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When Spotify raised more than $500m this month in a funding round that valued the music streaming company at $8.5bn, investors played down the risk of it being crushed in a bruising battle with Apple.
After all, the Swedish start-up was on a roll. Subscriber numbers had doubled over the past year to 20m, up from 15m in January, giving the company a big lead over rivals in the race for control of the fast-growing market.
But on Sunday, Apple gave the clearest signal yet of its ambition to dominate this nascent market at almost any cost — even if that means burning through a portion of its $200bn cash pile in the process.
With days to go before the launch of Apple Music, the company was facing an intensifying chorus of criticism from artists and independent record labels about key terms of its new $9.99-a-month subscription service. Singer Taylor Swift said in a blog post that it was “shocking” and “disappointing” that Apple was refusing to pay artists for music carried during a free three-month trial period for users.
Yet within a day of the rebuke from Ms Swift, Apple changed its tune and announced that it would pay for every single stream. Eddy Cue, the group’s senior vice-president of internet software and services, tweeted: “We hear you @taylorswift13 and indie artists. Love, Apple.”
Apple’s decision to splash more cash in their direction has been welcomed by people in the music business, but it represents an ominous development for Spotify. The lossmaking company was already under pressure from rights holders — including Ms Swift, who pulled her songs from the service last year.
Mark Mulligan, analyst at Midia Research, says Apple’s move to pay higher royalty rates than Spotify may be a calculated move to put pressure on the market leader.
“Apple has intentionally or otherwise pandered to the aspirations of the record labels to make as much money as possible,” he says. “That makes it incredibly difficult for a self-sustaining music company like Spotify to run at an operating profit.”
The big problem for Spotify is that its ability to make money is largely at the mercy of music copyright owners. These include Vivendi’s Universal Music Group, Sony Corp’s Sony Music Entertainment, and Len Blavatnik’s Warner Music Group, each of which owns a small stake in the company.
Under the terms of its licensing contracts, Spotify is required to pay out 70 per cent of its revenues in the form of royalties to record labels and music publishers.
This onerous licensing structure meant that in 2014, Spotify’s costs of sale amounted to more than 81 per cent of its €1bn revenues. After factoring in fixed costs such as staff and infrastructure, the group reported a net loss of €162m.
Andrew Sheehy, analyst at Generator Research, argues that the three major record labels have such a tight grip over the company that in the worst case, they could push it into insolvency.
“The main existential threat to Spotify is that a small number of execs in the music industry make the wrong decisions and end up killing the company,” he says.
One danger is that Spotify may be forced to match Apple’s payments to the music industry. For Spotify’s investors, this would be a disaster. Earlier this month Apple said it would pay as much as 73 per cent of Apple Music’s revenues to record labels and music publishers — beating Spotify by three percentage points.
“That was a very clever move by Apple and very threatening to Spotify,” says Jeremy Silver, digital media consultant at Media Clarity. “The labels have now got Spotify where they want it, because of Apple’s presence.”
For Apple, which transformed the music market 12 years ago with the launch of the iTunes download store, capturing a big share of the streaming market is essential. This is not because the company sees a profitable opportunity in streaming in and of itself. Rather, offering an attractive music service is an important part of helping it build its core business: selling devices, such as the iPhone.
Meanwhile, Google and its subsidiary YouTube are also investing heavily in their music offerings. These cash-rich companies are widely believed to be willing to operate their music divisions at a loss for the foreseeable future in order to support their broader business ambitions.
To stay ahead of the competition, Spotify has been ramping up its spending, even though that makes profitability a more distant prospect. This month the company added video and podcasts to its platform as part of a revamp of the product. It is also investing in technology and last year sought to improve its song and artist recommendations by acquiring The Echo Nest, a music data company, for €50m.
One Spotify investor says that Apple and Google are attempting “to enter the fray with products that are likely inferior in all aspects except for their ability to be pre-installed on every device”.
Spotify’s backers reckon that the company can continue to increase its share of the overall streaming market, which Midia Research forecasts will expand from $3.3bn in 2014 to $8bn in 2019. They also believe that Spotify’s free, ad-supported offering, which the company says has 55m users, has an opportunity to cannibalise the global radio market, which is worth $46bn.
One person close to Spotify argues that it is in the interests of the major record labels for the Swedish company to develop into a strong, sustainable business and serve as a counterweight to Apple and Google’s digital dominance.
Mr Mulligan says it is entirely possible that Spotify will be able to capitalise on its first-mover advantage and reach 35m subscribers within five years, which would give it more than half the paid-for streaming market.
However, he cautions that it is also easy to envisage a scenario in which Apple overtakes Spotify. Whichever company comes out on top, he warns that Spotify will need to find a way to cut dramatically its costs as “the current model is not commercially sustainable”.
Spotify and Apple declined to comment.
Additional reporting by Harriet Agnew
This article has been amended since original publication to correct the size of Spotify’s annual losses as were noted in the chart