Spotify Is Taking a Big Step to Increase Profits

Spotify (NYSE: SPOT) is giving artists a way to keep more of the money their songs make. The streaming service's latest feature allows artists to upload their music directly to Spotify, no third-party services or record labels needed. What's more, artists will receive 50% of the net revenue their songs generate.

Spotify currently pays out about 52% of revenue to record labels for each stream. From there, the labels turn around and pay artists anywhere between 15% and 50%. Cutting out the middle man can guarantee more money for artists, and Spotify gets to keep a little bit more of its revenue, too.

Growing gross margin through stronger relationships

Spotify's biggest expense is the royalties it pays on each stream, so cutting those down by a few percentage points will have a massive impact on its business. To that end, the company posted a gross margin of 25.8% in the second quarter. That's up 2.8 percentage points from the year before, reflecting the benefits of its new deals with the major record labels and indie label representative Merlin.

However, long term, the company still expects to top 30% gross margin. In order to get there, it will need to convince more artists to upload songs directly to Spotify and foster the two-sided marketplace management as described at its investor day earlier this year.

Expanding into higher-margin services for artists such as promotion, marketing, and career management will enable it to reach profitability over time. In order to get there, though, Spotify first needs to develop stronger relationships with artists. Allowing them to upload music directly to the platform without the need to pay a third party or go through a record label is just the first step.

Spotify has a lot of influence

Spotify can offer artists who work directly with the company a lot more than just higher royalties. Spotify is the most popular streaming platform in the world, with 180 million monthly active listeners.

What's more, the company is in charge of playlists accounting for about one-third of total listening on the platform. About half of that is algorithmically curated, while the other half is hand-picked. Both still present an opportunity for Spotify to favor songs where it pays a lower royalty rate, benefiting the artists who choose to upload directly to Spotify.

Spotify still wants to put the best product into people's ears, so it's not going to sacrifice quality for profits. Given the choice between two equally good songs for a playlist, though, Spotify will leave the less profitable song out.

Spotify is wielding a double-edged sword. If it shows too much favoritism toward its direct relationship with artists, it could end up costing itself in its relationship with the labels, which account for the vast majority of its content, and will continue to do so for the foreseeable future. That risk is amplified by the fact that Spotify isn't the only show in town anymore, with the rise of alternatives from big-name competitors willing to take smaller profits on their streaming services.

Growing Spotify for Artists

Ultimately, giving artists more control over their music and a greater share of revenue should increase the attraction of Spotify for Artists, the analytics tool providing personalized listener data to artists. The company says the tool's user base doubled over the last six months, to 200,000 artists.

Management said it will continue to provide regular updates over time, but it didn't promise to share numbers quarterly. Still, Spotify for Artists is the main way the company will move into higher-margin services, so it's the number to watch. Investors should also pay attention to gross margin, but focus more on its year-over-year numbers since Spotify's business has a lot of seasonality.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.