• Brett Schafer

3 Things I Love, and 3 Things That Worry Me About Spotify

Coming off of its non-traditional public listing earlier this year, Spotify has been gaining more and more traction as a potential investment. However, it has been quite the polarizing topic, as some analysts see it as the next FAANG stock while others don’t like its business model at all. I am an investor in Spotify, and like what the company has done and its future potential as a dominant player in the music space. However, unlike a company like NVIDIA, who has a strong moat and tremendous margins, there are some worrying things to look at when evaluating Spotify’s business.

3 Things I Love About Spotify

Size of the Network

Spotify owns the largest network of users in the music streaming business, with almost 200 monthly-active-users (MAUs) at the end of the Q3 2018. Gaining market share in consumer based tech industries is extremely important because of the winner-take-all tendencies that occur. YouTube, Facebook, and Netflix operate in similar ways with consumers, and they have been able to dominate their respective industries. If Spotify can continue to grow their MAUs by 30% annually they have a chance to build one of the biggest online communities in the world.

Premium Subscribers

The most looked at metric on every one of Spotify’s earning reports is the growth in premium subscribers. A premium subscriber is someone who pays about $10 a month for ad-free music listening and algorithmic-ally curated playlists. I have been a premium subscriber and absolutely love it. As of the last quarter, premium subscribers had grown 40% year-over-year to 87 million. In this regard they have copied the Netflix model, with the hope that as they grow costs can be diluted across more users. If we do some quick math, a 40% Y/Y growth (what they are at now) in premium users over the next 5 years would lead Spotify to have over 400 million premium users. If they are paying an average of $7.50 a month (based on student deals and other sales plans), these members would be bringing in over $30 billion in annual revenue. Now the growth rate in premium members might slow, but even a significant slow-down from the rates they are at now will still lead to a giant network of paying users.

Data and Other Potential Forms of Revenue

An advantage that Spotify has over its competitors like Pandora, Apple Music, or Soundcloud is the music listening data it has acquired from its users. The curated “Made-For-You” and other personal playlists are used significantly on the app, and is an advantage for Spotify because it can help find new songs and artists for the listener. This song/artist discovery is a huge moat for Spotify and should be a big part of their future. As well, they can sell data to artists so they know what type of people listen to them, how they listen, where they listen, among other things. This will be huge as long-term Spotify sees itself as the go-to place for connecting artists and fans. Nobody is close to this level of user personalization, which Spotify is taking advantage of.

Spotify’s Discover Weekly Playlist

Now with all these things I love about the company, things are not all sunshine and rainbows at the Swedish firm.

3 Things That Worry me About Spotify

Margins

Unlike their peer Netflix, 99% of what Spotify offers on its app is licensed from 3rd party companies, most of which are the big music labels. They end up paying about 52% of all their streaming revenue to the record labels, which puts a ginormous hit on their margins. If they continue to do this, any sort of meaningful profitability may be tough to get. However, if Spotify can re-negotiate their deals with the labels or just get rid of them all together, their margins should increase substantially. This may already be happening, as artists are signing-up with Spotify Studios and making music on their own. If this change keeps trending in Spotify’s favor, they could start increasing their cash flow at a tremendous rate.

Big Tech Competitors

It is a blessing and a curse. We are living in a world dominated by five companies, all of which seem to be in every business they can get their hands on. Music is one of these businesses. Apple is the biggest and probably only significant competitor, and just passed Spotify in premium subscribers in the U.S. This is mainly because Apple products dominate the United States, making it way easier to get someone with an iPhone to use Apple Music compared to Spotify. However, internationally Spotify should continue to dominate as they just started partnerships with Samsung and Google. As an investor what I want to see is Spotify continue to capture a solid portion of the U.S. markets and dominate on the international ones. If they can do that growth can continue to stay strong.

Music Industry as a Whole

Whenever a company has tried to enter the music industry on a digital scale, they have mostly failed miserably. Remember Napster? Rhapsody? SoundCloud is never go to take off, and Pandora was doomed for failure until Sirius X-M gave them a lifeline. If history is any indicator, the future for Spotify is bleak, and is the reason I think many investors are staying away. But if Spotify can sustain themselves (and that is a big if) they have a chance to explode in value and become a darling in the stock market.

This company is not a sure thing. It isn’t Starbucks, Coca-Cola, or a big bank. There is a small chance they could fall out of favor and become the next Pandora. That being said, I think there is a better chance they become the next Netflix, Facebook, or Uber, and is why I am investing in the company.

Disclosure: The writer may own stock in the companies discussed.

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