Cost of Spotify's free service cutting into profits

Spotify is facing a huge challenge in making enough money from its subscribers to overcome the costs of its ad-funded free music service, according to report from Enders Analysis. The research firm, taking a closer look at Spotify’s potential path to profitability, highlights that Spotify generates a healthy sum selling monthly subscriptions, pulling in gross profits of USD76m last year. However, it spent almost the same sums offering free music as a marketing tool to get users hooked on the service and then convert them to paying. Enders suggests that Spotify will need to look at a more stringent usage policy for free users if it is to trim losses and become profitable.

“Spotify has a profitable subscription business,” says Enders. “Losses of the ad-supported tier could be trimmed to produce breakeven by a more stringent policy on usage. However, with usage uncapped in the US until July 2013 and the launch in Germany in 2012, Spotify’s losses on the freemium tier could well continue to swamp the profits of the subscription side for the near term.”

Spotify is still a company in growth mode, attempting to build up an international base of paying subscribers. As such, its costs remain high, with the firm focused on launching in new markets and attracting new users, rather than trying to turn a profit. And while Enders believes the firm needs to cut users’ free access not only to bring down costs but convince more people to pay, Spotify sees the free option as critical to its business. Spotify is not the first company to offer a streaming music service, but it is succeeding where others have failed by offering a free tier. That option serves to attract consumers who might otherwise head down the piracy and illegal download routes, luring listeners in before convincing them to pay. Cutting down this access might make sense from a profitability stand point, but Spotify is looking at the bigger picture and remains convinced that if it is to survive in the long term it must continue to reel users in with a substantial amount of free music.

Despite this, it remains unclear if Spotify can ever make enough money to turn a profit. Currently, the firm generates 83% of its revenues from the just 8% of registered users it has convinced to pay. And while subscription revenues are growing faster than ad revenues, up 200% and 25% year on year in 2011 respectively, this isn’t enough to offset costs. Spotify, like many music services, does not directly benefit from having more users, with each new person adding further costs, in terms of royalty payments.