How Spotify Could Reverse Its Underperformance of the S&P 500

The company's strategy may lead to an improved outlook

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The pursuit of a two-sided business model could transform Spotify Technology SA’s (SPOT, Financial) financial performance. The company has the potential to generate revenue growth from its suppliers, as well as from consumers. Deals with artists, as opposed to record labels, could increase sales and allow the company to provide complementary services such as talent management.

Partnerships have the potential to further increase the size of the company’s user base. Investment in its platform, user experience and expansion into new territories could also be ahead.

Having fallen 19% over the last six months, the stock has underperformed the S&P 500. It could reverse this trend and appears to offer investment appeal.

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Supplier revenue

Spotify’s focus on developing a two-sided business could catalyze its financial performance. While it currently generates revenue from the consumer side of its business, there is potential for it to also monetize the supplier side. One way of achieving this goal is to charge record labels for services such as positioning a song in a specific playlist, or recommending certain playlists by a label’s artists. With the company having a large amount of data on listener preferences and behavior, it could offer a marketing service to record labels to promote their artists. The cost of providing such a service may be low, since algorithms could continue to be used to generate playlists.

The company’s latest feature to allow artists to upload their music directly to the platform could also increase its supplier revenue. It will pay artists 50% of revenue per stream, which is lower than the 52% it currently pays to record labels. With artists set to keep their full share as a result of there being no middleman, adoption of the service may increase in the future. The company may then be able to offer high-margin services for artists, such as promotion, marketing and talent management.

Growth strategy

Partnerships with Alphabet's Google (GOOGL, Financial) and Samsung (XKRX:005930, Financial) could generate further growth for Spotify. Family Plan master account holders receive a Google Home Mini as part of their subscription, with additional products set to become available in the future. A long-term deal with Samsung to become its out-of-the-box music service on the company’s devices may increase its scale. A deal with Sky, Europe’s largest paid-TV service, will allow users in the U.K. to add Spotify directly to their cable bill. A deal with Japan’s DAZN may offer cross-selling opportunities through the sports subscription streaming service’s growing user base.

Investments in the company’s core platform could increase its scale. Spotify intends to focus on the development of new discovery capabilities, as well as improvements to the user experience. Although the service currently operates in 65 countries, it has the opportunity to expand into new territories. Non-music content could also be a key growth area, with it seeking to build a catalog of podcasts to complement its portfolio. An improved ad platform may also increase conversions from free listeners to paid listeners.

Risk

Although the company has been able to increase the number of premium subscribers by 40% year-over-year to 87 million at the end of the third quarter, inactive subscriber numbers have also risen. They increased from 1 million in the first quarter of 2016 to 4 million at the end of 2017. As a proportion of the premium subscriber base, this has been an increase of three percentage points to 6%. Inactive subscribers are more likely to cancel their subscription if they are no longer using it.

The increase in the number of inactive accounts may be due to a rise in family plans. They have proven to be popular among consumers and also provide Spotify with a lower churn rate. The premium churn rate declined 90 basis points in the most recent quarter. Since inactive account numbers include those within a family plan, it seems unlikely that a family will cancel the entire service simply because one or two of its members are inactive. The company’s service is relatively affordable for most people and, therefore, benefits from a competitive advantage in terms of relatively sticky revenues.

Outlook

A two-sided business model focusing on supplier revenue alongside consumer revenue could catalyze the stock price. Dealing directly with artists rather than record labels may increase revenue, as well as provide growth opportunities in complementary segments such as marketing.

Continued investment in the user experience as well as expansion into new territories may improve the company’s scale. Partnership agreements have the potential to boost subscriber numbers in a number of segments. Having underperformed the S&P 500 in the last six months, Spotify could have investment appeal.

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