By Jeff John Roberts
May 3, 2018

Spotify announced its first quarterly results as a public company on Tuesday, and the market was not impressed. Shares of the music streaming service fell over 7%, even though the company met its goals for customer and revenue growth.

Unfortunately for Spotify, Wall Street was hoping it would beat expectations à la Facebook or Google (which regularly surpass stated targets) and when it didn’t, investors sulked.

Those investors better get used to disappointment. That’s because unlike other tech companies, music streaming services face a fundamental business problem they can’t overcome.

That problem is the price of music or, in this context, what accountants call “cost of goods sold.” The term refers to materials a company must acquire to sell its product—for instance, the flour and sugar a baker must buy to sell donuts.

In the case of streaming services like Spotify, they are uniquely dependent on a single supplier—the music industry—to provide them the goods for their product. And that supplier has both a monopoly and deep political influence to protect it.

Over the last ten years, the music industry has waged a relentless war in Congress and the courts to force streaming companies to pay more for the music they play. The justifications for the payments are often shaky—for instance, record labels and 1960s musicians sued Pandora over and over to pay an unprecedented royalty on pre-1972 recordings (essentially new money for old rope) until the company capitulated.

But regardless of whether such payments are justified, what matters is the music industry has the clout to demand them. The industry has a phalanx of lawyers to push their case in court, and is effective at charming Congress with lobbyists and celebrity star power. The likes of Spotify and Pandora are badly outgunned.

The upshot is, no matter how many subscribers they add, the companies will never enjoy the fat profits of other tech firms. Right now, the streaming services have yet to make any money and, if they ever do, it’s a safe bet the music industry will find a way to claw it back in the form of higher royalties. It’s much like the baker being totally beholden to a flour supplier that raises its prices every time donuts are on the verge of being profitable.

To see how this plays out from an investor’s perspective, take a look at the share price of Pandora, Spotify’s older cousin, over the past five years:

Yahoo Finance

And lest anyone think the music industry is going to let up, a new piece of legislation known as the Music Modernization Act just passed the House of Representatives. While the bill would do much to clean up a messy royalty collection system, it also contains some blatant giveaways for the industry, including new types of copyright that would last 144 years. It will be Spotify (and consumers) that will have to pay for those goodies.

Meanwhile, Spotify’s long-term prospects are bleaker still, given the company is also competing with the likes of Apple and Amazon, which can afford to lose money on their music offerings as part of a larger customer retention strategy.

None of this is to say Spotify is a bad company. Its CEO Daniel Ek has created a transformative new entertainment experience enjoyed by 170 million active users. But until streaming companies are able to gain the influence of the music industry, they will never make any money.

On Thursday morning, Spotify shares (spot) were trading around $153, well off their recent high of $170.

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