April 09, 2018 - 3:31pm EST by
2018 2019
Price: 149.84 EPS -1.34 -0.61
Shares Out. (in M): 178 P/E 0 0
Market Cap (in $M): 27 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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Spotify is priced for perfection.  We believe that investors are mistakenly viewing the business from a bottom’s up perspective using past growth rates to extrapolate the future, which misses new and growing competition that will take significant share from Spotify.

Current Investor View:

Spotify was a pioneer in introducing streaming music as an unlimited ad-free service. Spotify was likely able to get a first mover advantage due to the apprehension of the music industry to fully embrace the model.  Now streaming revenue has led to a turnaround in overall music industry revenue after struggling for nearly 20 years. Nearly all artists have embraced streaming, and Spotify has grown to be the #1 subscription music company in the world operating globally with large share and is usually the #1 position in nearly all markets.  The company is extremely dominant in its home Nordic market.

While the company has had a history of losses, mostly owing to low gross margins, gross margins have been improved dramatically through better contracts with record labels.  Gross margins were 12% in 2015, 14% in 2016 and jumped to 21% in 2017. The company expects this to go to 30-35% over time. Growth has been dramatic as paid subscribers have gone from 28 mln in 2015 to 71 mln in 2017.  Growth combined with better gross margins are growing scale in G&A should lead to a very profitable business for Spotify.

We believe we have some made reasonable assumptions that are baked in to today’s stock price. We forecast paid subscriber growth of 38% in 2018, slowing to 18% by 2022, leaving the company with 236 mln paid subs, and we estimate 2022 Gross margins of 32%.  With scaling G&A and R&D spend, we estimate 2022 EPS of $11.17 with some excess cash being built, a 20 multiple leads to a sub 10% CAGR over that time.



The Top-Down View, Rising Competition:

For years large tech companies watched from the sideline as Spotify built up a big business on their ecosystems, but that is no longer the case.  Spotify is a pure commodity, offering the same service as a host of other companies. While the company will point out that over 30% of its streams are programed by it through algorithms or its own curated play lists, if we invert that, that means that close to 70% of music streamed on the service could be 100% replicated by another service and that even the remaining part is just a repackaging of content with nearly nothing exclusive. If Spotify had a highly differentiated service that customers loved, we would expect to see a low churn rate, yet the company’s annual churn rate is running close to 50%.

Competition in streaming is clearly becoming more intense. Apple entered the music streaming business in 2015 and recently leaped Spotify in the U.S.  Apple is #2 globally and growing at a much faster rate than Spotify. It is important to note that Apple once controlled 88% of the digital music market. Amazon offers a limited music service with Prime.  It began offering an unlimited streaming service in 2013 and is growing at an incredible rate as the company piggybacks on the success of Alexa. Google’s YouTube accounts for twice as much time spent listening to music as all streaming services combined.  Google started offering a streaming service (Google Play) in 2013 and is now planning on combining it with their video sharing service YouTube Red.

What all of the above have in common is their service is attached to a device.  This puts Spotify at a great disadvantage. Just look at how quickly Apple overtook Spotify in the U.S..  Apple’s initial effort was focused on areas where Spotify was not strong (on the coasts). Apple will of course intensify its efforts in these areas. What really is potentially dangerous for Spotify in this area is we do not know if its competition is focused on making a profit in music.  For years Apple had near break-even margins in music despite the company’s dominant position, and it was happy to make its margins on selling devices related to the service. Amazon seems to be content to even use Alexa as a loss leader to get it into homes and to be used as deice to shop from.  Of course there is competition from other services, smaller players such as Pandora and Title, as well as national champions in various markets. Facebook is also expected to make a move into the market.

So what does all this mean for Spotify? Simply put it means less share and potentially a lot less.  Judging by the U.S., we expect for Apple to become the #1 player globally and for Amazon and Google to have significant share with smaller players retaining some share.  While this is just a naïve guess, we decided to put down our guesses on paper (see exhibit 2 below). What we can see is that it will likely be difficult for Spotify to maintain its current share of nearly 60% of unlimited music subscribers.  Our best guess at the upper bound for Spotify’s market share is 40%, with an optimistic scenario of the company getting around 30% of a much bigger market.

We then have to ask ourselves how many people will actually purchase unlimited music streaming.  The answer to this cannot be known with certainty. Spotify is quick to point out that over 1 bln people could purchase unlimited streaming. Of course before streaming, these same people could have purchased CDs, most didn’t.  We know that roughly 300-400 mln people purchased CDs at the height of the music industry. In the pre digital world of 1999 at an average total of $50 per person, only a small amount of these would have purchased enough CDs (>$75) to make streaming look cheaper.  Of course streaming is a different and better product than purchasing a handful of CDs, countering that the free alternatives have also gotten better. We believe this gives us an idea of the audience of people willing to pay for music. We believe that it is foolish to assume that this audience will be greater than the 400 mln people who purchased CDs and that it will likely be lower and fairly unlikely to be much higher for many years.  So using this we can forecast the industry total and then project Spotify’s share to get a better idea on how fast the company may grow and what it could earn. Below are our projections.


It could be worse, gross margins really improve:

As you can see from a top-down view, there is still a lot of downside despite us forecasting a major improvement in gross margin and scaling SG&A. But is gross margin improvement a really a definite?  From our conversations with industry experts, the answer is mixed at best. Music industry execs believe that Spotify will have a tough time increasing margins, while former Spotify employees believe it will happen. Roughly 80% of music is controlled by three major labels: Universal, Sony and Warner music. Universal is the largest and is roughly the size of the other two combined. The major labels have negotiated better deals than independent labels for streaming, and this may be the driving force behind consolidation in the space. So the labels are fairly powerful and maybe getting more so. Spotify got better deals recently from the labels, but while that has enabled Spotify to grow, it has not been profitable.  So the growth has padded the bottom lines of the music labels not Spotify. The best case for hope for Spotify comes from its playlists. It appears that many listeners are laid back listeners and that younger users are more playlist focused than artist focused. A powerful example, when Aerosmith left Pandora the company expected a lot of complaints, but it only got one saying that the Aerosmith channel should play more Aerosmith. (About 1 in 5 songs on this were previously Aerosmith.) It appears many users just want music they know in general and are okay without particular artists or songs. It is for this reason that we are giving Spotify the benefit of the doubt, but it is far from certain, especially when its competition is being subsidized by their device sales.


Other mistaken views of the bull case:

Isn’t Spotify similar to Netflix?

Yes from a use stand point, but no from a business stand point. There are four major differences. For one, movies and TV are dominated by what is new while more than 50% of music is old catalogs (giving power to the labels). Secondly, content is much more concentrated in music than it is in TV and film. Thirdly and perhaps most important, it is far more difficult to develop music than it is to create TV content. Music success is very unpredictable. It’s like a needle in a haystack and only about 1 in 10 new artists make a profit for labels, and that is with distribution everywhere. The problem is really a lack of predictability. For film, you can get a movie star and a specific director and have a reasonable shot of finding success, or at least predicting the odds of that, which is not the case in music. Netflix really broke out once it was able to develop its own shows. Since the debut of House of Cards, Netflix stock is up around 12x.  In the 18 months prior to that, it was down more than 40%. Lastly, Netflix also had a huge lead over any other streaming service while Spotify has more serious competition. It’s noteworthy that Netflix’s churn is in the mid-single digits roughly one tenth of Spotify.

Is Spotify growing though social media creating a network effect?

Spotify has grown a lot through word of mouth, and the company attempts to get users to interact on social media. This is a plus for Spotify, but if this were a true network effect, we would expect to see low churn as users would not want to leave the network. Yet Spotify’s churn is close to 50% annually. To put that in perspective, it appears that Facebook’s annual churn is under 3%. It’s possible that Spotify simply can’t monetize the gains it makes on social media, after all if your friend says he/she listened to a song on Spotify, you can listen to that same song on other services. Spotify bragged about how it turned a joke by Obama that he wanted to work for the company into a big publicity stunt, even creating a spoof job posting, and the company boasted that this posting got 900 applications.  Well, our neighbor put a junior financial services analyst position on Linkedin and got 800 responses. He has not bragged that this qualifies him as a social phenomenon worth in excess of $20 bln.

Is Spotify’s data advantage a large advantage?

Simply we believe no.  Spotify’s data is primarily used to give its users a better experience, not for marketing purposes remember ad revenue is only about 10% of total revenue.  For this 70 mln users is not 10x as useful as 7 mln, as the curve for better understanding from data is fairly steep. Also Google through YouTube and other platforms has more, and certainly Amazon, Apple and others should be close or better with their total data. For the individual user, it shouldn’t take very long for a new service to know which songs to recommend.

Will Spotify be able to get into other business lines?

Spotify will likely continue to put on some concerts as some radio stations did for years before it did, but all we have to do is look at Pandora and its failed attempts into things like ticketing to see that Spotify will likely be almost entirely a streaming company with some fringe projects around that.

Spotify has been growing paid users so fast, why would it stop now?

Spotify has grown paid users extremely fast with cumulative growth of over 150% in the past two years.  However, Spotify gets over 60% of its premium users from its free service. Non-premium users have grown much slower than premium users with YoY growth of under 20% in 2017. Slowing growth in free users should be a leading indicator for premium users. Additionally, the price per subscriber has already come down due to a higher % of low cost family plans and that trend should continue. Subscription prices will  further drag as the company grows disproportionately in emerging markets.


Potential Problems with our Bear Thesis:

From what we can see of estimates short-term, they are somewhat reasonable and only in the intermediate and long-run do they begin to get very aggressive.

While we see Spotify as far different from Netflix, this is a dynamic industry and there is at least a possibility that Spotify could develop its own audio content outside of music, such as podcasts, audio books or talk shows. These areas are much smaller than music and Spotify is not going down this path as of now.


Upside and Downside of Spotify:

Based on what we heard as potential upside, we have created the below model.  If this scenariowere truly possible we would not expect to see Apple have the success it has had in the U.S., so we reject the following projection as possible. Nonetheless, if we are wrong it lays out an upside scenario.



The downside of course could be very substantial as growth, we believe is likely to fall well short of expectations and there is also a good chance gross margins will not improve much, exhibit 5 below is an optimistic view of both of those scenarios, coming to fruition.




I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Loss of share/slowdown in subscriber growth

Google relaunch of music service, Facebook entering music


Lack of progress with negotiating better rates with labels and music publishing companies

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