Spotify Is Said to Profit From Its Subscribers, but Lose More Luring Them

September 5, 2012, 5:55 pm

By BEN SISARIO

Media Decoder recently looked at the books of Spotify and Pandora, two of the most popular digital music services, and noted that both companies - despite having very different business models - wind up paying most of their revenue in music royalties.

Many readers had strong reactions to the article. Some pointed to the “greed” of the music industry. Others defended record companies' (and artists') right to charge what the market will bear for their music; after all, it isn't the responsibility of the royalty owners to figure out a way to make a profit streaming music, they argue, that's a riddle for Pandora and Spotify to solve.

On Wednesday, Enders Analysis, a British research firm that special izes in media companies, published a report that looked more closely at Spotify's potential path to profit. On the one hand, the Enders report noted, Spotify generates a healthy return selling monthly subscriptions. On the other, it loses large amounts of money using free music as a marketing tool to attract those paying subscribers.

The challenge for Spotify is how to build its subscriber rolls without giving away too much of what the report calls “expensive free music.”

Spotify's two-tiered model is the core of its strategy, and the reason it has grown so quickly. For a decade now, there have been streaming-music plans that allow a listener to choose exactly what song or album to play, but they have always come at a cost; Spotify's insight was to make its service easier and more convenient than piracy, which meant there had to be a free option.

Spotify's bet is that enough users will want to subscribe - to eliminate the ads and get other perks - that they will eventually start paying about $5 to $15 a month, depending on the country. Four million people in 15 countries subscribe to Spotify, and a total of at least 15 million people use the service each month. (The majority of them, of course, do not pay a dime.)

Enders's report tries to separate the free and paid parts of Spotify's accounts. Using a combination of company data and its own estimates, Enders says that subscriptions gave Spotify a gross profit of about $76 million, while the company lost roughly the same amount on its ad-supported tier. “Spotify is now finding the legitimate free services can lure fans away from piracy, but at the expense of investor capital,” wrote the authors, Alice Enders and Ben Rumley.

According to Spotify's public accounts for 2011, it had about $236 million in revenue, 83 percent of which was from subscriptions, and the company paid $229 million in “costs of sales,” including royaltie s, distribution costs and other unspecified expenses. After salaries and other costs, its net loss for the year was $57 million.

Like Spotify, Pandora is also in growth mode, and is shouldering losses to attract more listeners. It already has more than 150 million registered users, and while the company reported a $5.4 million loss on $101.3 million in revenue in its second-quarter earnings last week, its stock rose soon after - in part because the company is starting to figure out how to make more money on mobile advertising, a weak spot in the past. (Like Spotify, Pandora has both free and paid tiers, but promotes the free service much more heavily and sees itself as a competitor to terrestrial radio.)

For Pandora, the key to survival is simply to sell more advertising. But for Spotify it will be figuring out how to manage the marketing expense of free music. Enders recommends that Spotify put limits on free listening for American users; in most of Spotify's ot her markets, listening caps - for example, no more than 10 hours a month - kick in after an initial grace period.

But how long is that period? When it came to the United States  last summer, Spotify said its limits would be waived for six months. More than a year later, however, there still are no caps. The Enders report says these “are not slated to be introduced in the U.S. until July 2013″; it did not cite a source for this detail, although in an e-mail, Ms. Enders attributed it to her interviews with company executives. On Wednesday a Spotify spokesman said there were no such plans for the United States.

Listening limits are probably inevitable, but they come with risk. While some users will react to caps by signing up, plenty will simply go elsewhere for their free music, perhaps to other legitimate services or perhaps to pirate ones - which is the last thing that either Spotify or the music industry wants.

Ben Sisario writes about the music industry. Follow @sisario on Twitter.