Apple's Biggest Bright Spot Is Putting The Heat On Spotify

Apple ’s second-quarter earnings report wasn’t quite as bad as investors feared on July 26, and a bright spot came in the company’s Services business, which grew sales 19% year-over-year. While investors cheered, this may in fact be an ominous sign for Apple Music competitor Spotify.

The Swedish streaming service and its CEO Daniel Ek are industry leaders, but they’re dealing with deep-pocketed rivals. When the company sold $1 billion in convertible debt in March, the pressure was on. The securities convert into equity when the company goes public, but both the interest rate (initially 5%) and the discount to the IPO price (initially 20%) increase every six months until the stock market debut, says a report in the Wall Street Journal.

While Spotify is currently the global streaming leader with 100 million active monthly users, according to a June report by Cowen & Co., its $8.5B valuation is up for debate. In January, mutual-fund Fidelity Investments marked its stake down by 27%, noted regulatory filings.

Questions about the Swedish startup’s business model don’t come as a surprise. Despite Ek’s reports of strong ad revenue growth, the company’s losses rose by 10% to about $194 million this past year. Expensive royalties and revenue sharing with music label partners are to blame, taking up to 80% of total revenue.

Spotify’s profitability needs are quite different than the tech giants like Apple and Amazon that don't depend on music to make a profit. For players like the latter pair, the “strategic value of high-frequency consumer touch points eclipses the revenue impact,” notes Cowen & Co. analyst John Blackledge. In other words, Apple Music and Amazon Prime Music can lose money as long as they drive user traffic to places like the App Store and Amazon’s shopping sites.

Lucky for Apple, synergies created between the App Store, Apple Music, iTunes, and iCloud have added up quite nicely. With revenue from Apple’s Services business generating a quarter record of $6B in June, Apple’s presence in on-demand streaming is likely to pick up momentum.

The purchasing power of the 600 million iPhone, iPad and iPod owners leaves Apple in a position of strength. iPhone users are spending $68 a year on apps, music and other services, according to estimates by Credit Suisse.

Spotify and other independent on demand streaming services are also at the mercy of tech giants’ distribution channels. In late June, Spotify accused Apple of anticompetitive behavior in response to the App Store’s “business model rules” which charge a 30% fee on any sale through the App Store. To earn the same revenue, Spotify must charge subscribers $12.99 a month rather than the standard $9.99. Lo and behold, Apple Music is priced at $9.99 a month.

The so-called “Apple Tax” has been around for quite some time, but anti-competitive complaints have promulgated only recently, following the launch of Apple Music last year.

What’s more, in a filing surfaced by the New York Times in mid-July, Apple plans to “streamline royalty payments” with the help of the Copyright Royalty Board, a panel of federal judges who oversee rates in the U.S. The proposal holds that streaming services should pay 9.1 cents in songwriting royalties for every 100 times a song is played.

While this guideline may make it easier for artists to figure out what they’re owed, it could eviscerate the financial viability of Spotify’s free-platform which currently encompasses about 70% of its total subscriber base. The proposal would further increase the rates that Spotify already pays, a major hit to its bottom line.

Apple’s loss-leader mentality is reaffirmed by the fact that Apple is already paying higher than usual rates after arranging direct deals with artists at the time of Apple Music’s launch last year.

“The stakes are high for Apple to get it right” says Blackledge. Anything that keeps consumers spending time in Apple’s ecosystem is a benefit.

However, Cowen highlights that Spotify’s free, ad-supported version is a consumer traffic generator that differentiates it from Apple, which only offers a three-month trial rather than a free option, and Amazon, which only offers its service to Prime members paying an annual fee.

Spotify’s chief revenue officer, Jeff Levick plans to amp up revenue from the free-ad platform by exploring larger deals with major ad-holding companies. In May, Levick hired former Fox and CNN executive, Liberty Carras Kelly as Spotify’s new head of Americas sales. Danielle Lee, former Vevo VP of commercial marketing also joined the team as Spotify’s VP of global partner solutions.  

Spotify’s premium subscriber base grew 90% year over year for two consecutive years beginning in 2013, according to the June Cowen & Co. report, which also notes that major record labels Universal, Sony , Warner and EMI own a collective stake in Spotify near 20%. That provides at least some incentive for the industry to give Spotify, which is helping drive revenue to the labels, a fair shot at staying ahead of its well-heeled challengers.