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Spotify - The path to 20%+ sustained revenue growth and 35%+ gross margins is getting clearer
Revisiting the thesis
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.
I continue to watch SPOT 0.00%↑ closely, but have yet to buy into the company - overall I continue to gain confidence in the my overall investment view, and do expect this will form a reasonably large part of my portfolio in the next 12 months or so.
Since writing the first set of notes on the company, I have had a number of questions via Twitter and email, which I have decided to answer here to share with everyone, by way of an update of my thesis. I’ve also addressed 2 questions I have been asked multiple times at the end of this piece.
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Music is a “wedge business” to build an audio platform. Spotify’s free tier is unappreciated by the market. It gives it scale, making it a valuable internet property.
Amazon first sold books. Cloudflare started with its CDN / DDOS protection product. Spotify’s first act is selling music (or giving it away for free users). Spotify is the only streaming company that offers a comprehensive free tier. This creates scale making 2x larger than the second largest player. Similar to Bezos and Prince, Ek is following a similar playbook, and using the scale of the initial music product to sell adjacent higher margin products. Scale is the critical ingredient to build a successful platform, which will ultimately drive sustained revenue growth and margin expansion.
On the face of it, the free tier doesn’t make sense. It is basically a 0% gross margin business. Even the premium music business only has a gross margin of ~28%. The low(er) margin music product is the trojan horse here, to build a larger, valuable business.
Though not obvious today, Spotify has built the foundation to grow a defensible high margin business, with strong network effects. As the platform expands, customer LTV will also increase. Margins today are muddy due to increased investment in podcasting (exclusive content) and a sub scale ad business.
With the infrastructure in place, the marginal cost of delivering additional products (podcasts, audio books, market place revenue) is de minimus, with the bulk of those revenues dropping to the bottom line as contribution margin (operating leverage is a beautiful thing).
Spotify made a big bet on podcasting, first with the Joe Rogan Experience, but also agreeing exclusive contracts with local regional creators also. The initial investment was important to make the platform the preferred destination for listeners.
The business has also made a number of acquisitions (i.e. Whooshkaa) to help creators produce high quality content, and become the platform of choice for creators.
Having achieved scale on both the listener and creator side of equation, there are number of ways in which Spotify can leverage the platform to create ancillary revenue opportunities, including:
Spotify’s nascent but fast growing advertising business is well behind its platform peers. Today, Spotify’s Ad ARPU is 1/6 the size of a large competitor platform. Interestingly despite Audio representing almost a quarter (22.8%) of total time spent with media, equivalent Ad spend represents just 5.2% → indicating there is a large gap for Spotify to bridge.
Leveraging the creator economy, and helping creators monetise their product. For example, recent introduction to enable podcast’s behind a paywall (Spotify takes 5% cut).
Spotify becomes a market place facilitating transactions between fans and creators. For example, the ability to buy concert tickets, artist merchandise or sell exclusive experiences through the platform. While still early, market place revenue has grown rapidly from 8m EUR of revenue in 2017 to 161m EUR in 2021.
Adding further ancillary audio products (audio books is the next cab of the rank)
This is not dissimilar to other platform businesses identified above, and at the most recent investor day the CFO noted they will be launching 3 new audio verticals in the future (your guess is as good as mine).
As shown on the investor day, music gross margin has steady increased since 2017, and is now at 28.3%.
Spotify is really a discovery business, hiding in plain sight. Its singular focus on audio and the creator experience will make Spotify the natural platform for creators / artist to be discovered by fans.
While almost all of the largest internet companies are competitors to Spotify, Music / Audio represents a small part of their businesses. Ek is solely focussed on winning audio, which creates an innovation edge. Focus is how David beats Goliath.
Spotify is decentralizing the music industry (an industry which has historically been very centralized where only few artists take the bulk of the pie). At the investor day, Daniel Ek pointed to the CD era, where the top 50 artists represented 25% of all album sales. Compare this to 2021, where the top 50 artists represented 12% of music streams on Spotify. Changes are afoot.
In addition platform starting to show early signs the power of discoverability on the music side, and what this means for the next tier of artists.
In 2021, 1040 artists generated over $1m on Spotify, while over 50,000 artists generated over $10k revenue from Spotify alone (with most earning over $40k across all recorded revenue sources). In both cases, both these metrics have more than doubled since 2017.
^^ this is a strong early indication that Spotify is additive to the artists, and the company should be able to replicate this for creators with podcasts and other audio verticals over time (noting for podcasts, the businesses ability to use NLP to aid discovery will be critical in driving this).
Spotify is misunderstood by the market. It is not Netflix NFLX 0.00%↑?
The market continues to value the business a music streaming business, which will perpetually be low gross margin. It is 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 EUR1.4bn + in sales and growing at ~31% yoy). It’s also discounting the power of the platform and the continued expansion into adjacent high margin audio verticals.
Analysts continue to compare Spotify to Netflix. There are 3 key reasons why its not a fair comparison.
Uniformity of content in music is actually an advantage - I’ll come to podcasts in point 3 below, but in terms of music there is no real differentiator between Spotify and its main competitors. Subscribers get a uniform product across all the major music streaming products.
Unlike Netflix, Spotify has multiple revenue streams - Today Spotify has 2 main revenue streams, premium subscription revenues and Advertising. In addition to these 2 streams, there are a number of nascent but growing revenue streams. Netflix only benefits from subscription revenues.
Spotify doesn’t have a content creation problem like Netflix - Subscriber churn for Netflix is driven by people (including me) switching platforms to access new content. People tend to come in and out of a subscription depending on what content is available. Over time, as Spotify becomes the leading platform for creators (which I believe it will), content costs will continue to decline in podcasting. Exclusive content was an early bet, but won’t be required in the long term.
World class founder let management team with a proven ability to execute.
Daniel Ek continues to be unwavering and uncompromising in this vision, even if it hurts the stock price in the short term. While still to be proven, I think 10 years from now, Ek will be talked about in the same way we talk about Bezos, Zuck, Hastings et al today.
Why do you value Spotify on a gross profit multiple and not revenue?
Firstly as a rule of thumb, as I mentioned in my investment notes, for unprofitable, low gross margin businesses (GM’s less than 50%), gross profit is a more appropriate measure of to approximate what a steady state EBITDA margin should look like. Specifically with respect to Spotify, I think of its gross margin as net revenue for a business like Spotify. If you think about a $1 of premium revenue, ~75% of that is paid out in royalties (similar to a payments company that takes a percentage of transaction value). Overtime as margins increase, I may consider using a revenue multiple to value the business.
Why have you not bought the stock yet?
I have not bought any stocks in 2022. I continue think the market will be an extended bear period. Matthew Prince, CEO of Cloudflare ( NET 0.00%↑ ), noted the following in his Q2 earnings call:
Let me be clear. I think that the economy is still in really rough shape.
And I don't know -- and again, I'm not a member of the -- I'm not an economist. But from what we hear from customers, customers are really still suffering, And the economy, I wouldn't say that the economy itself has stabilized. What I would say is we have had the flexibility in our business to be able to adapt to a very difficult environment. That environment continues to be difficult, and I think it will be difficult at least through the rest of the year.
If you have another question, feel free to leave it in the comments and I will come back to you!