Spotify Investment Thesis

Published on 03/13/21 | Saurav Sen | 4,912 Words

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Thesis Summary

As of March 3, 2020: Growth in number of smartphones and in music streaming penetration is primed to boom in the next 3 years. Spotify will likely command a high market share (albeit reduced), given its focus on Personalization and Ubiquity.

Competitive Advantage - The Castle: 

  • Core Competency? Music Streaming Software – the pioneer in this revolution.
  • Product Differentiation? Claims to have better data & software. Translates to better UI/UX.
  • Historical Growth? High Revenue and Active User growth. Expected to continue.

Durability of Competitive Advantage - The Moat:

  • Competition/Threats? Apple and Amazon have deep pockets.
  • Moat? User History + better AI = better experience. Also, relationships with Music Labels.
  • Market Share Growth? Expect that it will decrease from current level of 50%.

Management Quality - The Generals:

  • Strategy & Action? Good. Focused on Scale, Software and Acquisitions.
  • Sustainable Return on Equity? Low. Margin pressure will remain.
  • Sustainable Free Cash Flow? *****Redacted.

Competitive Advantage: The Castle

Core Competency? Music Streaming Software – the pioneer in this revolution.

Streaming killed the MP3 star. More specifically, Spotify killed the MP3 star. Let’s get even more specific. Spotify put a dagger through Apple’s iTunes dominance in the post-Napster Music world. Now Apple’s itching for a fight in Music Streaming, but more on that later.

Spotify, unlike Apple or others, is purely about Streaming Music. They don’t have other base-businesses. They were born as a love-child of Apple’s legitimate iTunes revolution and the illegitimate Napster that almost killed the Music Industry. Legitimacy + Convenience was Spotify. What impressed me most was how Daniel Ek (founder) and company figured out a workable copyright/IP arrangement with the big Music Labels. Somehow, they made it work after they saw what people want. People like a Free (or low-priced) all-you-can-eat menu of Entertainment. Netflix responded with Video Streaming. Spotify responded with Music Streaming.

Spotify pays the Music Industry in the form of royalties, mostly to the big 3 Music Labels – Sony, Warner, Universal. They own a big chunk of all music rights in the western world. Spotify has bespoke contracts with the Big 3, who in turn pay the artists according to contracts between those two parties. Spotify pays the big 3 (and some others) every time a song is streamed for more than 30 seconds. The actual amount they pay differs from artist to artist and label to label. It’s hard to get accurate granular data. I discussed this in Investing in Music that the best estimate of royalties is Spotify’s Gross Margin. As of now, it’s safe to assume that Spotify pays about 75 cents on every dollar it makes (we’ll discuss Spotify’s Gross Margin later). These royalties have helped bring back the Music Industry from the depths of darkness. Check this out:

Spotify deserves credit for reviving the music industry. Once Napster ruined everything, Artists were struggling to sell albums. Then iTunes unbundled the album but that hit most artists as well. Remember, back in the day, we had to buy 10, 12, 15, 20 songs on an album, whether we wanted them or not. Those were the golden days for Artists. After the Napster mayhem, Apple allowed us to buy one song for 99 cents. Artists saw their revenues decline. Now, Spotify has created a new business model and a new industry. Things are looking up. But the Music Industry still needs some sweeping changes to thrive. We’ll discuss that in the Competition/Threats section.

With success comes competition. Since Spotify’s dream run, big guns like Apple, Amazon and Tencent have invested heavily in Music. That should scare Spotify, but:

  1. It’s got a head-start. That counts for something, which I’ll discuss below.
  2. The overall pie of Music Streaming is growing.

On point #2, consider this: There are about 7 billion people in the world. About 5 billion people have mobile phones. But about half of those – slightly over 2.5 billion people – have smartphones. Right now, Spotify – by far the most dominant Music Streaming Platform – has just over 200 million subscribers. That’s 200 million out of a total addressable market (TAM) of 2.5 billion smartphones. And if everyone who has a flip-phone today has a smartphone in, say, 5 years, that’s a TAM of 5 billion users.

Spotify’s current market share, as per company data, is about 50%. If they hold on to that share, they’ll have a serviceable market of about 2.5 billion users in a world where everyone has a smartphone. That’s more than 10X their current user-base. Why are these lofty assumptions conceivable? Because almost everyone loves music. And Spotify has figured out – and, by now, mastered – how to deliver 35 million songs at the click of a button for a low, flat, monthly fee.

In the back-of-the-envelope assumptions above, the most debatable ones are Market Share and the ubiquity of Music Streaming. Can Spotify hang on to its market share as streaming becomes more popular? It can, if it offers a fantastic product that’s far better than competition.

Product Differentiation? Claims to have better data & software. Translates to better UI/UX.

Unlike its big competitors, Spotify is purely a software company. Is that an advantage? We’ll tackle that in the Competition section below. But it is a differentiator.

Spotify claims that because it’s a pioneer, has a head-start, and that it’s a bona fide software company, its software is better. And the head-start factor gives it a data advantage. The combination of more data and software expertise translates to both a better user interface and user experience. All of this is utterly believable.

I’m just going by the hard fact of their popularity. They outstrip their competition in active users by 2X. And then I also go by the anecdotal evidence of friends and family swearing by Spotify. I’m an Apple Music user, and I don’t have the reaction with Apple Music. I like Apple’s vast catalog (not a differentiator) and their user-interface is “meh”. My experience is strictly OK. But I hear my friends rave about their Spotify experience.

Something my friends rave about is Spotify’s curated playlists. It jives with the message that Spotify wants to deliver to investors, since it went public in 2018: We’ve got better data about our users, which means we can personalize the content more, which further means that:

  1. Premium Subscribers stick around.
  2. Free (Ad-based) Subscribers convert to Premium.

So far, it seems to me that Spotify’s script is playing out as they wanted. Check out how their user-base has grown:

The most amazing statistic I stumbled upon in their 2018 Investor Day was that 60% of Free Subscribers convert to Premium. 60%! I don’t know how that number has progressed since then. But I suspect it’s hovering around the same level given the stats shown above. That’s amazing.  In the same presentation, Daniel Ek and team distilled down Spotify’s product differentiation to 2 factors:

  1. Personalization
  2. Ubiquity

Personalization is a software factor. Spotify has been investing heavily in AI and Machine Learning to use their treasure-trove of data and deliver amazing curated content. It’s hard to judge whether Spotify’s AI is better. But it would be reasonable to assume that it is, given Spotify’s user-growth, some anecdotal evidence, and the indisputable fact that they have more data about Music consumption patterns.

The Ubiquity point is a thinly-veiled attack on Apple. Spotify says that they can be played on any device, anywhere. Ubiquity is a differentiator and maybe even an advantage because it’s hard to imagine Android users using Apple Music. It happens, but it’s rare.

Lastly, Spotify is diversifying its content. It’s adding Podcasts – like the latest acquisition of The Ringer, a top sports podcast in the US – and it’s also adding content for children. It’s trying to become a one-stop shop for Audio entertainment. It’s trying to get as many people on board as possible – Free or Paying. More people, more data. More data means better experience. Better experience means more conversions and more word-of-mouth marketing. That leads to more users. And on and on the flywheel goes. So far so good.

Historical Growth? High Revenue and Active User growth. Expected to continue.

Spotify has been growing at tremendous pace because the product is good, if not the best. The flywheel seems to be working. They’re following Amazon and Netflix in focusing on scale first, and then on profitability. We’ll get to profitability in subsequent sections. But they’re definitely scaling up fast. They need to.

But one stat has been declining. That’s Average Revenue per User.

This trend is a sign of volume growth. Spotify tends to get more signups on its Free (ad-supported) service. People like to try it out before to sign up for a Paid Subscription. So, as Spotify has been attracting potential subscribers, MAU grows faster than revenue. This is likely to continue for a while.

The question is: how much can Spotify grow? We did some TAM analysis in the first section, which implies an upside of 10X in revenue. That math was dependent on two assumptions:

  1. Almost everyone in the world will own a smartphone.
  2. Almost everyone loves music.
  3. Spotify will hold on to its market share of around 50%.

The last assumption may be a bit aggressive because competition is formidable. But even if Spotify has a market share of 30%, it’s a TAM of 1.5 billion people. That still suggests massive upside potential.

How much market share Spotify commands as the world increasingly switches to streaming on their smartphone? US and Europe maybe be close to saturation. But Asia and Africa are up for grabs.

However, Spotify’s path to domination is not easy.

Durability of Competitive Advantage: The Moat

Competition/Threats? Apple and Amazon have deep pockets.

Apple and Amazon were followers. They joined the party late and they have fewer subscribers. But they have deep pockets and complementary products. Both Apple and Amazon look at their Music Streaming businesses as a carrot that attracts customers to their core product. Apple sells software packages in slick hardware. Amazon’s Prime Video strategy is meant to reduce churn in their Prime Shipping subscription business. Amazon Music serves the same purpose. Both Amazon and Apple have Video Streaming businesses that can be bundled into one nice little entertainment package. Would you pay, say, $15 for Prime Video and Music? Seems attractive.

The point is that – as of today – Music Streaming is not a big money-spinner streaming platforms. Spotify spends about 75% of its revenue on royalties. I doubt that number will decrease much. There just isn’t much operating leverage built into the profit model. Royalties are paid on a per-stream basis. If Spotify gets more users, they will stream more. Costs will go up along with revenue. Gross margins are unlikely to improve. The fear is that Apple and Amazon – with their deep pockets – can outbid Spotify for music talent by paying higher royalties. This part of the Music Industry – royalties and Artist income – seems primed for disruption.

Artist Income got disrupted because of piracy (Napster etc.). Then came Streaming, and things started looking better. But from an artist’s point of view, the technology doesn’t seem meritocratic. Big Artists backed by big labels get a lot of attention (streams). So, they make a lot of money. But this becomes a self-fulfilling phenomenon. Algorithms tend to reward already-successful artists who are already streaming at high volumes. This creates a snowball effect resulting in massive disparity between a select few musicians and the rest.

Alan Krueger, a Princeton economist, wrote a book on the economics of the music industry, post-streaming. It’s called Rockonomics, and I highly recommend it. The book talks about the almost winner-take-all dynamics that music streaming propagates. He called it the “Superstar Phenomenon”. There are two reinforcing phenomena at play:

  1. Streaming algorithms reward top artists.
  2. Streaming Royalties are still low, so artists make most of their money from live concerts.

Artists treat streamers like Spotify and Apple almost as advertising platforms for their real money-maker – concerts. Krueger points out:

  1. Artists make a lot more money from concerts now than they used to.
  2. Famous Artists take more of the concert pie than they used to.

“The Pollstar data indicate that the top 1 percent of artists increased their percentage of total concert revenue from 26 percent in 1982 to 60 percent in 2017. The top 1 percent now take in more revenue than the bottom 99 percent combined. And the top 5 percent of performers increased their percentage of total concert revenue from 62 percent to 85 percent over the same period. The top 5 percent of performers earn almost six times as much revenue as the bottom 95 percent combined—a superstar market if ever there was one.”

He goes on to say:

“Today, even superstar recording artists, whose records account for the vast majority of industry-wide music revenue, make most of their income from live performances, rather than royalties. In 2017, for example, Billy Joel, the original Piano Man, earned $ 27.4 million from live performances, only $ 1.3 million from record sales and streaming, and $ 0.6 million from publishing royalties. In other words, more than 90 percent of his income was derived from live concerts. 25 And that was true for Joel in the early 2000s as well, long before he landed his monthly gig at Madison Square Garden (which insiders sometimes refer to as the Garden’s fourth franchise, after the Knicks, Liberty, and Rangers). Or consider Paul McCartney, who has written and recorded more number-one songs than anyone in music history. He netted 82 percent of his income from performing live shows in 2017.”

My point is that even superstar artists aren’t making (by their standards) a lot of money from Streaming. Maybe Taylor Swift and Drake are exceptions. Even superstars believe that touring is necessary to make money. But they have the advantage of brand name, which most of them garnered before streaming dominated. What about the non-superstar? If she doesn’t get enough interest (streams) on Spotify, who will back her up for a concert? How will she make her money then?

The Music Industry is better off than it was 10 years ago. But it’s also more unequal. Streaming can be fixed to make things more meritocratic. Deep pockets like Apple and Amazon have the ability to do it by simply paying more for music. That’s the danger for Spotify. Will margins get compressed?

The other competitors – Sirius XM, Pandora and Youtube – also pose some threats. Youtube is visual, and that puts it in a separate bucket. There is no reason Spotify cannot tack on a visual medium on top of their massive music base to give artists another way to sell their music. In fact, they already are. Sirius XM and Pandora are radio services – so it’s tough for them to beat Spotify in the “personalization” feature. Spotify does more with data than streaming radio can.  Also, those two seem to be losing the battle amongst younger audiences. In this field, demographics count. Someone who’s been on Spotify for 5-10 years has a musical history that Spotify uses to enhance her experience. Why would she leave that to go somewhere else for essentially the same Music catalog? Personalization and Demographics (capturing younger audiences who will stick with the service) go hand-in-hand.

Moat? User History + better AI = better experience. Also, relationships with Music Labels.

The Music Catalog – the total library of songs – is (or will become) a commodity. I think it’s in the Artists’ and Labels’ interest to have their content available on all streaming platforms. It doesn’t cost them to put up their content. So, competitive advantage doesn’t lie there. It lies in user experience.

The virtuous cycle of more users, more data, better personalization, better experience, all leading more users is a powerful Moat. Spotify is ahead in the game and they intend to maintain the lead. This phenomenon of breaking away from the pack is something I’ve talked about in various worldview articles before:

  1. Investing in AI
  2. Investing in Global Dominators

The idea is simple: “software products enhanced by AI, delivered via Cloud” will favor powerful incumbents. This phenomenon explains the dominance of a few firms in the S&P 500 Index, for example. In fact, Krueger makes my argument better than me. As any good Economist does, he summoned a couple of succinct terms to explain the firm:

  1. Power Law
  2. Cumulative Advantage

Power Law is about exponential growth. And Cumulative Advantage is like Competitive Advantage + Moat. Once a competitive advantage is in place, and it keeps growing, it’s cumulative advantage. Spotify is in a position to have Cumulative Advantage.

Spotify’s big advantage is volume of data. That is indisputable. They had a head-start and they’re building on it. Now, if their AI-infused algorithms are good enough to make user experience fantastic, they can become unstoppable.

In the previous section on Competition, I mentioned that Apple and Amazon have the cash to offer artists more incentives and change what’s broken the in the industry – that it’s becoming increasingly winner-take-all.

Market Share Growth? Expect that it will decrease from current level of 36%.

A lot depends on the quality of Spotify’s AI and its’ initiatives like Artist Discovery that enhance user experience. Personalization is the key. That’s the Moat. I think Spotify should try to be the Instagram of Music – where a cumulative “life-album” of each user builds up over time. Then it can increase its already impressive market share.

But the problem is Apple and Amazon’s deep pockets and ability to bundle with Video platforms. They can take losses for longer. But even for an Amazon or Apple, losses have limits. If the market for Music Streaming grows to the 3-4 billion people, losses will mount up. The most rational scenario is this: there will be 2-3 major players with roughly equal market share. Different consumers will prefer different streaming services, not because the music catalog is different but because of:

  1. User experience
  2. Inertia
  3. Brand Identity

In all 3, Spotify has the advantage right now. That can change. Apple, for example, is no slouch in UI/UX, software design and brand identity.

I would go with the assumption that Spotify settles on a 30% market share.

Management Quality: The Generals

Strategy & Action? Good. Focused on Scale, Software and Acquisitions.

Scale is the key. It means more data and more leverage with the Big 3 Music Labels. Spotify’s management is maniacally focused on Scale. That’s good.

The slightly scary thing for me is that scale can come at the cost of Free Cash Flow. Everything can be reinvested in an attempt to stave off competition from Apple and Amazon. And then they’d be competing with deep pockets. At the moment, Spotify does generate some Free Cash Flow but that’s mostly because of working capital benefits. We’ll discuss that in the last section. But Spotify’s management seems to want to become the Netflix of music. The problem is that Netflix, after all these years in the Streaming business, is yet to be cash-flow positive. Spotify, to be fair, is already there. And the cost of music content acquisition – amount and model – is different from video content acquisition. Besides, anything other than streaming is dead in music. In video, there are still other popular (but declining) options like TV and the movie theatre.

Spotify has also been on an acquisition spree. They want Podcasts. They want Music Production tech companies. They want to become the Audio Entertainment giant. The move on Podcasts was smart. Unlike music, Podcasts are direct contracts with the creator. They can be exclusive on a streaming channel – like Howard Stern on Sirius XM.

If I were the CEO, I would go on an acquisition binge of streaming services in big, international markets like India and Africa. That’s where smartphone penetration is still lowest. And for the most part, they are music-rich regions. Of course, $10 a month may be pricey, but at least in India, $5 seems reasonable for an unlimited catalog of Bollywood songs going back 5-6 decades.

And finally, Daniel Ek is a founder-CEO. I like that in a company. He’s a tech guy who has the drive to see this dominate its space. Incentives matter. But emotions rule our existence. This is Ek’s baby and he wants to see this succeed. Or get bought out.

Who would buy Spotify? I guess Apple buying it would be an anti-trust issue. My bet would be on Google. They’ve got the only competing mobile Operating System. They don’t have much of a Music Streaming business to speak of. The synergies are obvious – Google’s AI capabilities with Spotify’s data. If Apple is the common enemy, then Google and Spotify should be friends.

Friendly reminder: Android is much, much bigger than iOS in terms of users, globally.

Sustainable Return on Equity? Low. Margin pressure will remain.

The main chink the Power Law + Cumulative Advantage Model is the royalty model in streaming. Fees are paid on a per-stream basis. More users = more stream. The cost is variable, not fixed. That means scalability will take longer to flow through to the financial numbers. Margins will remain around the same level unless Spotify – if it becomes the big enough – can renegotiate rates with the Big 3 labels.

Until that happens, margins will remain low and ROE will remain low. What does that mean? Usually, I look at ROE as a report card for how Management runs the business. In this case, it may not be so appropriate. The name of the game now is SCALE. It changes everything. From a financial perspective, it gives Spotify the power to renegotiate rates to improve profitability. And then ROE increases. This is at least 2 years out.

Until then, we’ll have to make some assumptions.

Sustainable Free Cash Flow? Roughly $1.7 billion. Translates to $180/share.

The main assumption behind the $1.7 billion Free Cash Flow number is Revenue. The assumed Sustainable Revenue number is about $20 billion. As of the end of 2019, Spotify’s revenue number was about $6.7 billion. Yes, big jump, I know. But hear me out – here are the assumptions behind that $20 billion number.

As things stand today:

  1. No of smartphones in the world: Roughly 2.5-3 billion.
  2. Spotify Market Share: About 50%
  3. As of December 2019, no. of Monthly Active Users: 277 million.
    1. Implies Music Streaming has penetrated only 20% of all smartphones.
    2. Paid Subscribers: 124 million
    3. Ad-Supported: 153 million
  4. Revenue: $6.7 billion.
    1. Paid Subs Revenue $6.0 billion
    2. Advertising Revenue: $0.7 billion
  5. Average Monthly Revenue per month from Paid Subs: $4.72
    1. The $10/month fee is diluted by things like Family Plans and Free 3-month trials.

Assumptions about where things will be in about 3 years:

  1. No of smartphones in the world: Roughly 3.5 billion.
  2. Assume “Music Streaming Penetration” of 80%.
  3. Spotify Market Share: 30% (with Apple, Amazon and Tencent dominating the rest)
  4. Number of Monthly Active Users: 924 million (3.5 billion x 80% x 33%)
    1. Paid Subscribers: 370 million (assumed 40% in line with current ratio)
    2. Ad-Supported: 554 million (assumed 60%)
  5. Average Monthly Revenue per month from Paid Subs: $4.5
    1. Expect this will decrease to maintain high market share.
  6. Paid Subs Revenue = 370 million * $4.5 * 12 = Roughly $20 billion.
  7. Advertising Revenue: Not counting.
  8. Total Revenue: $20 billion.

You can see that this $20 billion number is utterly believable. The big jump really is in the “Music Streaming Penetration” number – from 20% to 80%. That makes Spotify’s no. of Active Users jump by 4X. This is a Venture Capital type of assumption but from everything discussed above, it is believable. In my view, Streaming Music is the only rational way to listen to music now. Streaming Video, by contrast, still has TV, Sports, and the Movies to compete with, and it’s more time-consuming because it’s not passive. Listening to Music can be quasi-passive (while working or commuting or in the gym etc.). It’s also a lot less data-intensive. And, above all, from the looks of it, Spotify’s Personalization is a lot better than Netflix’s. Data seems to be more of an advantage in Music. In my view, the 20% “Music Streaming Penetration” number is ridiculously and unbelievably low. The next 2-3 years will be pivotal.

The rest of the financial assumptions are:

  1. Gross Margin remains at 25%.
  2. R&D costs double
  3. SG&A costs double
  4. Every other metric is proportionately in line with the last 12 months.

The bottom-line is that Free Cash Flow would amount to $1.7 billion. That’s a huge jump over current Free Cash Flow of $314 million. Scale is amplified by some operating leverage in this analysis. I’ve that R&D and SG&A costs double instead quadrupling along with their user-base. A big chunk of those costs are fixed.

With this assumptions, Spotify’s stock price shows some margin of safety – more than 25%. We will be picking up some stock slowly over the next few months.

As Charlie Munger says, “Invert, always invert.” Well, we just did by asking the question, “what do we need to believe to buy into this story?”

Many Happy Returns.

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