Spotify, A Compelling Moat At An Attractive Price

Spotify is the global leader in music and podcast streaming. With 551 million monthly users and 220 million paid subscribers, Spotify has a large and growing market share lead. Monthly Active Users surged 27% to 551 million last quarter. Net additions of 36 million were 21 million ahead of guidance and represent an all-time high for the company. 

Streaming, especially the “freemium” model led by Spotify, has saved the once-declining music industry and restored it to growth over the past decade. Music streaming, the most affordable form of entertainment, has a big growth runway from penetration, developing markets, and advertising.

Beyond music streaming, Spotify has rapidly established itself as the leading podcast company, with heavy investments in the platform and content. Despite last year's tech stock selloff, as well as controversy around its star podcaster Joe Rogan, Spotify stock has grown 82% YTD. 

As a result of its heavy growth spending — much of it through the income statement — the stock may not look cheap at first glance. Looking deeper, however, the stock represents a compelling value, and offers the likelihood of strong compounding if high-ROI growth persists.

While the company has formidable, well-resourced competition — Apple, Google, and Amazon — it has established a moat with scale, brand, and network effects. The strategy focuses on optimizing the lifetime value (LTV) of its user base with AI-driven personalization, growing content (music, podcasts, audiobooks), and an ecosystem of creators and artists loyal to the platform.

The company’s highly capable founder and CEO, Daniel Ek, recently bought $50 million of SPOT stock, a large sum compared to other executives. 

At the June 2022 investor day, Spotify revealed its long-term aspiration to be a $100 billion revenue company by 2030, with 20% operating margins. Starting from Spotify’s recent enterprise value of only $20 billion, this growth offers strong potential for compounding over the coming decade.

Background

Even with the recent share price declines, Spotify does not look cheap using traditional valuation metrics such as EV/EBITDA, P/E multiples, or others. Yet Spotify operates a wide-moat business at a highly attractive entry point thanks to recent price declines from almost $400 a share which have taken the stock back to pre-pandemic levels, even while the company has dramatically extended its lead over its rivals.

Competitors such as Apple Music, YouTube, and Amazon are well funded and present a threat to Spotify’s moat. Still, Spotify has a huge lead in the number of paid subscribers, and somehow that lead continues to get larger year after year. This is an extremely important indicator of its moat.

Early on, that moat could be attributed to Spotify’s technology advantage. The company was the first to deploy instant  music streaming – no delay, no buffering. Eventually, though, this was not a unique value proposition, and competitors adopted that technology too. 

Today, the biggest driver of Spotify’s competitive differentiation is the personalization engine. Spotify knows what each user likes based on their listening habits.

In fact, Spotify does this not only by genre but by mood and time of day. It knows that users listen to different music on Saturday morning cleaning the house, than on Thursday afternoon while working, or on Friday night when having friends over for drinks.

This personalization engine is extremely powerful. Spotify’s artificial intelligence and machine-learning tools have assets that no competitors have, with  more listeners to learn from, and vastly more user-generated playlists to generate a recommendation engine based on other users' preferences. In fact, Spotify has over a billion playlists to help learn preferred moods, genres, beats, and acoustic styles. Apple, the next largest competitor, has only 30 million. 

And because of those users and playlists, both independent artists and major labels are clamoring to be in Spotify’s curated playlists, like “Discover Weekly'' or “Fresh Finds.”

Industry Context

Some may remember the music file-sharing platforms of the late 1990s and early 2000s, such as Napster or Zune, or Limewire. With the digitization of music into easily transferable MP3 files, pirate radio platforms devastated the revenues and profits of the music labels which historically controlled distribution.

Apple’s iPod – a thousand tunes in your pocket at 99 cents a song – was a model that helped slow the erosion, but the industry continued to tailspin until music streaming finally reached significant scale around 2014, the year of Spotify’s global adoption. The industry is back in growth mode even as the penetration rate of paid subscribers is still low compared  to global smartphone adoption. 

But the spread between smartphone adoption and paid subscriber count is a strong macro tailwind for Spotify’s continued growth. 

Assumptions of higher penetration rates are not unreasonable given the entertainment value proposition. Among various media types, music remains one of the cheapest sources of entertainment on a cost-per-hour consumption basis. 

And on an inflation-adjusted basis, total consumer music and media spending is still dramatically lower than it was 20 to 25 years ago when CD’s and tapes were the main medium of music consumption. 

Monetization

While the platform has about 551 million monthly active users today, the company is forecasting that it will hit about a billion MAUs later this decade, an estimate that aligns with projections from Deutsche Bank. It is interesting to note that while the market treated Spotify like a huge COVID beneficiary, growth has been consistent, whether before COVID, during COVID, or post-COVID reopening. 

There are a number of factors behind this, including expansions into new countries, greater penetration of new artists driving a wider catalog of music and music appreciation, and the continued migration from the freemium offering to paid subscriptions. In fact, conversion rates from free users to paid subscribers have been consistent over the past few years. 

Spotify's ad-supported user base presently generates only a fraction of the revenue compared to its paid subscribers, signifying substantial untapped growth potential. Compared to other leading ad-supported competitors, such as Facebook, which earns between $35.00 to $50.00 per user, and YouTube, which earns approximately $9.00 per user, Spotify has ample room to maximize monetization from this listener segment.

An intentional focus and capability building has now enabled Spotify to go after this market further and to see broader diversification of these revenue streams. 

A Two-Sided Marketplace

Spotify has been known as a great tech developer and innovator for the streaming space, and it is clear the company has been strengthening its platform to grow not only standard audio music streaming but a number of revenue streams, from ad stack monetization and content personalization to podcast hosting and distribution.

It has been busy creating the capabilities needed to grow this business over the next decade. In addition, there have been a number of acquisitions to support Spotify’s marketplaces business, which is now becoming an incremental and quite important contributor to its music business gross margin. 

The 2019 acquisition of SoundBetter, a freelance production marketplace, gave independent  artists access to production tools and professional support. With independent artists representing an ever-growing mix of the available catalog, this is a meaningful growth driver to revenues and margins for Spotify over time.

Today, the Marketplace business represents close to $200 million of contribution margin, where a few years ago, it was only $20 million. 

A few years ago, this marketplaces business represented about $20 million of contribution margin. Today, that’s closer to $200 million. This will continue to grow over time and is a significant driver of the music business continuing to improve its gross margins as we move forward.

While many perceive revenue and royalty share with music labels as Spotify's primary gross margin driver, CEO Daniel Ek has consistently emphasized a different perspective. During the company's 2022 Investor Day, Ek reiterated that the real margin opportunity lies elsewhere.

Despite Spotify's considerable scale and significance in the modern music distribution landscape, Ek has opted not to leverage its negotiating leverage for a larger share of revenue in royalty negotiations with labels. Instead, he aims to maintain a relatively flat revenue share and focus on boosting margins through additional value-added services to the labels.

Spotify's marketplaces business, offering production capabilities to independent artists, also extends its benefits to major record labels. The company's personalization engine, generating playlists like "Discover Weekly," presents a golden opportunity for both independent artists and traditional labels. Artists, eager to optimize their marketing and distribution costs, willingly pay Spotify for inclusion in these curated playlists, along with user-generated playlists, opening up significant growth prospects for the labels and independent artists.

By fostering such symbiotic relationships and prioritizing value-driven initiatives, Spotify is charting a course towards enhanced gross margins, capitalizing on its diverse portfolio of services and empowering the music industry's diverse array of talents.

Ek believes that engaging in royalty rate battles would result in a win-lose situation, and instead, he advocates maintaining the status quo while focusing on creating value for the labels. This value-driven strategy benefits both artists and labels and contributes significantly to Spotify's margins, making it a prudent path for the company.

While much attention has been given to Spotify's podcast capability and talent acquisitions in discussions around the company's financials, the core music business has also reaped substantial benefits from businesses acquired over the past decade. As a result, the gross margins for this core streaming business have shown consistent improvement and are expected to rise from the mid-20s to the mid-30s over the next few years.

Strategic Partnerships

In line with industry leaders like Netflix and SiriusXM, Spotify has been making substantial investments in owned content that resonate with and scale across its expanding user base. While recent investments have garnered attention, they have proven to be worthwhile.

One of the most significant deals in the podcasting arena has been Spotify's partnership with Joe Rogan. Despite some controversy, the Joe Rogan Experience remains the number one program across an impressive 93 markets. Monthly, it becomes the most listened-to show in various markets, driving user acquisition and subscriber adoption. The show's highly engaged audience is a valuable asset for both subscription conversion and ad monetization.

In fact, Rogan's listeners display remarkable loyalty, regularly returning to Spotify and consuming more content than any other user segment on the platform. This has been instrumental in making Spotify the leading US podcasting platform, creating a beneficial network effect. As more users flock to this captivating content, more content creators and artists seek to bring their offerings to this targeted and unique user base.

Furthermore, the podcasting realm now presents an incremental moat, reinforcing the network effect. The growing ad stack available to marketers seeking access to a well-defined demographic has become especially valuable in light of Apple's privacy policies, which have curtailed ad targeting capabilities on other platforms like Facebook and Snapchat.

Valuation

Investors may be puzzled by the apparent disconnect between Spotify's underlying strengths and its balance sheet figures. Some headline numbers can be misleading, requiring a deeper examination to fully grasp the intricacies of the business.

The integration of an advanced personalization engine with creator tools in the marketplace segment has resulted in a robust music streaming franchise, expected to drive margin expansion in the coming years. This strong core music business has provided Spotify with the means to fund acquisitions and venture into new revenue streams, positioning itself as a leader in the podcasting realm with substantial growth potential in both subscribers and ad monetization.

One of the reasons for the recent six to nine month selloff, is that those investments in the podcasting side of the business have driven down margins even further and continue to do so as unsuccessful deals fall off.

Per the second quarter earnings release, Gross Margin was 24.1% in Q2, down 47 bps Y/Y due to €44 million in net charges primarily related to the shutdown of various podcast shows and the impairment of excess real estate

At the 2022 Investor Day, management outlined how growing the podcasting business has offered valuable insights into scaling across other segments, such as music, where these lessons can now be applied at scale.

Most investments across all segments are being recorded through the income statement, which obscures the true profitability and traditional value metrics of the business.

For instance, Spotify's research and development costs are primarily allocated to growth capex, but since they are classified under R&D expenses, they burden earnings and EV/EBITDA metrics instead of appearing as growth capex investments on the cash flow statement.

Similarly, marketing and sales expenses may largely be aimed at expanding the user base, but these growth investments affect the income statement. To gain a clearer view of Spotify's true profitability, an adjusted perspective is necessary, which involves assessing the business value when accounting for potential reductions or suspensions of growth investments.

To gain a comprehensive view of Spotify's potential and core business value, a standstill free cash flow perspective is adopted. This approach allows for an assessment of the company's worth without factoring in future growth. 

Considering its scale moat, even in a no-growth scenario, Spotify's value is estimated at around $100 per share, indicating that investors would be acquiring all future growth opportunities for free. At $150 per share today, the stock is still steeply discounted relative to its growth potential. 

The logical question then concerns the potential upside of this business. Over the past years, Spotify has reinvested about 75% of its standstill free cash flow into driving growth. This high reinvestment rate has yielded attractive returns in the range of 35% to 45%.

Considering the current market price, it seems to imply a scenario where reinvestment rates decline significantly, and returns on those reinvestments converge to around 10% to 15% cost of capital. However, this view underestimates the numerous growth drivers that Spotify possesses, indicating that the current price does not accurately reflect the company's value in the years to come.

CEO Daniel Ek articulated an ambitious vision for the company, aiming for a $100-billion 

Over time, Spotify's moat has evolved from its high-caliber software capabilities to focus on curated playlists, artificial intelligence-based capabilities, brand affinity, and recommendation engines. This transformation has resulted in a more sustainable moat, leveraging its massive user base of over 400 million to drive penetration and growth beyond. In essence, Spotify's evolution has positioned it almost as a social network in its own right.

The journey towards this ambitious goal includes a 40% gross margin, with both gross margin expansion and sustained growth contributing to operating margin improvement.

Spotify's robust balance sheet provides a margin of safety during the current market downturn. The company boasts a healthy cash position and is free cash flow-positive, despite not yet showing positive accounting earnings due to ongoing investments. The negative working capital business model further strengthens the company's financial position, as growth becomes accretive to free cash flow.

Moreover, Spotify's $1.2 billion exchangeable notes should be viewed more as quasi-equity, offering additional stability and liquidity to the balance sheet. Despite the current stock price suggesting some skepticism regarding the moat, Spotify has demonstrated its ability to fend off tough competition and maintain and grow its market share, bolstering its position in the music streaming industry.