Between an expanded alliance with Hulu and reported plans to improve its free service, it looks as if Spotify (SPOT - Get Report) is hungry to find low-cost ways to counter tech giants that are bundling costly video services with their music offerings and can provide tons of free marketing for them.
But there's no such thing as a free lunch. And ultimately, Spotify's moves might prove to be half measures that only do so much to prevent it from having to make costly video and marketing investments.
On Wednesday morning, Spotify and Hulu announced that they're teaming to provide a $13 per month bundle covering Spotify's individual subscription plan (normally $10 per month) and Hulu's "Limited Commercials" plan (normally $8 per month). For the first three months, Spotify subs will only have to pay an extra $0.99 to get Hulu, which is set to be majority-owned by Disney (DIS - Get Report) . The move comes 7 months after Spotify and Hulu unveiled a $5-per-month bundle for students.
Separately, Bloomberg reported on Tuesday that Spotify is prepping an overhaul of its free/ad-supported service that will make it easier to use, particularly on phones. The revamp will reportedly let free mobile users "access playlists more quickly and have more control over what songs they hear on top playlists."
Spotify shares fell 3.4% on Wednesday to $149.57 following the Hulu news, perhaps due to worries about the deal's margin impact. That left shares 10% below April 3rd's post-IPO opening trade of $165.90.
The Hulu deal could provide a boost to Spotify's subscriber growth in North America, where it had 22 million subs at the end of 2017. But it's worth keeping in mind that with 17 million U.S. subs as of January, Hulu's domestic subscriber base is much smaller than the ones claimed by Netflix (NFLX - Get Report) or Amazon Prime. Netflix, which struck a deal in September to bundle its services with T-Mobile's (TMUS - Get Report) postpaid unlimited data plans, had 54.8 million subs at the end of 2017. In January, Cowen estimated that Action Alerts PLUS holding Amazon.com (AMZN - Get Report) has 60 million U.S. subs for Prime, which bundles the Prime Video service.
Moreover, a portion of those Hulu subs are on its $12-per-month ad-free plan rather than its Limited Commercials plan, whose ad-supported nature is a turn-off for many consumers. And perhaps more importantly, Hulu's services are only available in the U.S. and Japan; around two-thirds of Spotify's subscriber base resides somewhere else. For all those reasons, Spotify might still find it necessary in time to make sizable video investments of its own.
Meanwhile, Action Alerts PLUS holding Apple (AAPL - Get Report) , Spotify's biggest rival in the U.S. and many other locales, has inked several deals for original shows that could wind up bundled with Apple Music. And Alphabet's (GOOGL - Get Report) YouTube Red service pairs the Google Play Music service with ad-free access to YouTube, which has over 1.5 billion monthly logged-in viewers, as well as some original content.
Amazon hasn't bundled any exclusive video content with its Music Unlimited service. But it does sell the service to Prime members at a discounted price of either $8 per month or $79 per year ($6.58 per month). Jeff Bezos' company also offers a version of Music Unlimited that only works on Echo devices for $4 per month.
Just as the Hulu deal is meant to give Spotify a cheap alternative to spending heavily on its own original content, improving the free service could indirectly be a way of keeping Spotify's marketing spend down as it tries to hit its year-end subscriber guidance of 92 million to 96 million (a 30% to 36% annual increase).
At last month's Investor Day, Spotify disclosed that 60% of its gross subscriber adds since February 2014 were driven by its ad-supported service. Thus the service, which had 92 million monthly active users (MAUs) at the end of last year, acts as a valuable customer acquisition channel for a company battling tech giants that can cross-sell their music services to hundreds of millions of existing users at little or no cost.
But it wouldn't be right to say that Spotify's ad-supported service acts as a free customer acquisition channel. In 2017, the service had a paltry 10% gross margin (GM) after backing out licensing, cloud hosting and other costs. Assign to the service a reasonable share of Spotify's considerable marketing, R&D and administrative spend, and it's clearly a loss leader for Spotify's premium services.
Not that the premium services, which account for about 90% of Spotify's revenue, are all that profitable right now. They had a 22% GM last year, in large part due to the impact of Spotify's costly and complex 2-year licensing deals with top music labels. And there's a good chance the margin the company sees on Hulu bundles is lower still.
Though Spotify bulls have argued the popularity and stickiness of its subscription services will translate into long-term pricing power, the company seems to be going in the opposite direction a bit right now by creating discounted bundles and making its low-margin free service more appealing. Not to mention that Spotify's average revenue per user (ARPU) has already been trending lower -- it fell 14% last year to €5.32 ($6.58) due to a mix shift towards Family and Student plans.
Together with the company's aggressive R&D and traditional marketing investments, all of this helps explain why Spotify has guided for a 2018 operating loss of €230 million to €300 million ($285 million to $371 million). While Spotify clearly has an effective formula for growth, whether it can come up with a formula for profitable growth remains an open question.
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