Description

I recommend a long position in Spotify. I assume basically familiarity with the business model (two good prior VIC write-ups for context (one short/one long):

 The recommendation is based on a few core beliefs:

            1) Increasing scale in revenue, subscribers, and monthly active users will continue to build value and durability in the Spotify platform, leading to improving economics and sustainably higher earnings;

            2) streaming will be the permanent form factor for the delivery of audio entertainment for a long time. It is hard to conceive of a better consumer value than all of the world’s music delivered on-demand, merchandised and personalized in a dynamic and engaging way, for a low monthly fee;

            3) Spotify’s management and sole focus on audio create a strategic and operational advantage that will allow the company to move fast and innovate on behalf consumers;

            4) The current stock price implies a value of ~2x E2020 sales, which represents a good risk/reward given the installed sub base, data, growth potential, and unique strategic value of the platform;

            Net of the cash + main non-core asset ( stake in Tencent Music), Spotify has an enterprise value of about $18B; the stock is trading ~2x E2020 sales (assuming $9B in revenue in 2020). Over the past few years, Spot has grown revenue around 30% p.a, +/- a few points. Given the subscriber base (estimated to be 120mm premium subs at the end of 2019), monthly active user base (estimated to be 255mm at the end of 2019), proprietary data on consumer music preference/listening habits, optionality on podcasting/other forms of audio entertainment, and strategic value of Spot as the world’s only global pure-play audio platform, I believe that the current price represents a good risk/reward. Spot should have many years of subscriber and user growth ahead, maintains a solid balance sheet and generates good free cash flow as it grows due to favorable working capital dynamics.         

It is possible that the value of Spot is going to be maximized as part of a larger company, and a lower valuation should attract more attention from potential buyers. Global media and entertainment companies want to capture and monetize as much consumer attention as possible. Spotify has an engaged global user base, direct digital consumer relationships, and a giant growth opportunity in audio entertainment, a competitive position that should appeal to many larger companies. Microsoft, Disney, Comcast, Amazon and several other large companies could pay a significant premium to Spot’s current stock price, and it would still be a very manageable acquisition. For any of those companies, I believe Spot would offer an attractive, high-growth consumer software asset that could deliver a lot of strategic benefits. As one anectode, Netflix is working with Spotify on its new rap competition show, Rhythm and Flow (one of the contestants will get to rap on Spotify’s popular rap playlist brand, Rap Caviar--good global cross-promotion.  

             As many know, Spotify faces intense competition from Apple, Amazon, and Google, three of the largest, most well-capitalized businesses in the world. None of those companies needs to make money directly on a music streaming service, and each of the three can bundle music with other offerings (Apple Music/Amazon Prime). Amazon and Google have a particularly strong position in audio due to their voice assistants. Each of the major music streaming services basically has access to the same music content because the major record labels do not make their catalogs available to the streaming services on an exclusive basis. Bears believe that lack of exclusivity commoditizes the music streaming market/limits Spot’s long-term subscription pricing power i.e. why pay more for Spotify when the user can get the exact same music library at a lower cost/bundled from Amazon or Apple.

            To be long Spot, one has to believe that for some large base of consumers, music streaming is not a commodity; it is a personal and emotional experience that is elevated through personalization and a seamless user experience. I believe Spotify has become the leading global brand in music streaming, and many people love the service and would not switch to a lower cost option.

            Similarly, to be long Spot, you must believe that the record labels want and need a healthy and growing Spotify. Spotify relies on three (four if you count Merlin) major record labels for the bulk of its music content. The labels negotiate royalty rates (publishers negotiate separate rights through the copyright board). The supply base is concentrated, which allows the labels some leverage in the negotiations.  Still, Spotify’s gross margins have grown from 20% in in 2017 to 25.5% in 2019.  

             Streaming now represents about 47% of the total recorded music industry revenue. Streaming has put recorded music back on a growth trajectory after many years of declines due to falling packaged music sales and the digital unbundling instigated by iTunes/YouTube. By providing a great user experience and value, Spotify has encouraged consumers around the world to pay for music. The continued growth of Spotify means more money for the labels, and a strong Spotify should prevent too much market power from failing into the hands of Apple/Amazon/Google—three companies where music is non-core/ used a loss-leader. A global music market dominated by Apple/Amazon/Google is probably scarier to the labels than a world with a healthy Spot.

             The labels do not want to pay Spot one dollar more than they have to—but big picture, they are now firmly dependent on Spotify doing well. Also, Spotify has several initiatives that could benefit the labels by creating marketing efficiencies/audience finding.  While there is likely to be continued public food fights between Spot/labels, the long-term incentives should be fairly aligned. Thus, I don’t think industry structure is a long-term negative for Spot and the company should be able to continue to negotiate reasonable terms and access to content with the labels.

            Spotify is currently pursuing a strategy similar to other large online platforms with large addressable markets: invest aggressively in product and marketing to expand globally and establish leading market share and consumer mindshare in a relatively new category (music streaming) underpinned by a new technology. This strategy prioritizes customer and revenue growth over profits. The logic seems to be that because the market is so large, the benefits to scale in software are so pronounced (more and better data/ability to attract and retain software talent/infrastructure to establish and scale a supporting device ecosystem/digital real estate (i.e. home screen on the phone) is so scarce),  and consumer habits and associations may be formed early during the advent of a new technology, it is rational to invest early and aggressively to drive maximum market share. As is often the case with other online platforms, there is a compounding flywheel effect that comes from market share growth: more customers streaming more audio on Spot’s platform= more data to improve the experience + more revenue to invest in product and content = a better user experience and better subscriber economics. 

            Likewise, scale can support the creation of new high value businesses in some digital platforms. In Spotify’s case, there are several new business opportunities/revenue streams that should become more viable and profitable as the business scales. I believe that the two most promising are advertising and original audio content.

            With intimate direct mobile relationships with a global base of highly engaged customers, Spotify should be able to scale a valuable advertising business over time. The company is in the early stages of building out the advertising infrastructure. On Spot, advertising can be customized, supplemented with video, and highly targeted due to mobile. There should also be creative ways for advertisers to combine music with their brand message (sponsored playlists etc). The labels may end up with a cut of the advertising money, but if Spot can grow the pie for everyone, should be a healthy dynamic.

            Original audio entertainment also holds a lot of potential for Spot, beginning with Podcasting. In 2019, Spot has spent around $500mm acquiring three podcasting companies (two producers and one UGC publishing platform). Podcasting listening hours are growing around the world, and with a large installed base of customers, and the infrastructure to merchandise, market and personalize podcasting for users, Spot is well-positioned to become one of the leading podcasting platforms in the world. Spot has said that 60mm people listen to a podcast every week in the US, and Spot podcast users spend almost twice the amount of time on the platform, and they spend more time listening to music. If Spot can deploy the merchandising and personalization capabilities that made the music streaming experience so good for podcasts, it should sustain a leading competitive position in podcasting.  There are not many global media platforms that can capture hours per day of consumer time.   

            In success, Podcasting can materially improve Spot’s economics. Spot can generate more operating leverage on the fixed content investment into podcasting content because it will not have to pay per stream royalties, which could benefit margins long-term. Spot can also own the underlying rights in original podcasting IP, which it may leverage through licensing. Increasingly, film and tv companies are adapting IP based on popular podcasts due to the large built-in fan bases. Podcasting is the first major move into non-music audio for Spot; other areas could include audiobooks and spoken-word games. Spotify has publicly said that non-music audio could eventually make-up 20% of the listening hours on the platform. I think 2020 may be the year when Spot’s podcasting ambitions, and the potential benefits to its economics, start to become recognized by the market.

            Lastly, I think Spotify has a great management team. Specifically, CEO Daniel Ek, and CFO Barry McCarthy, combine vision and financial discipline. I place a lot of emphasis on management in these situations because the market is still new and the business model has not demonstrated that it can produce sustainable profits. I have confidence that this team will innovate on behalf of customers, and act in the best interests of shareholders.

Catalyst

original audio entertainment initiatives begin to take hold in 2020

acquired