Media company Spotify Technology (NYSE:SPOT) primarily generates cash from streaming music to listeners digitally, and judging by its third-quarter results, where total revenue grew 11% on the previous year to $3.4 billion, business is good for the Swedish-based firm.

Subscribers and non-subscribers are able to listen to millions of songs from a variety of genres from indie, rock and pop to classical music on Spotify’s vast library, which also includes podcasts.

Spotify offers a free service, which is ad-supported but with lower audio quality, and a premium subscription service with better audio quality, no adverts and the ability to download songs.

In the third quarter, Spotify grew its premium subscriber numbers by 16% year-on-year to 226 million, two million above the company’s expectations.

This rise was despite Spotify increasing its prices in the US, UK and 50 other markets last July by 10%. Its standard monthly subscription for UK customers now stands at £10.99 per month rather than £9.99.

The company told subscribers at the time the rise was to ‘invest in and innovate our product offerings and features’, which it has done by unveiling new personalised experiences for users and tools for ‘creators’ like artificial intelligence (AI) voice translation for select podcasts, an expanded AI DJ to 50 markets and a tool to help artists promote music releases.

What do investors like about Spotify?

Spotify has many high-profile investors, including Scottish Mortgage Investment Trust (SMIT) which has owned a 1.9% stake since 2015 because it believes the company is ‘reshaping the music industry’.

The trust’s managers argue Spotify has created a platform ‘where artists can own copyright and be heard by new listeners, while fans get more choice and closer relationships with artists’.

The firm has become an industry leader by ‘making music a constant companion and creating machine-generated personalised playlists. Exponential growth in podcast production is also increasing user engagement‘, add the managers.

Just as Steve Jobs was considered pivotal to the early success of Apple (AAPL:NASDAQ), so Spotify’s co-founder and chief executive, 40 year-old billionaire Daniel Ek, is seen as integral to the Swedish firm’s success.

‘Ek is thinking on a universal scale for Spotify; he wants to put it in front of every single person on the face of this universe who’s interested in music. He is also committed to making it possible for creators to live off their art’, say the managers.

BALANCING ACT

Although Spotify is generating healthy revenue through its increased subscriber numbers and advertising, the company has mounting costs to the music industry.

According to a company presentation, as of 2022, Spotify’s total pay-outs to the music industry were approximately $40 billion in both recording and publishing royalties.

Yet the company has come under increasing criticism for how little it pays musicians, which is on average between $0.003 and $0.005 per stream.

This year, Spotify is introducing a significant change to the way it calculates recorded royalties meaning tracks must have reached at least 1,000 streams in the previous 12 months to generate royalties on the platform.

This change in strategy, the company said in a blog post, will ensure that each of the tracks streamed will earn more.

BAD RAP 

The firm has also come in for a fair amount of criticism over its podcasting strategy, where errors of judgement have resulted in job cuts.

During the pandemic, the company invested heavily in podcasting to build its audience but ended up overpaying for content. For example, the company spent more than $2 million per episode for a dozen podcasts featuring Prince Harry and Meghan Markle.

Last December, Spotify announced the departure of chief financial officer Paul Vogel. Just days after the firm announced a further 1,500 job cuts, Vogel cashed in $9.3 million worth of shares.

Laying off 17% of the workforce may not be an unusual move for a tech company, and in fairness the big beasts of the sector were all doing it – Meta Platforms (META:NASDAQ) cut an additional 10,000 jobs in March, Amazon (AMZN:NASDAQ) laid off 9,000 workers and Alphabet (GOOG:NASDAQ) shed 12,000 jobs globally in 2023 with more redundancies announced this month.

When asked about the timing of Vogel’s departure, Daniel Ek simply said ‘over time we’ve concluded that Spotify is entering a new phase and needs a new CFO with a different mix of experiences.’

MONEY MAKER

To make a sustainable profit in the long term, Spotify has to keep a lid on costs and innovate to fend off competition from Apple, Alphabet and Amazon, all of which offer their own music streaming services.

Ali Mogharabi, senior equity analyst at Morningstar, notes: ‘Unlike Spotify, these firms don’t rely solely on streaming music or podcasts to drive profitability and can potentially run at breakeven or even as loss leaders while monetising users via other products and services.

‘It might also be harder for Spotify to steal share from these competitors over time, as Apple Music and Apple Podcast listeners are probably entrenched with other Apple products, Amazon Music with Echo and so on.’

However, Moghrabi is upbeat about the company saying Morningstar has raised its projections: ‘We now anticipate a higher user count and wider margins given the strengthening of Spotify’s flywheel, resulting in a $183 fair value estimate, up from $170, a level at which the stock is trading currently after nearly a 10% jump in reaction to the firm’s quarterly results.’

Over the past year, it’s fair to say Spotify shares have performed well having gained 129%.

Justin Patterson, equity research analyst at KeyBanc Capital Markets, is also upbeat about the firm’s prospects.

‘Spotify is leveraging AI across its platform. Coupled with audiobooks rolling out to premium subscribers, we believe the company has several opportunities to drive engagement and eventually stronger monetisation.’

In the long term, if Spotify can invest in more services and tools for artists then the company may be able to attract artists away from record labels and toward independent distribution, which may allow it to pay lower royalties over time.

Diversification into different content is also key for Spotify over the next 10 years, for example video which will attract more users and advertisers.

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