Spotify's Best Chance at Beating the Digital Streaming "Suicide Pact" Is With Ads

By Erin Griffith , written on October 5, 2012

From The News Desk

A damning analyst report on Spotify's financials has been making the rounds today. It paints an ugly picture: Spotify is operating at a loss and making little progress toward closing that gap. Even as its top line revenue grows ($244 million last year), the company's margins haven't improved. Meaning that each additional dollar it earns flies out the door.

It's a result of the Internet radio "suicide pact" Spotify and its peers suffer under. The more they grow in users and listening hours, the more they have to pay out in pricey royalty fees. It's so bad that Pandora has spent no small amount of energy lobbying for laws that require its powerful terrestrial radio counterparts start paying for their access to music, too (they currently pay no royalties). And that says nothing of complaints that Spotify and its peers don't pay enough to artists.

According to the report from a company called PrivCo, Spotify's flat fee subscription system is "clearly a broken business model," which it needs to rectify "ASAP."

Two things: These are 2011 numbers, which take into account just a few months of the service being in US. And secondly, this analysis is focused on Spotify's subscribers. But Spotify has a trick up its sleeve for its relatively new presence in the US: Ads. If it does ads right, the company actually will be able to make gains on its ugly margins.

The company's advertising business is as critical as its subscription business, Spotify VP of Sales Jon Mitchell explained to me today. Spotify doesn't have a real preference over whether users are free and monetized by ads, or whether they subscribe. "Without ads, we're like Rhapsody and have a much smaller business," he said.

Spotify entered the US over a year ago and the vast majority of its users are on the free service. Over time that may shift to a greater mix of subscribers. Almost a third of Spotify's 15 million monthly active users subscribe, but the subscribers are not propping up the free users with their monthly subscription fees. The free users are being monetized by ads. The company has had to get scale in the US and new regions before it could really sell many ads.

I've always thought that Spotify's reason for running ads was to annoy people into subscribing. Ads run more frequently on Spotify than their streaming competitors' services. Furthermore, when Pandora doesn't have an ad to run, it simply won't run one. (The company's inventory is growing faster than it can sell ads, particularly on mobile, so this happens often.) If Spotify doesn't have an ad to run, you'll hear a house ad for Spotify. I've grown to truly loathe the phrase "HEY SPOTIFY LISTENER!" which is how most of the spots open up. I'm apparently not alone in that thought. When I asked Mitchell about it, he was dismissive.

"I've been with Spotify since the beginning and I've gotten this question for five years," he said. To prove that Spotify's ads are not designed solely to upsell people on subscriptions, he pointed to the company's abandoned ad-free product. Spotify had offered users the option to pay $5 a month to merely eliminate ads. No one bought it, he said. Either they were okay with the ads, or they would pay the $10 a month for a full subscription, which includes mobile access to offline listening.

The reason Spotify serves house ads when it hasn't sold the spot is to manage users' expectations. It's too easy for users to get used to not paying for anything for content in a new medium. Waiting for scale (which is required to sell ads) isn't an excuse to give them the expectation they can always have something for free. That's why Pandora users who were accustomed to not hearing ads weren't happy when they started appearing. Meanwhile, no one acts shocked when radio or TV commercials come on. That's just what we've come to expect.

Spotify is in the early days of having scale in the US, a huge geography for the service. With scale comes increased ad sales and fewer "HEY SPOTIFY USER" house ads. The company will be able to improve its margins as it fills that inventory. At least, in theory.

There are significant challenges to an ad-supported business model, as Facebook and Twitter have learned. Pandora has too, and now Spotify, even with its supplemental subscription income.

Listening is shifting from traditional radio to digital. The Radio Advertising Board will tell you otherwise because traditional radio still has the same reach. What they won't tell you is that the hours we spend listening to old school radio are shrinking and digital radio is growing like crazy. Ad dollars -- not so much.

Traditional radio ad spend is holding strong at around $16 billion in ad revenue a year. Meanwhile online radio hovers closer to a measly (but growing) $800 million. Most of that spend comes from experimental pools of capital allocated to digital advertising, not radio. The category of advertising is in a weird, in-between zone where it's not just digital and it's not just radio. There will be a learning curve before advertisers really take the plunge. The future of Spotify and Pandora remains in the lurch.