Does Spotify Have Pricing Power?
In this piece, we are going to explore whether Spotify will ever be able to raise prices. I explored this same concept with Netflix (turns out we might be undervaluing their pricing power), so I thought why not do the same with the leader in music streaming.
The Spotify platform was launched barely a decade ago in October 2008 and has since grown to become a global brand for audio content. They reached 15 million active users in 2012, and as of today have 217 million users, 100 million of which are premium subscribers. Over the past few years, they have invested heavily in their podcast offering by improving discovery, usability, and by signing exclusive podcast deals (the Obama’s even signed a deal with Spotify a few days ago).
Over 90% of the company’s revenue comes from Netflix-like monthly subscriptions for ad-free, downloadable music. Since this makes up so much of their earnings, it is important for investors to evaluate whether Spotify could raise prices now or in the future.
*Source: Spotify, Q1 2019 Earnings
As you can see from the diagram above, there is nothing terrible or outstanding about Spotify’s earnings. Revenue is growing fairly fast, users as well, and they are starting to generate free cash flow.
An important financial metric to follow for Spotify is average-revenue-per-user (ARPU). Over the past few years, the company’s ARPU has actually shrunken quite a bit.
*2019 only includes Q1.
This is occurring because Spotify is sacrificing sales for user growth, which can actually be a good thing in the short-term. Their popular student, partner, and family plans go for $3-5 a person compared to the standard $9.99 for a single membership.
Spotify is also growing faster internationally than in higher-income markets like the United States and Europe. They recently launched in India, with premium subscriptions going for a dollar or less a month.
Every year, Spotify’s user base should come more and more from Latin America, Africa, the Middle East, and India since those audio streaming markets are not nearly as saturated as the western world. This, in turn, will likely drive ARPU numbers even lower over the next few quarters.
But what about down the line when Spotify wants to actually become profitable? Can they pull levers to eventually increase their ARPU? Let’s explore that now.
Less Pricing Power, But More Ways to Monetization
The problem with comparing Spotify to Netflix or Disney+ is 95-99% of their content is not unique, but a commodity. I can get the same music library from Apple, which has caused a pricing war between the competitors. This is why Spotify and Apple Music cost the exact same while video streaming services vary greatly.
It’s comparable (but less intense) to the Uber and Lyft rivalry. Neither ridesharing firm can raise prices because they don’t offer anything unique to users. It’s why I think both are terrible businesses at the moment. But that’s for another day.
What’s strange is I think I would actually pay more for Spotify than Netflix, but only if it was still the cheapest option. And the problem is, since Apple is an $800 billion company, they can basically keep prices low forever.
Realistically, I see two ways Spotify can differentiate themselves to achieve pricing power:
Be by far the best audio discovery platform, saving users time and providing them a valuable service
Steadily increase exclusive offerings, starting in podcasts (which they are already doing) and then with music
As discovery goes, Spotify is generally considered number one, but they can always improve to get even farther ahead of Apple. The “Made For You” playlists work great but are nowhere near as good as they could be. Look for Spotify to add discovery tools for podcasts to try and increase their market share in that as well.
If you want some more in-depth analysis on why I think exclusive content is the way to go for Spotify and why I think that makes the stock a buy, read my article on it here.
Analysts also forget that, unlike Netflix, Spotify gets hundreds of millions in advertising revenue annually. Right now it makes up only 8% of sales, but their recent acquisitions of Anchor and Gimlet should increase that number in the coming years. Podcast advertising is higher margin as well and therefore will help juice profitability.
What if Spotify Achieves Pricing Power?
Let’s assume Spotify achieves there goal of differentiation. At that point, they would start raising prices, likely in 5-10% increments like Netflix. Let’s also assume they can sustain 30% user growth for the next five years. Here is what their Q1 earnings numbers would be each year, applying 5% ARPU growth in 2021 (Spotify doesn’t say how it calculates ARPU, so I just did total sales over total active users for the quarter). Active users are in millions, and sales and gross profit are in billions. YearActive UsersARPU* ($)Sales ($)Gross Margin** (%)Gross Profit ($)20192177.8841.71124.70.4232020282.17.8842.22425.5562021366.738.283.03725.5.7742022476.758.694.143261.0772023619.789.125.65226.51.4982024805.719.587.719272.084
*Again, not the same as the proprietary one Spotify gives out.
**Also assuming gross margin will increase slightly over time.
You might think 800 million subscribers in five years is unattainable, but remember Spotify is a global brand, so there’s no reason they won’t eventually reach one billion users like YouTube, Facebook, Instagram, and WhatsApp did.
If Spotify can reach those 2024 numbers, they will have quintupled their gross profit in just under six years. Now, let’s be clear that it is not likely things will play out exactly as I predict. The company might delay profitability until a later date, user growth could slow, and podcasts might not be as lucrative as people think.
But if they are able to achieve these gross profit numbers (remember Q1 is seasonally their worst quarter), then Spotify could be worth $100-$150 billion in 5-6 years. They might not have Netflix level pricing power, but don’t count out Spotify.
Disclosure: The author is not a financial adviser, and may have an interest in the companies talked about.