Description

Overview

Spotify is a digital service provider (“DSP”) of music to 329mm global MAUs.  It provides an ad-free subscription service to 144mm “Premium” subscribers as well as an ad-supported service to an additional 185mm MAUs, with Premium driving the majority of SPOT’s value (90% of revenue, 100% of gross margin over LTM Q3-20).  DSPs are contractually obligated to pay three types of royalties:

1.     Recording owner royalties: Multi-year MSAs contracted with Distributors (ie “labels”; UMG, Sony & WME represent 90% of the artists); 50-60% of total revenues; represents ~80% of total royalties pie

2.     Public performance royalties: Negotiated and collected by Performance-Rights Organizations (“PROs”, including BMI, ASCAP, SESAC & AMRA)

3.     Mechanical royalties: Set by the Copyright Royalty Board (“CRB”), collected by mechanical royalty collection agencies (ie the Harry Fox Agency); combined with public performance, these are ~12-13% of total revenues, representing ~20% of the total pie

Premium gross margins have fallen within the ~26-28% range since Q1-18.

DSPs are commoditized with negligible negotiating power vs. labels – neither party can afford to aggressively negotiate, with labels in a slightly more advantageous position considering its customers (artists) are contracted across multiple albums, while DSPs customers are on monthly contracts.  Public performance and mechanical royalties will increase over time as rates (royalties as % of total revenues, set by the CRB) increase ~100bps annually.  In status quo, margins will decline over time.

Competitors have begun to take share of Premium subscribers – SPOT share of Premium subs has declined from 36% in Q2-19 to 34% in Q4-19 and 32% today.  While SPOT has focused on driving growth internationally, emerging markets have lower Premium take-rates.

Most likely in response to competitive pressures on its core music streaming product, management has begun to focus on incremental avenues of monetization.  It has been an early mover into podcasts, spending $1bn+ on exclusive content and tech (data analysis, podcast creation), despite the lack of a proven business model.  Management has also begun to experiment with other revenue streams; while features like “Marquee”, “Two-Sided Marketplaces” & “Discovery Mode” could all drive value, they inherently decrease the effectiveness of SPOT’s unique and highly-effective recommendation algorithm.

SPOT’s provides clear value propositions to its various stakeholders today:

1.     Customers: best-in-class recommendation algorithm and size of catalogue

2.     Investors: market leader driven by massive international presence and 30% historical sub growth

3.     Suppliers (labels and their artists): customer reach and best-in-class recommendation algorithm (driving new fans)

I believe that the clearly detrimental effect SPOT’s growth initiatives will have on the company’s non-investor stakeholders (audience + creators, primarily podcast), in the context of management’s positioning to the investor community since IPO (strict focus on Premium sub growth and market share) points to a management team pursuing short-term market share focused on maintaining near-term market share at the expense of profitability and long-term competitive positioning.

Despite a deceleration of fundamentals (YTD-20 Premium sub growth down -200bps, even with record-low churn), SPOT has performed in-line or better than peers with business models which benefitted more from WFH (ie SPOT’s NTM GP multiple has expanded +105% since pre-Covid, compared to +14% for Netflix), with podcasting the ramp-up of podcasting the only clear difference over the 10mo span.

A continued deterioration of fundamentals (decelerating growth, Premium gross margin contraction) at earnings would catalyze a reconsideration of SPOT’s long-term growth and profitability profile in context of other Internet peers and pre-Covid trading multiples.  Furthermore, a failure to monetize the Podcast platform and/or materially affect KPIs (ie churn, sub growth, etc.) throughout FY-21 would also catalyze a re-rerate.

In summary, I believe SPOT’s risk profile at current valuations is asymmetric; any upside to be gained from what are unproven adjacencies and monetization initiatives is already largely incorporated, SPOT will encounter medium-term headwinds in the form of continued market share loss and margin pressure, and is underpinned by an unattractive long-term secular growth story.

Thesis

1.     Commoditized product with limited negotiating power vs. labels

a.     While losing SPOT as a platform would have significant effect on labels’ (WMG, UMG and Sony represent ~80% of SPOT’s content) revenue; in an extreme scenario, removal of any label would immediately brand SPOT’s product is inferior vs. peers

                                          i.    Would lead to an immediate churn event for SPOT considering low (would only be non-monetary) switching costs and month-to-month contracts

                                         ii.    SPOT doesn’t have ability to bundle – for instance, Apple can bundle with Apple Home and in-house hardware & software, while Amazon can incorporate into Prime

b.     Movement into podcasts was a recognition that long-term driver of growth wouldn’t originate from existing music streaming model

2.     Primary competitors are able to naturally incorporate music streaming into adjacent offerings (ie YouTube, Prime, Apple TV/iCloud), increasing convenience for the consumer, which would put pressure on SPOT’s industry-leading market share

a.     Lack of exclusive music content creates dynamic where value proposition comes in the form of song recommendations, UI and convenience

                                          i.    As it stands, SPOT’s only competitive differentiator is its collaborative filtering recommendation algorithm, which has required and will require consistent investment

                                         ii.    Otherwise, will be competing with Big Tech on essentially who can manage costs better, something SPOT lacks the relative scale to do approach as effectively

b.     Combination of declining S&M ROI and industry-leading market share (~33% globally) could point to desire to maintain growth, with little regard for cost

3.     As a result of #1 & #2, business model creates dynamic where GMs will either stagnate or decline as SPOT brings on lower value subs

a.     Labels take greater of a) a percentage of total revenue and b) a per-sub amount, limiting ability of SPOT to expand GMs

                                          i.    Only lever management can rely upon is top-line growth and opex optimization, however difficult to see lower R&D in foreseeable future considering reliance on recommendation algorithm and near- to medium-term elevated S&M driven by podcast ramp-up

                                         ii.    In a situation where ARPU continues to decline as SPOT brings on lower-value Premium international subs, GMs should decrease

b.     Increase in listening hours (ie, number of streams; up 34% YoY on a total hour listened-basis in FY-19) doesn’t directly translate to higher bottom line

                                          i.    While SPOT would most likely benefit as Ad-Supported MAUs convert to Premium, the company would be obligated to share incremental Premium revenue with labels (no margin expansion), while paying more for content consumed by remaining Ad-Supported MAUs (margin contraction)

c.     YTD-20 margin expansion was exclusively been driven by rapid on-ramp of podcast platform which operates outside of the music streaming business model

4.     Margins will experience downward pressure as the CRB-mandated public performance + mechanical royalties increase

a.     This rate, which represents royalties as % of total revenue, is mandated to increase ~100bps annually

                                          i.    Currently at 13.3% and will rise to 15.1% by FY-22, at which point the CRB will institute a new rate structure

b.     This adjustment would imply a 3.25% increase in ACPU and -240bps decrease in GM

5.     Consolidated GMs will be under pressure as geographic mix continues shift towards low Premium take-rate Latam & ROW

a.     Sub growth in mature markets decelerating as law of large numbers becomes more prominent

                                          i.    Europe has decelerated YoY -140bps on average since Q1-19, and NA has decelerated -200bps YTD

b.     Total MAU growth in Latam & ROW slightly higher than Premium subs growth, implying higher proportion of low ARPU Ad-Support product

                                          i.    Anecdotally, only 2% of India’s 1mm MAU base are Premium subs

                                         ii.    In the event Latam & ROW GMPU are lower than the US, since royalty payments are calculated on the greater of a) % of revenue and b) a per-sub basis, GMs should decline as ARPU declines

6.     Consensus’s projections for SPOT’s long-term revenue trajectory imply an unrealistic expansion of revenue share

a.     Implies expansion from 31% in FY-19 to 50% by FY-26

                                          i.    SPOT is projected to grow music streaming revenues at a 17% CAGR to ~$23bn, while the global music streaming industry is projected to grow at an 8% CAGR over the same period

b.     Additionally, SPOT sub projections in line with industry growth rates implies that SPOT will drastically increase ARPUs far more than competitors

Investment Risks

1.     Investment in exclusive podcast content will open up TAM and drive long-term differentiation, benefitting from the same exclusivity dynamic Netflix does – SPOT’s industry-leading 42% share of podcast listeners is an appealing starting point as consumer preferences shift

a.     Mitigant: Recent deal with UMG didn’t include any financial commitment to maintaining the platform and labels remain skeptical of efficacy of data product

                                          i.    Likely that they have not engaged in pricing war as the unit economics are unattractive over the near- to medium-term, implying SPOT’s $1bn+ investment in podcasting is an extreme response to constrained bottom-line music streaming growth

b.     Mitigant: SPOT UX underwhelming in a space with myriad competitive offerings exclusively focused on podcasts (Castbox, Stitcher, Castro, Overcast, etc.)

                                          i.    Lacks features of competitors, like smart playlists, ability to dynamically remove silence between words thus saving time, dynamically remastering of audio so voices are clearer (compression, EQ, etc) and more optionality when choosing playback speeds

1.     While easy to incorporate, these issues have been well documented since early FY-20, highlighting a lack of focus on UX

                                         ii.    Competitors exclusively focused on podcasting can offer more attractive prices – for instance, Castbox penetration (3mm DAUs as of Jul-19) is driven by its unique recommendation engine, and charges only $1/mo

c.     Mitigant: 78% of SPOT listeners don’t use it for podcasts

                                          i.    SPOT has spent $1bn+ so far entering the podcast business – LTV breakeven only under the assumption Premium subs who do listen to podcasts on SPOT are willing to pay 40% more/mo (assumes 40% in content COGS)

d.     Mitigant: Ability to monetize a key issue – while 21% of users say they are more likely to pay attention to an audio ad vs online display ad, 36% of podcast weekly average users usually skip ads in podcasts

e.     Mitigant: Netflix not a great precedent considering high production barriers to entry of scripted video content

                                          i.    Podcasts require minimal initial costs (especially if audio quality isn’t an early requirement) with minor delay between production and distribution – content creators disenchanted with SPOT

                                         ii.    Netflix ARPUs have also steadily increased over time, driven by increase in content library but also lack of competition, the latter dynamic of which SPOT doesn’t enjoy

f.      Mitigant: SPOT still yet to find right balance between allowing content creators freedom and controlling production timelines – implying early focus on profitability at the expense of growth, and risk of substitution from platforms willing to take a more hands-off approach

                                          i.    Anecdotally, Joe Budden announced he was pulling his podcast (560k monthly listeners) off of the platform in late Aug-20, noting SPOT’s unwillingness to pay a contractual bonus, allow time off for Christmas and New Year’s Eve and their general negative approach of “pillaging the audience from the podcast...without any regards for the fans”

1.     He also noted that compared to 2yrs ago when he first signed on, podcasters can find better deals from multiple streaming companies and that SPOT’s only interest is in finding new popular shows rather than feeding its podcasting “ecosystem”

                                         ii.    Focus on profitability combined with lack of consensus at this stage on monetary value of podcasting stream implies SPOT would be less flexible with average content creator as opposed to competitors

                                        iii.    While ability to own the relationship with the customer and control the RSS feed is clearly beneficial to SPOT, over time as creators gain audience share and SPOT looks to monetize and – based on precedent – take a more walled-garden approach to an ecosystem with an adherence to a recommendation algorithm driven by high-CPM content, creators will lose creative license

1.     SPOT’s competitors have taken a different approach:

a.     Apple podcasting doesn’t take a walled-garden approach, making its directory available on 3rd-party apps like Overcast and Castro

b.     In Dec-20, Google announced it would support private RSS feeds, allowing users to listen to content they already pay access for

g.     Mitigant: Podcast platform could follow similar path as Facebook Creator and Video Publishing platform, which invested significantly and were flexible on revenue-sharing to drive adoption, then once audience coverage was high, took a walled garden approach to ecosystem, requiring content creators to buy ads in order to increase organic reach

2.     Outside of podcasts, Two-Sided Marketplaces represent opportunity to increase TAM

a.     Mitigant: SPOT’s recent deal with UMG didn’t include any financial commitment to maintaining the platform and labels remain skeptical of efficacy of data product

b.     Mitigant: Management has pointed to three-step approach to execution (grow artists’ fan bases, engage further with artists’ fan bases, monetizing those fan bases), and specifically to live & merchandising as opportunities on the monetization side, however live would be a extreme departure from SPOT’s existing software-based business model (see #3 below) and merchandizing would have low margins

c.     Mitigant: Similar to previously-rolled out initiatives like “Marquee”, sponsored recommendations algorithm (CPC ads) capability counterintuitive to the company’s existing competitive advantage, its recommendation algorithm

d.     Mitigant: Considering early-stage nature of initiative and little dialogue from management in regards to monetization, should be treated more as option call with high execution risk

3.     SPOT has the potential to disintermediate labels by signing artists directly

a.     Mitigant: SPOT and Apple tried beta tests in 2017 & 2018 to go around labels to no effect; have since shut down platforms

b.     Mitigant: 80% of artists income comes from touring (as opposed to digital), which is a labor-intensive process and would represent a significant deviation from SPOT’s existing business model

4.     Acceleration of MAU growth rates and record-low churn point to long runway for stable growth

a.     Mitigant: YTD-20 financials (MAUs and net adds from Europe and NA) have benefitted from on-ramping of podcast platform and Covid-induced pull forward of Premium penetration – financials could tail off in-line with (or more exaggerated than) FY-19 trends, exposing weakening underlying fundamentals in FY-21, particularly H2-21

                                          i.    Podcast engagement increase of 300% YoY in Q3-20 has helped buttress customer retention and adds

1.     Initial users are the customers deriving maximum utility from the platform – future subs will have declining marginal utility rates, diminishing stickiness going forward

                                         ii.    Exclusive Joe Rogan Experience started streaming in early Sep-20, Michelle Obama podcast in early Oct-20 (which was released by SPOT on other platforms as well, so not wholly exclusive) and deals were announced with Kim Kardashian, Addison Rae and DC Comics

1.     Ability for popular comics/movie series and TikTok stars to make successful transition to podcasting unproven

b.     Mitigant: What has been a drastic (-70bps YoY) decrease in churn over the LTM has been completely offset by an increase of SAC by +15% in FY-19 (+20% YTD-20) and decrease in ARPU of +2% in FY-19 (+8% YTD-20)

                                          i.    Taking everything into consideration, implied LTV/CAC has trending negatively

c.     Mitigant: Business mix has steadily shifted away from Premium and towards near-zero growth Ad-Supported, with Premium MAUs as % of total down -70bps YoY

d.     Mitigant: MAU and sub growth has been buttressed by introduction of new pricing plans (ie Duo in Jul-20), which present opportunity for subs on existing high-individual pricing plans to take discounts as part of a group, which will put additional pressure on ARPU

Valuation

Catalyst

1. Earnings

2. Lack of traction in podcasting (e.g. no leverage on gross margins)