spotify Session at its London office on June 3, 2014.

Spotify recently raised $1bn from investors at an interest rate of 5% a year, plus a discount of 20% on shares once a planned initial public offering (IPO) takes place.

Under the agreement the interest rate to investors goes up every 6 months until the IPO happens, forcing the company to pay ever larger repayments.

Now, according to a report in the Wall Street Journal, Spotify is considering not holding a public sale of shares.

The paper reports it is looking at simply listing its existing shares on an exchange in what is known as a direct listing. It wouldn't raise any money, much to the disappointment of Wall Street.

And while this drags out, artists, songwriters and labels, are clamouring for more money in exchange for song plays.

A court hearing is currently underway in the United States to decide how much money streaming firms such as Spotify should pay, every time a song is played.

Apple, Spotify, Google, Pandora and Amazon are all making their cases to federal judges who will also hear the case from song writing trade groups.

The decision expected at some point in 2017 will determine pay rates until 2022 and Apple has suggested a flat rate of 9.1 cents per 100 streams.

This offer is viewed as a tactic to hurt Spotify, which currently pays a lot less per song.

Needham analyst Laura A. Martin published a note in October last year, calculating that Spotify's average revenue per user is about $8.80 per month based on 2015 figures.

She said Spotify is "strategically critical" to the music industry, is growing rapidly and helps consumers access new musicians, which is a major issue for labels.

But on arguments about royalties and the future of music, Needham said onlookers have missed the industry's key shift.

"The music business is no longer primarily about selling music.

"It's about attracting, building and retaining a global audience of dedicated fans that will buy a broad range of products, including (but not limited to) music," she said.

US singer Taylor Swift performs during the annual New Year's Eve celebrations in New York.
Jewel Samad | AFP | Getty Images
US singer Taylor Swift performs during the annual New Year's Eve celebrations in New York.

Needham cited megastar Taylor Swift suggesting that of her estimated $170 million earnings in 2016, only a third will come from music, with concert sales and sponsorship making up the bulk.

Spotify has tried to address its revenue recently, unveiling a new policy where only premium users can access new music from top artists.

But Goldman Sachs, while noting a nascent turnaround in the fortunes of the music industry, has said that tactic in itself could pose a risk to the industry.

"Artists and labels' pressure on streaming services to limit the content and functionality of their free tier could be detrimental to the user experience, and thus encourage a return to piracy," the investment bank wrote in a note last October.

Goldman also said artists who release songs exclusively on a platform for a limited period of time, could also frustrate fans who may again seek illegal versions via the internet.

In its note, the bank cites the example of Kanye West's album 'The Life of Pablo'.

Kanye West and Jay-Z onstage at the Tidal launch event
Jamie McCarthy | Roc Nation | Getty Images
Kanye West and Jay-Z onstage at the Tidal launch event

It says by releasing the album exclusively on the streaming service Tidal, subscriptions at the Jay-Z venture more than doubled from 1 million to 2.5 million.

The album itself reportedly surpassed 250 million streams in its first ten days but there was a wider negative impact as the Bit Torrent host, Torrent Freak, claimed there had been more than half a million illegal downloads on the first day alone.

Tidal was also sued for claiming the album would only ever be available on its platform, but Kanye West later reneged on this.

Goldman Sachs also suggested that one way out of the impasse for musicians and streaming services such as Spotify, may be to bypass the major labels such as Sony, Warner and Universal. Although the bank noted the significant cost of a label's role in promoting and distributing.

Wheezing like an out of tune accordion, the music industry has struggled to catch up with the dramatic changes forced on it by the internet. It will hope now the big bet placed on music streaming will prove to be profitable and harmonious.