Some Thoughts on Spotify

A look at the leading audio streaming company

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Spotify (SPOT, Financial) is a leader in the audio streaming business, with its service currently available to users in 92 countries (and more to come). As noted on the investor relations page, the company has played a role in changing how people around the world access and enjoy audio content:

"We are transforming the music industry by moving from a transaction-based experience of buying and owning audio content to an access-based model allowing users to stream on demand."

As opposed to paying $20 for an album or 99 cents for a song on iTunes, users now have unlimited access to more than 60 million songs, along with a growing slate of podcasts and other content, for $9.99 a month (and even cheaper on a per user basis with Duo, Family and Student plans).

From a consumer perspective, the attractiveness of this offering is evident in the numbers. As of the most recent quarter, the company had 138 million premium subscribers (+27% year-over-year) and 163 million ad-supported monthly active users (+31% year-over-year). As shown below, the number of total subscribers has roughly tripled in the past four years, from ~100 million to ~300 million.


Despite persistent competition from some of the largest companies in the world, including Apple (AAPL, Financial), Amazon (AMZN, Financial) and Alphabet (GOOG, Financial), Spotify has maintained its leadership position. With 35% to 40% of the global music streaming market, the company has nearly twice the share of its closest competitor, Apple Music (15% to 20%). In addition, based on estimates from Spotify's management team, their service has two to three times the per user engagement of other scaled streaming platforms. The average user spends 25 hours a month on Spotify, a cost of less than $0.25 per hour on a premium ARPU of $5.25 per month. Considering that the vast majority of content currently consumed on the platform is a commodity (the same songs you'd find on any other service), I find those data points interesting. It suggests Spotify is connecting with its audience in a way that its competitors have failed to replicate (and despite the many advantages those larger competitors bring to the table). I think it's some combination of a better user experience, more advanced curation / discovery tools, and a cleaner (more focused) brand.

The combination of a larger and more engaged user base is a competitive advantage. Over time, I think the company's leadership position may give them the ability to evolve their relationship with key suppliers, most notably record labels. To be clear, I don't think this necessarily means negotiating lower royalty rates and grabbing a larger piece of the music pie. Instead, Spotify and the labels may work together more closely in hopes of achieving mutual goals, with the end result being a larger industry that benefits all involved (artists, the labels and Spotify). As management has noted in the past, "there are certain elements [of what labels do] that we can bring efficiency to." One notable example is discovery: Spotify has a deep understanding of each user's tastes, with more than 30% of consumption on the platform driven by music that Spotify suggests to listeners. As we think about the value of Spotify's user data over the long run, it starts to become clear how serving both sides of the two-sided marketplace may come with economic benefits for the company.

In addition to the benefits that may come from an improvement in their relationship with key suppliers, Spotify is also likely to see tailwinds from a change in business mix. As noted on the second quarter conference call, the 1.5 million podcasts available on Spotify (compared to 185,000 in 2018) are now listened to by 21% of all users (up from a mid-teens percentage a year ago), with consumption up 100% year-over-year. In addition to being a much more fragmented (decentralized) market than music, podcasts are still a relatively new audio format, with key questions still to be answered - particularly as it relates to monetization for creators. In my opinion, Spotify will likely play a role in helping answer that question through the introduction of its advertising services / tools like SAI for exclusive and non-exclusive podcasts alike. Scale advantages also enable Spotify to pay higher (fixed) outlays for exclusive content, meaning they can sign agreements with marquee talent that others cannot justify (like the estimated $100 million for the Joe Rogan Experience, which draws millions of listeners each episode). This same logic supports some of the deals they've completed in the past 18 months, including the acquisitions of Anchor, Gimlet and The Ringer.

Ben Thompson of Stratechery has written about this ladder strategy:

"First Spotify played 3rd-party podcasts, then it published its own podcasts, next it will monetize its own podcasts, and finally it will be in a position to provide 3rd-party podcasts superior monetizing capabilities, even as it increases user engagement and retention."

I think that's an accurate read of how the company got here, along with where they're looking to go. It's difficult to overstate how important this could be for Spotify.

As I think about the risks and opportunities on this investment over the next decade, I'm of the belief that Spotify is in the driver's seat from a consumer perspective. It's their game to lose. I say that because Spotify is focused on a single objective (market) with a distinct brand in the eyes of current and potential customers. On the other hand, I see their big tech competitors - namely Apple, Amazon and Google - running in an endless number of directions. I think their lack of focus shows up in the relative quality of their product offerings. You don't have to take my word on that. Despite the numerous advantages that these companies bring to the party, including unparalleled financial resources and distribution advantages (pre-installed applications on their mobile devices, app store economics, etc.), the market share and engagement data that I discussed above clearly show that Spotify is still winning. Simply put, the results speak for themselves.

As an example of what I'm referring to, consider these comments from Erika Nardini, CEO of Barstool Sports, which produces some of the most popular podcasts in the United States:

"My first question: what is Apple doing? Apple's eye is not on the ball... They are pretty disinterested. I couldn't name one person, without looking in my email, who works in podcasting at Apple... They're just asleep at the wheel… It's not a priority for [Apple's] business... Apple has always been uncomfortable about content itself. I think Apple is way more comfortable in platforms and software and technology versus content and people, which is just messier and more complicated."

This is anecdotal, but I think it's indicative of the problem for the tech companies. The audio streaming businesses at Apple, Amazon and Google will never demand the attention of the key decision-makers like it does at Spotify. It's worth noting that founders Daniel Ek and Martin Lorentzon hold majority voting power. I realize this seems like a "soft" answer (not based on a quantifiable, sustainable advantage), but I think it's among the most important realizations on an investment like this. Long story short, Spotify will maintain its leadership position because they are the only scaled player who is 100% focused on building the best audio offering(s) – and based on the market share and user engagement data, it appears to be making a real difference.

Here's another way of thinking about that: in ten years, if all goes as planned, what information will you look at and go, "In hindsight, I should've known this company was in a good position – and would probably be a good investment - when I looked at it in 2020"? Let's think about that for another well know consumer subscription business: Netflix (NFLX, Financial). What indicators could you have looked at in 2010 or 2015 that suggested Netflix was here to stay and had a chance at meeting and exceeding seemingly high expectations despite the threat of heightened competition? The answer for me is user growth, engagement, etc. While investors were focusing on near term free cash flow and the company's credit rating, Netflix's ability to satisfy its (growing) customer base was what truly mattered. In that sense, I feel that Spotify is in a similar position – and as they continue to grow their engaged user base in the years to come, it will present opportunities for the company.

A fair retort is Netflix had differentiated content, particularly as they moved into originals like House of Cards and Orange is the New Black. How does that apply to a (primarily) music streaming service that has the same songs as every other scaled competitor? I think the answer is that the uniformity of these offerings, at least in terms of the music selection, will eventually lend itself to some inactivity (lower churn). Said differently, if I'm paying $9.99 a month for Spotify and I enjoy the product, what would incentivize me to switch to a comparable offering at a similar price point? For many, I think the answer is they won't. They will stick with Spotify because there's a "cost" associated with switching – mostly your time – and no real upside from doing so (as Spotify builds out its stable of exclusive podcasts, there will be some downsides as well). It becomes like a bank relationship.

Assuming you accept what I've written, how do we intelligently think about valuing Spotify? I'm honestly not sure, at least with any specificity. Here are some high level thoughts.

As I noted above, Spotify's user base is growing 30% year-over-year. Even if that slows to a mid-teens growth rate, Spotify will have 600 million or 700 million total subscribers in the next five years. At a blended (premium and ad-supported) ARPU of $2.00 to $2.50 per month, the company would generate more than $15 billion in revenues. As it relates to long-term profitability, most notably a lower share of revenues to the record labels (largely due to mix shift, but potentially from effective negotiations and other value-added services as well), I think Spotify can deliver double digit operating margins (30%+ gross margins and operating expenses as a percentage of sales to 20% or lower). At that level, on more than $15 billion in revenues, I think the business could generate a few billion dollars in normalized operating income. At that point, Spotify would still have room to add hundreds of millions of additional users over time, in addition to being in a position to invest even more aggressively in content for the sake of reducing churn and driving higher ARPU's. Said differently, I think their competitive position five years from now will be stronger than it is today – and as they invest more aggressively, they can make it even stronger over the subsequent five years.

With a market cap of nearly $50 billion, Spotify doesn't sound undervalued to me. To justify today's valuation, you must believe the business will continue to report significant user growth for years to come, in addition to building a more attractive financial model that results in a step change in profitability (on both of those fronts, higher customer retention will be an important variable). Based on the research I've done, I'd say that outcome is more likely than not. Looking out over the next 10 years, I think you can paint a picture where Spotify ends up being worth more than $100 billion.

For now, I'm on the sidelines. That may change in the near future.

Disclosure: None

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