Investment notes – Spotify ($SPOT)

Spotify represents an opportunity to invest a global leader, led by an outstanding management team that has the potential to compound at 20%+ over the next 5 years.

Disclaimer: The below does not constitute investment advice. Please do you own research or obtain your own advice. The views presented are my own. I do not own Spotify shares at the current time, but am watching them closely. I will update this disclosure if I buy the stock.

 

Overview

Founded by Daniel Ek and Martin Lorentzon, Spotify is the global leader in audio streaming services. Its platform offers music, podcast and most recently audio books. Spotify is available in over 180 countries, is platform agnostic (available on iOS, Android, Windows etc) , and is one of the only players to offer a freemium model. Spotify competes with a number of tech behemoths own music streaming offerings (Apple Music, Google Play, Amazon Music). There are currently over 70 million songs available on its catalogue. The business is listed on the New York Stock Exchange under the ticker $SPOT.

I don’t intend to present a deep dive on the business, its model or financials. There are a number of free high quality deep dives available here on Substack and online. Rather the purpose of this piece is to lay out the key thesis and risks for investing in Spotify. If you are not that familiar with the business, I’d encourage you to read those first.

Investment thesis – what do I need to believe to compound capital at 20%+ annually?

Spotify is the clear market leader in Audio, led by (in my view) visionary CEO Daniel Ek. Audio and music streaming is a reasonably nascent business globally with only ~9% of the global population streaming vs Sweden where 35% of the population stream music.

The company has recently launched into additional countries and now serves 184 different markets. Management has publicly stated its goal of reaching 1bn global subscribers. I believe it has the potential to compound revenues by 20%+ over the next 5+ years, with gross margins of ~35% (vs ~25% today). If Spotify is able to achieve this, it would generate gross profits of ~$9.2bn annually by 2026. At a gross profit multiple of 10x this implies an Enterprise Value of US$83bn vs ~US$23bn today (factoring in 10% dilution from share bases payments) - or a share price of around $550 - $600 in five years. I think my assumptions are conservative, and see good probability of the stock returning over 5x money. While, I think it will be a while before management starts optimising the business for profit / free cash flow (FCF), I do think FCF margins on gross profits could be as high as 25%. If Ek can justify the re-investment into the business for growth, I’m not too fussed about cash generation. Part of the thesis here is to back Ek and his capital allocation ability.

Revenue growth will be driven by increased monetisation (ARPU) of its free tier (advertising), monetising both sides of its marketplace and other ancillary revenue opportunities which I’ve set out below. Gross margin will continue to expand from the addition of podcast and eBooks (changing listener mix as users stream other content outside of music), changing revenue mix (as advertising scales), value add services to creators through data & analytics and pricing. While not in my base case, I do see potential for Spotify to continue to negotiate more favourable terms with record labels as Spotify increases its overall proportion of their revenues (currently ~15%). I also note that current free tier gross margins are depressed as they include costs to produce exclusive content for Spotify (like the $200m Joe Rogan deal).  Over the long term, Web 3.0 represents a huge opportunity (and risk) for Spotify.

What the market is missing

The market continues to value the business a music streaming business, missing the overall expansion into audio and the potential size of the radio advertising market. Spotify is chasing a huge advertising opportunity (currently run rating at EUR1bn + in sales and growing at 40% yoy). In addition to being the leader in music streaming, Spotify is now also the leader in podcasts (which is a game changer from a gross margin perspective). I also think the market is taking a short term view and underappreciating the value of Spotify’s free tier user base, expanding network effects and its overall gross margin potential as the business scales. As such, I believe the market views Spotify as a music streaming business and not an audio platform with cutting edge AI/ML capabilities (which creates stickiness with users) chasing a huge advertising opportunity. While today, Spotify is somewhat at the mercy of record labels for music supply, overtime I see the potential for a structural shift where the labels might become more dependent on Spotify, resulting in better negotiating leverage. The singular focus on audio and providing the best experience for fans and creators alike provides Spotify a competitive edge over its larger more diversified peers (both Warren Buffett and Bill Gates have talked about the power of focus).

Does the business’s economics benefit from scale?

Yes and no. This has been the area I have focussed on the most as part of my diligence. It’s probably the thing that has stopped me from diving in and buying shares. Unlike a classic SaaS business, music costs are essentially a fixed proportion of revenues (not a fixed cost), creating a gross margin conundrum. One might think Spotify’s business model is similar to Netflix – it’s not - Netflix pays for the content once, and then doesn’t pay for it as users consume it. Spotify pays a royalty every time a user listens to a song, so every time you play that Taylor Swift song, she gets paid. Having said this, CEO Daniel Ek has said before “Scale changes everything”, and I think he is right. Based on my work around gross margin expansion, I do think there is a path for Spotify to get to 35%+ gross margins as the business grows.

How do gross margins expand?

As an overarching comment, gross margins for the business have increased from 12% in 2015, to ~26% today. I still think there are a number of levers for gross margin expansion as the business scales with the bulk of the low hanging fruit coming from the free tier of users which is currently at ~11%.

• Shift in audio mix as listeners spend more time on the platform on podcasts and audiobooks instead of music

• Data and analytics capabilities being offered to labels in return for lower streaming costs (i.e. discover mode, where artists are promoted in playlists for a lower cost per stream). Spotify could also sell this data to labels and artists to better understand their fan bases.

• Content creator costs reducing going forward. Spotify currently expenses content creator costs (like the Joe Rogan deal) as part of COGS, depressing its gross margins. Over time I anticipate creators will naturally choose Spotify given its market leadership and creator led model.

• Ads business will benefit from scale (ads are a largely fixed cost business and margins will appreciate with scale)

• Change in dynamics between labels and streaming providers

• Pricing – based on public comments made by Daniel Ek, I don’t see this lever being pulled anytime soon but note Spotify has tested this in smaller markets in Europe and also in New Zealand with good success (so it is an option)

Does the valuation make sense?

Yes. Given it has relatively low gross margins, I think its most appropriate to value Spotify on a gross profit multiple. Spotify trades at ~8x gross profits (share price in March 2022).

Thoughts on management and alignment?

Strong founder led management team, and shareholders are well aligned. Spotify is led by co-founder and CEO Daniel Ek. Ek is a visionary, and the concept of Spotify single handily saved the music industry which was declining from the rise of illegal downloads (the industry has recently returned to growth, largely thanks to Spotify and the introduction of streaming). I love the unrelenting vision of Ek, and his refusal to bow down to the short term nature of the public markets. Both co-founders take modest (or zero) salaries and each own ~10% of the company. To get a sense on why I think Daniel is impressive, it’s worth reading about his life and career pre Spotify, but also listening to their earnings calls.

Where could I be wrong?

Risks are set out below, but I see 3 key areas where I could be wrong and my thesis unravels.

• Labels band together and form their own streaming service. similar to what HBO did for SVOD (I think this is unlikely but still possible. The artists tried this with Tidal and that failed - but I do note the labels start from a stronger position).

• Web 3.0 and the decentralisation of the internet (see below)

• Spotify is unable to execute on its grand vision to become the leader in audio.

Web 3.0 and the de-centralised web?

Today we live in a Web 2.0 world, where the internet is centralised. The rise of online social networks has allowed Facebook, Twitter, TikTok to be become behemoths. The centralised web means people rely heavily on their platforms to connect with their networks. Take YouTube for example – where else does an artist release their music video? It means the artists interactions are intermediated through these centralised platforms, which is hugely inefficient for creators. Web 3.0 changes the opportunity set for creators.

Simply explained Web 3.0 decentralises the internet and also allows private property ownership on the internet. It represents both a huge opportunity and a risk for Web 2.0 companies like Spotify. Web 3.0 allows creators to monetise intangible assets (tokens and other digital assets – for example Jack Dorsey selling the ownership of his first ever tweet) and also control their interactions with their fans from a de-centralised platform (via block chain technology). I think it’s a game changer for creators as it allows them to get closer to their fans and control multiple revenue streams. Web 3.0 puts the power back into the hands of the artists. The sales game for a creator goes from “selling” songs / podcasts to the ability to sell tokens, unique digital assets and exclusive events for their closest fans. It also allows the creator to get closer to its fans, through a direct creator to fan relationship. To illustrate how powerful this is, let’s consider an creator and how it engages with its fans today (and ultimately makes money).

• Streaming platforms like Spotify, Apple Music etc

• YouTube for music videos, interviews

• Instagram, Facebook, Tiktok to engage with fans

• Artist website to provide information, update fans

• Sells tickets to a concert through a ticketing websites

• Sells Merch at a venue / via a website

This is not a unified experience for the creator nor the fan. Creators need to manage multiple channels to keep fans engaged, and fans need to be across all those channels to say engaged. On top of all this, almost all of these platforms takes a cut of the creators revenue. How frustrating!   

Web 3.0 decentralises all of this, as it allows the creators to engage with fans without the requirement of intermediaries. They can sell exclusive experiences, digital assets, invite fans directly into the creative process - all while controlling the entire experience for themselves.

This is powerful.  In order for Spotify to be an enduring company, I am of the firm view it has to win in a Web 3.0 world. Based on some of its more recent job ads, I think Spotify has realised this too.[1]  

How might Spotify be a trillion dollar company?

Spotify ultimately disintermediates the industry, with artists bypassing labels. Spotify superior data and analytics capabilities results in it becoming more valuable to artists then the labels itself. Spotify becomes the preferred platform for its creators, and thrives in a Web 3.0 world.  

Merits and Risks

Investment merits

The clear leader in audio streaming: Spotify is the clear leader in music streaming with its subscriber base 2x bigger than the second largest player. Additionally Spotify has moved into adjacent audio offerings including podcasts and (more recently) audio books, providing these services within a single platform. I think the expansion into podcasts, which has rapidly expanded in the last few years to become the leading podcast provider, creates a meaningful revenue and gross margin opportunity.

Positive flywheel driven by freemium business model: Spotify offers an ad supported free option with a limited feature set. While the freemium tier provides an efficient top of the funnel to add premium subscribers, I think the market is underestimating the potential value of free users and the ad business Spotify is business. Spotify is still in the early innings of monetising its free tier of users – building a valuable ad business takes time. As Spotify increases ARPU per free user, it will be able to offer free users better features, creating a positive flywheel attracting more users.

Expanding network effects: Spotify operates a two sided market place, however as Spotify builds out its platform I see increased user engagement creating opportunities for deeper relationships not just between creators and fans, but also network effects on each side of the market place (i.e. creators x creators and fans x fans).

Large and growing data set: Spotify’s large user base generates vast amounts of data which its algorithm leverages to more effectively match users with content that best aligns with their listening preferences – increasing user engagement and time spent on the platform. Within its free tier, I expect the business to leverage this data for its advertising business as well providing high value data and analytics to creators.

Clear path to gross margin expansion: I discuss the marginal cost problems with Spotify’s business model below, however my view is that the business can obtain gross margins of ~35% over the longer term driven by change in product and revenue mix.

Creator focussed platform: Spotify has made it clear it wants to be the destination for creators.

Well aligned, founder led management team: Daniel and Martin each own 9% and 11% of the company respectively. Ek has consistently invested in the company at the expense of short term of profits.

Investment risks

Spotify has a marginal cost problem resulting in low gross margins: Unlike most tech companies, which benefit greatly from economics of scale and typically only spend ~10% on marginal revenue to service its customers, Spotify pays out ~70% of premium revenues in royalties to labels, publishers and song writers.

Mitigant:

1. Spotify has compelling product road map which focusses on changing the listener mix (away from just music) adding high margin revenue streams including advertising, paid podcasting and value add services for creators through its data and analytics capabilities.

2. Ads are a fixed cost business, which today are a drag on margins as the company builds the framework to monetise its free tier. Over time as this revenue stream grows, I anticipate margins will improve and exceed that of the premium tier.

Competition from well-funded internet behemoths: Apple, Amazon, Google, Tencent and Bytedance all have competing products. These competitors have strong balance sheets and can afford to run their music streaming businesses at a loss for a sustained period.

Mitigant:

1. Spotify singularly focusses on becoming the leading audio platform. It differentiates itself by offering music, podcasts and audio books as well as a free tier to users. Even though Spotify is selling a commodity to its users, we’ve seen great businesses born from selling a commodity product (Netflix, Costco). [2]  

Supplier concentration: Over 90% of Spotify’s music content is the product of four music labels (UMG, Warner, Sony and Merlin). If one or more of those record labels decide to pull their catalogue from Spotify, this would impact Spotify’s ability to attract and retain subscribers. Additionally the oligopolistic structure of the market makes it difficult to negotiate attractive pricing.

Mitigant:

1. Labels rely on Spotify for 15% of their total revenues (50% of total labels revenues come from streaming, with a third of this from Spotify) and for artist success (data and analytics capability, ability to break artists etc). As Spotify increases its market leadership and provides even more value to labels through its data and analytics capability, I anticipate that it will become even more important to the labels its serve, potentially providing it negotiating leverage.

Artists leave the platform: In the past a number of high profile artist’s have left Spotify for competing providers or disagreements with the company (Jay Z, Taylor Swift and most recently Neil Young).

Mitigants:

1. Spotify’s market leadership makes it difficult for artists to leave and stay engaged with their fans. As a result, most of these departures have been temporary, with artists often returning to the platform. Finally, Tidal, a competing service which was owned by artists (including Jay Z, Kanye West and others) was unable to make an impact on Spotify.

Execution risk: My thesis relies on Ek and his team to execute the long term vision without bowing to the immediate pressures of the short term nature of the public markets.

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[1] Spotify’s recent hiring indicates its acutely aware of this. Job descriptions for backend engineers explicitly mention Web 3.0 as a growth technology for the company.

[2] Spotify’s music product is heavily commoditised – they are essentially selling an undifferentiated product which Apple, Amazon and Google also sell. While on the face of it, it would appear that this renders any competitive advantage as moot,  I think Spotify is selling this product better than its competitors. Two analogies which come to mind is the Netflix vs Hulu battle in the early days, which Netflix won despite its handicap relative to Hulu which was owned by strategics and Costco which literally sells what every other supermarket sells – it just does it better. Both of those companies have been compounding machines.