Spotify's Drake Problem Is Bigger Than You Think

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There's been no higher-profile IPO this year than Spotify Technology (NYSE: SPOT). Shares of the company are up over 35% from its direct-listing price of $132 in April. Even a weaker-than-expected quarterly earnings report hasn't significantly slowed the stock's advance.

Most recently, the company has come under pressure for aggressive artist promotion. In celebration of Canadian rapper Drake's new album -- "Scorpion" -- the company declared it "Scorpion SZN," attaching the rapper's face to nearly every playlist while mass recommending songs from the 25-track album to its 170-million user base.

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While this sounds like a minor issue, it strikes at the heart of Spotify's value proposition to listeners.

Subscriber conversion is the key to the company's success

The reason the Drake controversy is important? It hurts Spotify's business model in two ways: First, Spotify's free ad-supported business isn't profitable and likely will never be so due to poor unit economics.

Therefore, Spotify is operating a de facto "freemium" model, allowing users to listen at no cost in the hope of eventually converting them into a paying Spotify Premium subscriber. In the last year, the company has done a solid job with this effort, growing Premium subscribers 45% to 75 million.

In the first quarter of 2017, the split was 40% Premium and 60% ad-supported users versus 2018's split of 45% and 55%, respectively, which allowed the company to significantly narrow its operating loss.

The no ads bit is important here as many premium subscribers felt the Drake promotion was so pervasive and aggressive that it was advertising. A few users noted they had asked for, and received, a refund for the month because of the Drake promotion.

This strikes at Spotify's business model

The second reason is the promotion strikes at Spotify's value proposition with all users. From a product standpoint, there's little differentiation from one streaming music service to another. For example, although streaming-rival Tidal tried to differentiate via offering exclusive albums, better audio, and more artist-friendly economics, it hasn't caught on in a major way.

If there's any differentiation in the streaming industry, it lies in curation, with algorithms recommending new songs and playlists based on a listener's history. What makes the ubiquitous Drake promotion so damaging is it exposes this process as something that can be manipulated to provide, as Pitchfork notes, the maximum value to Spotify, not you the listener.

Spotify must keep Premium users happy

It's important to note that streaming audio is an industry with near-zero switching costs and decisions can be made with a simple app download and a few swipes on a smartphone, so the effect of any missteps is quickly magnified.

Spotify is well-situated in the ad-supported space because of a lack of serious competition. However, the race in the subscription-based market is heating up with Digital Music News reporting Apple Music just took the U.S. lead for subscribers (Swedish-based Spotify still leads globally, however).

And for a company struggling with profitability, it makes sense for Spotify to ensure Premium subscribers are happy with the service, increasing the lifetime value of each subscriber, rather than leveraging one-off deals with artists for promotion. Spotify got stung by Scorpion SZN but hopefully won't let this happen again.

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Jamal Carnette, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.