Spotify has Launched Its Two-Sided Marketplace

Since it was founded in 2006, Spotify has made the majority of its revenue from its subscriber base. The 108 million premium subscribers brought in $1.5 billion last quarter, around 90% of the company’s total revenue. The 124 million ad-supported users accounted for only $165 million in sales.

This revenue imbalance should change shortly with Spotify’s latest service: Artist Promotions.

Now, artists will be able to pay Spotify to promote their new music to people who either: a) listen to them already, or b) have similar tastes to their current listeners. Here is Spotify explaining it:

“We personalize these new album recommendations based on your listening taste, combined with human curation. With an upcoming test we’re running in the US, we’re giving artists and their teams the ability to directly tap into this process and connect with the fans that care most about their music.

In this test, we will let artist teams pay to sponsor these recommendations, giving them the power to tell their listeners on Spotify—across both our Free and Premium tiers—about their latest release.”

The Start of the Two-Sided Marketplace

Spotify has hyped-up the two-sided marketplace (just a fancy way of saying they will start making money off of artists) in their earnings reports ever since going public in 2017. They even had a whole section dedicated to it in the most recent one.

Why do they care so much about this? Because their traditional revenue stream (charging users and paying the labels for every stream) has an inherently low-margin ceiling. Just as an example, last quarter they only had gross margins of 26%. This means that only 26% of their sales can cover operating expenses, severely hampering their ability to generate substantial net profits.

Spotify adding a high-margin business like Artist Promotions could help reverse this effect.

What Higher Margins Would Look Like

Here is a table from a piece I wrote this summer about Spotify’s pricing power:

The point of the article was to quantify what the company’s financials would look like if they grew users and average revenue per user (ARPU) over the next five years. However, it only included small gross margin increases because of the pay-per-stream model the majority of their business is under.

I believe the two-sided marketplace can bring in higher margins than music streaming. Here is a redo of the table above, but this time with assumptions that in 2024 Spotify will bring in $1 billion in “Artists” revenue and will reach total gross margins of 32%. Remember, these are predictions for quarterly financials. To get annual, multiply sales and gross profit by four.

YearUsersARPU ($)Sales ($)Gross Margin (%)Gross Profit ($)20192177.881.71124.70%0.42320202827.882.42426.00%0.63020213678.283.43627.00%0.92820224778.694.74429.00%1.37620236209.136.45631.00%2.00220248069.588.72132.00%2.791

I’m assuming a lot in this table, and it is highly likely Spotify will not go down the exact financial path I’ve laid out. But if they can start getting substantial revenue from all the aspiring artists on the platform, it would likely be a huge profitability boost. Not to mention, it would help users find more of the music they like.

Different revenue streams and monetizing all aspects of their global platform is one of the big reasons why I love Spotify stock.

Disclosure: the author is not a financial advisor, and may have an interest in the companies discussed.

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