Battle of The Giants: Winner Take All Dynamics in Music Streaming

By Alexandre Taylor

Spotify’s share price has plummeted to less than $100 a share (as of May 2022), down from a February 2021 high of $365, despite beating earnings and growth projections in April. Of course, rising rates tend to hit growth stocks the hardest, but Spotify’s slide is particularly devastating considering its sluggish pre-pandemic performance. To understand Spotify’s slide, we should consider two key factors: “winner take all” dynamics in two-sided marketplaces as well as the changing competitive landscape of the music streaming industry.

Two-sided marketplaces are platforms which connect two distinct groups of customers, both of which have their own set of revenues and expenses. Ridesharing apps, which connect riders and drivers, are a recent example but so are video game consoles (connecting players and video game studios) and credit cards (connecting shoppers and stores). Internet-age platforms are famously profitable once competition has subsided, as two-sided marketplaces can take a cut from both sides of the market by leveraging data analytics and machine learning. For example, Airbnb charges both homeowners and guests a service fee in exchange for providing booking recommendations and dynamic pricing, among other services.

The immensely profitable nature of two-sided marketplaces often leads to “winner take all” strategies, which see high levels of investment and subsidies suppliers and users. Important to consider is that profits often only occur once a space has been dominated as raising fees is impossible while competitors pose a threat. In the ridesharing industry, Uber subsidized both riders and drivers. For Spotify, the firm subsidizes listeners by paying the difference between subscription rates and record label royalties. Thus, costs for marketing campaigns and subsidies mount while profits remain low.  

Another reason why two-sided marketplaces can be so profitable is their self-acceleration: for Spotify, more subscribers mean more artists, as well as better data services as the number of users expands. However, unlike many platforms which take advantage of highly fragmented consumers and suppliers, music streaming service profits are restricted by their suppliers – record labels. In effect, because music streaming firms do not own the music itself, but depend on the intellectual property to drive revenues, record labels have incredibly high leverage over music streaming platforms. In 2020, Spotify spent 70% of its revenues on paying record music fees and royalties.

In response, Spotify has implemented numerous strategies to seek to reduce its cost of revenue and thus increase its margins. First and foremost, it has invested in alternative audio streaming, such as podcasts. As opposed to the music industry, podcast suppliers are decentralized and fragmented, allowing for deals such as Spotify’s exclusive signing of The Joe Rogan Experience, the world’s most popular podcast. In addition, Spotify’s playlist and queue algorithms, which have a large impact on U.S. music charts, are in turn helping Spotify increase its leverage over record labels. The result of Spotify’s efforts have largely been successful – its cost of revenue in 2021 was 73%, down from 79% in 2017.

Yet despite its success in growing its profits, investors have not been responsive. Partially this is due to new entrants, particularly Apple Music, now the second-largest streaming service. Apple Music’s greatest strength is its integration into the Apple ecosystem. Prior to Apple Music’s launch in 2016, the company had already built a loyal following through its hardware and music-purchasing software iTunes. Not only could current iTunes users be easily on-boarded, but Apple’s previous relationships with record labels allowed Apple Music users access to a larger music library. In addition, Apple developed features which allowed users to sync music across devices as well as wirelessly stream to Apple speakers and headphones.

In addition, whereas Spotify is seeking to limit its dependence on record labels, Apple has strengthened its relationship with music providers. In 2021, Apple released “artists pages” for record labels which is likely to deepen their individual ties with listeners. As Ethan Millman writes for Rolling Stone, “Outside of the most intense music listeners, music fans don’t hold brand loyalty and demand toward one major record label’s content the way they do to a movie or TV studio... In the digital era, [labels] are relegated to fine print, appearing only as a small copyright line at the bottom of an album page of streaming services. With a direct feed to fans to dig into a label’s catalog, fans can begin to see more directly which labels are behind their favorite projects.”

Spotify’s success depends on its ability to grow its user base to the point where it can negotiate better terms with record labels and therefore significantly reduce its cost of revenue. However, for Apple, its music platform is more valuable than a standalone asset. Apple Music adds another layer to the Apple Ecosystem and gives the company a competitive edge over its hardware competitors, such a Samsung. In addition, Apple can also use data from its music platform in marketing efforts. Thus, Apple’s investors can stomach losses on music streaming whereas Spotify’s cannot.

Due to the popularity of Apple Music, as well as the entry of new competitors such as YouTube music, Spotify will likely not reach the critical mass of users necessary to dominate the music streaming space. To succeed, Spotify must therefore diversify its revenue streams. It should continue to invest in alternative audio streaming, perhaps by partnering with membership platforms such as Patreon. In addition, Spotify could separate its music revenues into record and independent-backed streams and seek to differentiate itself from its competitors by becoming a hub for independent artists. For larger artists, it could also backwards integrate and become a music label responsible for the recording, marketing, and distribution of music.

Of course, diversification poses a significant threat to record label profits and labels could decide to align themselves with Apple Music by offering exclusive streaming rights. However, doing so would increase label reliance on Apple Music for profits to an unprecedented level. In addition, Spotify remains the largest music streaming platform, and an exclusive deal with a competitor would significantly reduce record label profits.

Although the competitive landscape of the music streaming industry continues to evolve, a winner take all strategy is unlikely to succeed for Spotify. By diversifying, Spotify can continue to grow its user base, reduce the amount of direct competition with Apple Music, and return profits for its investors. Without doing so, Spotify’s investors are likely to continue to tire of high revenue growth but low profitability, restricting Spotify’s access to capital – a very dangerous possibility in such a high-expense industry.