Corporate Finance: Spotify Needs to Better Manage Cost Structure

Image representing Spotify as depicted in Crun...

Image via CrunchBase

Renowned digital music service Spotify is growing at an impressive rate, but so are its losses in revenue given the high variable cost structure due to licensing fees that limits its options to rein in costs.

On Spotify’s Financial Performance
PrivCo reported that the company posted a 131% annual increase in sales compared to its 2011 results. Gross margins, which mainly reflect licensing fees relative to revenues, are also improving, now at 16.5%. However, Spotify’s challenge is that its costs are not flattening quickly enough to become profitable. Even after having eclipsed Pandora, Spotify suffers from the highest costs of revenue in the business and this impairs the company’s ability to generate an operating profit.

An analysis of Spotify’s financial statements shows that the company’s cumulative losses now exceed $200 million, with the company now having raised nearly $300 million in outside funds. Recognizing its need to preserve cash, Spotify has managed to generate positive cash flow by deferring payments to its trade creditors: in fact, the annual increase in its trade payables balance accounts for more than all of Spotify’s cash flow, indicating that the firm’s cash management strategy is based on stonewalling suppliers.

From: PrivCo

BLM Implications

PrivCo’s CEO acknowledges that there is a problem with Spotify’s business model, and BLM concurs with him. He says, “Its pricing is fixed but the costs are variable, causing losses from the heaviest users. The dilemma is that the heaviest users are also the ones most likely to return; the lightest users are the ones most likely to cancel. So the churn comes from Spotify’s most profitable users.”

The current business model of Spotify is also is Achilles’ heel or weakest link. A single payment that grants an all-pass access will cause the variable costs incurred from licensing to hemorrhage the revenue and prevent a good profit from the business. Perhaps Spotify can take a serious look at its pricing strategy and charge customers in tiers rather than a flat-out fee. Somewhere along the line, a cap has to be drawn, just like a mobile data plan. For telecommunications companies, the mobile data plan cap acts as a deterrent from overuse so as to free up bandwidth for subscribers willing to pay for the service of having more data. In like manner, if Spotify introduces a price-tiering system, not only will it be able to capture users according to usage, it will alleviate the effects from some of its currently unhealthy cost structures.

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3 thoughts on “Corporate Finance: Spotify Needs to Better Manage Cost Structure

  1. Wow that was unusual. I just wrote an incredibly long comment but after I clicked submit
    my cimment didn’t appear. Grrrr… wll I’m nnot writing all that over again.
    Anyway, just wanted to ssay wonderful blog!

  2. Spotify’s current business model is one that cannot stand if it wants to stay in business. By offering such a large access of music for a low rate per month it can’t handle the losses taken. Spotify must pay large fees by producers to use their music, this makes it difficult to create a profit with some people downloading thousands of songs at a low rate. Spotify also takes money away from some of the other parts of the market such as itunes, cds, and albums. It cannot be sustained unless Spotify raises prices or changes its business plan somehow.

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