LONDON/STOCKHOLM (Reuters) - Spotify SPOT.N sent its shares tumbling as much as 10 percent on Thursday after the world's most popular paid music streaming service said it would continue to sacrifice profit margins to generate future growth.

The Spotify logo is displayed on a screen on the floor of the New York Stock Exchange (NYSE) in New York, U.S., May 3, 2018. REUTERS/Brendan McDermid

The Swedish company came close to making its first-ever operating profit in the third quarter, years ahead of schedule, which the company said was because it had not been spending heavily enough to hire more engineers.

“Operating margin improvement in Q3 was largely due to shortfalls in hiring,” the company said in a statement, adding that its failure to spend more on hiring was continuing in the fourth quarter.

Spotify pledged to accelerate the pace of investments in research and development in new music services and additional content during 2019, which the company said would reduce its operating margins “for the foreseeable future.”

Hit by the global tech stock sell-off over the past month, Spotify’s shares have given up their 30 percent gain since their stock market debut in April on the New York Stock Exchange.

The shares dropped to $137.73 in early trading following the third-quarter report, which showed gains in paid subscribers, revenue and gross margins that were roughly in line with market expectations. The stock closed at $149 on its first trading day.

Hargreaves Lansdown analyst George Salmon said the performance was much better than forecast.

“However, much of this improvement is due to costs not increasing as fast as expected, due to shortfalls in hiring,” he said, noting that these issues have continued in fourth quarter.

Third-quarter operating margin shrank to a negative 0.5 percent from negative 7.1 percent in recent quarters. Spotify reported an operating loss of 6 million euros after previously guiding investors to expect losses between 10-90 million euros.

“Unfortunately profitability is no good (and) that’s too bad,” Tomas Otterbeck, an analyst with research firm Redeye in Stockholm, said, referring to the company’s determination to prioritize revenue growth over profitability for years to come.

The company tightened its expectations for full-year 2018 monthly active listeners to between 199 million to 206 million users. Analysts, on average, had been predicting 208 million users by the end of the year.

Monthly subscribers, which deliver 90 percent of revenue, rose to 87 million, up from 83 million in the second quarter ending June, it said. The latest results matched the average forecast in a Thomson Reuters analyst poll.

Total users rose to 191 million, including free, advertising-supported listeners.

BALANCING ACT

Spotify is seeking to develop a “two-sided marketplace” that connects both artists and recording industry labels to consumers but in non-traditional ways, using data on listener behavior to generate popular playlists that drive revenue to rights holders.

During the third quarter, Spotify expanded its direct licensing of musicians and their recordings, which it says about 250,000 artists have signed up for so far.

But Spotify still relies on striking licensing agreements with major record labels, which account for the vast majority of music streams on its service. The company is entering into re-negotiations with the labels during 2019.

“We’ve made it clear that our strategy is not to become a label, and not to compete with labels,” Chief Financial Officer Barry McCarthy told reporters on a conference call.

“(Spotify and the labels) have developed a mutual dependency on each other. It’s in both our economic interest to achieve a constructive outcome,” he said.

McCarthy said he aimed to convince music labels that Spotify remained a music industry ally and that its efforts to support independent artists and other distribution partners would expand the market for all major parties.

In the previous round of music licensing negotiations, record labels increased Spotify’s share of royalties to around 25 percent of revenues from around 15 percent.

McCarthy declined to comment when asked if the label renegotiations would potentially mean improved margins for Spotify.

Gross margins rose to 25.3 percent from 22.3 percent in the third quarter of 2017. Analysts were looking for margins around 24.9 percent, according to the Thomson Reuters poll.

($1 = 0.8789 euros)