“Invest in What You Know” – Peter Lynch

As a product, I absolutely love Spotify. Heck, guess what app I’m using to listen to Andrea Bocelli right now (hey, don’t hate on Andrea)? Spotify. When I leave work today, guess what app I’m going to use to listen to the Foo Fighters in the car? You guessed it, Spotify. I use Spotify almost every single day. It adds value to my life. Clearly others share my opinions as the company IPO’d with a near $35B market cap. Spotify generated close to $5B in revenues last year (growth of 26% YoY) with 170 million monthly active users and 75 million Premium subscribers; those numbers are up 30% and 40% respectively YoY. Although SPOT is a “new IPO”, the company has been around for 10 years and has grown to generate $215M in Operating Cash flow with close to $157M in FCF.

Spotify has barely captured most of its addressable market and is just now beginning to tap into Latin America, Asia, and the Middle East with their latest launches in Israel, Romania, South Africa, and Vietnam. This brings their total footprint to 65 countries and territories. This is a tremendous runway for growth. Spotify claims they have a chance to address billions of potential users, both paid and ad-supported. As Spotify reaches more people, it generates a stronger network effect, creating a self-reinforcing competitive advantage. Now the best part about this network is that it creates outrageous value for music creators, what Spotify calls the “other-side of its two-sided marketplace”. By creating a valuable product for both listeners and producers, Spotify sets itself up as the most valuable player in the music streaming industry, something Pandora and Apple Music can’t claim.

The company is projecting revenue to grow from $5B to $8.3B by the end of 2020, with projected earnings reaching $0.27 by 2020, and achieving positive EBITDA by 2020. With current EV/Revenue at 6.4x and projected revenues hitting close to $9B, it puts a potential EV of close to $60B in 2020. To go along with the growth in revenues and EBIT, the company expects premium subscribers to reach 92 – 96M FY2018, an increase of 32%. Gross margins are expected to fall anywhere between 23 – 25%, but the company notes that it has been on the higher end of the Gross Margin estimates so far.

Spotify’s Business Model

Spotify’s business model is relatively simple from a macro perspective. The company offers both an Ad-Supported & Premium membership service. The premium membership is for a flat monthly fee, while the Ad-Supported service acts as a funnel into the Premium option, with less features to enjoy than those that pay for the service. To put some numbers to this “funnel” claim, over the last year, 60% of premium subscriptions came from Ad-Supported channels. In other words, 60% of premium users started as Ad-Supported users. The premium subscriptions have grown 46%, which is mainly driven by Spotify’s Family Plan, which enables a family of up to 6 to be on the same subscription while paying a low monthly fee (Note: This is a great way to divvy up the cost of paying for Spotify premium).

There are three options within Spotify Premium: Standard, Family, and Students. The standard Spotify Premium is for $9.99/month for one user. The Family plan is $15/month for up to 6 people (read: I only pay $2.50/month for my Spotify), and the Student plan is $5/month for one user. Plans such as the Student and Family plan are driving down average Revenue Per User, from $8/user in 2015 to $6.22/user in 2017. However, this shouldn’t worry the potential investor too much. The reduction in ARPU is simply due to the fact that more people are signing up for Student and Family plans. This isn’t “lost ARPU” more-so than it is the potential to lock in the Standard Premium plans. The Family and Student plans help Spotify extend SPOT’s network effect, reaching more users they wouldn’t otherwise be able to grab if they only offered one payment plan.

Churn % & Acquisition Costs Drive Margin Expansion

The positive effects of these lower cost plans is seen in the company’s Premium Churn % (how often people opt out of the Premium service after joining). Premium Churn % has dropped from 7% in Q2 2016 to 5.1% in Q4 2017. These are excellent numbers. Although the ARPU is decreasing, more people are paying and not leaving once they sign up to pay. In the company’s latest quarterly call, CFO Barry McCarthy pointed out that it’s not as important to focus on strictly ARPU or Churn Rate, but rather both of them together as a ratio. On churn percentage, Barry points out seasonality in their churn rate, and that taking a longer term look at the rate gives a better picture, saying (emphasis mine):

“There is seasonality to churn, particularly following periods of rapid growth related to promotional campaigns. So […] there will be periods of time when churn kicks up sequentially on a quarterly basis, but as long as we are seeing that the individual cohorts by month of subscriber life are maintaining the trend line then we can be confident in the overall health of the business.”



So, we know that churn percentage (on average) will most likely trend downwards as more and more people choose the lower payment plans, but that isn’t enough of a reason to really get excited about generating long-term value. The other side of this coin is the fact that acquisition cost per user are declining. Combined, lower churns and lower acquisition costs create a recipe for not only aggressive margin expansion, but a sustainable network effect.

Music & Non – Music Growth

Users know Spotify for its incredible breadth of music options, but Spotify is reaching into the non-music space (read: Podcasts & Radio), an industry they think can add tremendous user value and shareholder value. Their latest earnings report hinted at the company’s goal of generating more non-music content, saying they are adding, “more and more podcasts by the day.” SPOT is taking notes from Netflix in that they are interested in creating more of their own non-music content with the hopes of expanding margins through the growth of the non-music space (producing your own content cuts out paying for it). However, I want to touch on the biggest potential area for margin expansion and “moat building” capabilities, and that is SPOT’s aim at helping labels and artists with promotions and marketing.

According to IFPI.org, 26% of the Music Industry’s revenues go towards marketing. That number comes out to around $4.5 Billion. A newly signed artist can cost anywhere from $500K – $2M in total marketing costs (this includes recording, art, tour support, etc.). Without a doubt the biggest costs is the marketing and promotion portion of that package. From IFPI, breaking an artist to a significant audience unlocks a wide range of revenue opportunities, from live to merchandising. But, in order to get that chance it can cost an arm and a leg upfront … at least it used to. Daniel Ek remarks in the Q1 earnings call that Spotify is uniquely positioned to leverage from this demand for artist creation and helping labels find artists. He points out that Spotify sits on all the data, sits on all its consumers, and sits on their preferences. This creates a goldmine that labels would pay ridiculous sums of money to have access to (consider how much it would cost for independent record labels to build that kind of network database, it’s astronomical).

Looking out three to five years, the long term value within Spotify comes from its data. This is where the moat shines. Spotify creates a network-like effect within the music industry similar to Facebook with social preferences. SPOT can then use this data to curate both original content on their own platform while leveraging their services to new artists and labels, capturing both sides of their two-sided market. By leveraging their data, not only do they create a springboard for original content and labeling, but they bring more negotiating power to the table with record labels to bring music to their platform.

Winner-Take-All Market?

Digital Trends does a great job at comparing SPOT to its competition; Apple & Pandora. I won’t go too deep into the analysis, but if you want to read more in depth on the user-interface comparisons between the two, the link is right here. The article concludes that Spotify, although not having the advantage in Music Libraries, destroyed Apple Music in every other category (Music Discovery, Workout Modes, Social Features, Fees, and UI Experience).

With Spotify defeating Apple Music in a couple rounds, let’s move on to Pandora Music. In terms of music choices, Digital Trends claims a tie. This tie is mostly due to Pandora’s acquisition of Rdio, giving it access to more songs than it previously had (1 – 2 million). In terms of social features Spotify is the clear winner again with integrations with Facebook, Twitter Skype, and Tumblr. Pandora picks up a victory in the Music Discovery category, but that’s it. Once again, Spotify takes the cake.

However, despite the apparent dominance against its competitors, management at SPOT claims the online music streaming industry is not a winner-take-all market. Management believes that multiple services will exist in the market, and they are still in the infancy of a rapidly growing market. The company is focused on capturing more market, not necessarily worrying about being the “winner-take-all”. When you think about it, not viewing the online streaming industry as a winner-take-all market makes sense. Music is arguably the largest art form throughout the entire world with billions of listeners (and probably billions of creators).

Using radio as a proxy for online streaming, you begin to understand the size and scope of this market. Billions of people use radio, most of which is to listen to music. The same thing is happening with online streaming of music and non music. We haven’t seen a winner-take-all in the radio business, so it is hard to see a winner-take-all in the transition into online.

Finding a Valuation

Valuing a business like Spotify is tough because there are so many unknown variables and so little time to look back. The company is currently trading at 5x forward revenues. Looking forward to 2020, the company projects sales to reach $8.3B. If we keep that same multiple with 2020’s projected revenues, the company would be trading around $242/share, around a 25% premium to where it is now. By 2020, the company expects to be profitable in the earnings department while continuing to bang out strong FCF.

Investing in IPO’s can be tricky, but SPOT has a long runway for future margin expansion and FCF growth. Through their network effect, SPOT can increase their moat through reducing record label costs and monetizing their data on their consumers through producing their own content, or using it as leverage to sell to record labels trying to push their own artists. Spotify isn’t interested in capturing just one side of the market (the listening side), they want to have their cake and eat it to.

Reading The Tape

SPOT closed yesterday (07/26/2018) up 4% breaking out of its ascending wedge pattern. Although I am not 100% comfortable with entering on a chart like this, it might not be a bad idea to enter a starter position at this break, or if it holds into the close on Friday. Then, as price advances, add to the position. Once again, this position woud

Where is My Fallibility?

SPOT is a growth stock, no doubt. If the company can continue to grow its Premium and Ad-Supported customer base like its projected, this will expand margins, increase FCF, and turn the company positive by 2020. The biggest risk to the bull thesis for Spotify is Apple Music. Although we’ve demonstrated Spotify is currently superior, Apple has the cash and the brand power to really give SPOT a run for its money. Even more, Apple Music doesn’t have to be profitable for it to work over the long haul. Since Apple Music is merely a small extension of the Apple mega-machine, the company can afford to keep slimmer margins and potentially offer a lower-cost option for a longer period of time, something Spotify wouldn’t be able to keep up with.

At the end of the day, most of the costs of an online music streaming business like Spotify go towards music labels and record companies for the rights to have the music. The inflection point for Spotify’s price lies in its ability to leverage its internal data and its network effect to negotiate better rates with labels and record companies, thus expanding margins into the future, all the while having a larger revenue base to work with.

Finally, SPOT is an IPO, and IPO’s can be tricky to invest in. Although estimates of SPOT’s fair value range fluctuate between $225 – $240, the first sign of weakness could send shares plummeting as investors develop feelings that, “this is just another high flying tech IPO that will eventually burst.”