Jan 2020: Spotify – Spot prize

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Spotify – Spot prize

Jan 2020 ($142)

 

A toll road is perhaps one of the best original cash collecting business models. As admirers of the modern versions of it including the likes of Mastercard and Moody’s, we are always on the lookout for a new one. Additionally, we have spent a lot of time recently studying disruptive businesses and the managers that established them. Spotify is a company we think potentially falls into both of these categories. Hard core value investors will see very low margins and high PE multiples. We see these too, but we also see many other business and entrepreneurial drivers that we seek – Buy Spotify.

Disruptors – Common Traits

During 2019 we read three biographies that detailed the business lives of three unconnected but highly successful business leaders^[1]. These contained fascinating stories of how each individual found their way to business excellence. However, what really resonated with us was a number of consistent traits that ran through all three even though they were decades and oceans apart. Having studied business books like ‘Outsiders’ and ‘Good to Great’ we know well the theory of what type of businesses excel, but there is nothing like real-life stories to make these traits really come to life.

Each of these books^[2] offers a first-hand account of what it takes to be a disrupter. Their study covers diverse markets such as low-cost airlines, alterative telecom carriers and wealth management. Each company leader possessed the owner manager/entrepreneurial/allocation skills we seek, but importantly also additional common traits. All these disputers:

• Challenged the status quo within their industry
• Offered the customer a step change in value for money
• As a result, the product/service/company was typically
  • loved by the customer…
  • …but hated, discredited (even ridiculed) by the incumbent industry players

We thought these were interesting commonalities and ones that arguably if we had known to look for them maybe we could have identified these companies as winners earlier in their lives. Reflecting on how powerful these disrupter businesses became from very small starting positions had us thinking about what other sectors are ripe for such disruption and who is doing the disrupting?

Thinking on this, not just using our analytical hats, but those of consumers in a modern society has thrown up a sector and a company we know very well indeed from a user’s perspective – the music/audio industry and specifically Spotify. We have spent a great deal of time in recent weeks studying this company and we very much like what we have found.

Enter Spotify

In this note we address:

1. The business model employed by Spotify and how it and its founder Daniel Ek exhibits many of the disrupter (and ‘Outsider’) traits we look for
2. The competitive landscape, noting the biggest challenge coming from Apple and Amazon no less
3. The end game: The opportunity to be the primary toll road for global audio distribution

A land grab and the big prize: A global toll road on audio

“I don’t think the market necessarily is purchased music. I think the market is much larger than that. I think it’s audio. Two billion people listen to radio. Most of that today isn’t monetized very efficiently. It doesn’t get back to the artists in any real form. And it’s kind of unclear who gets what. If you think about commercial radio, today, conservatively, that’s a $50 billion industry globally. The U.S. industry is $17 billion. What do people listen to? Primarily music. The market is much bigger than most people think.” – Daniel Ek, Spotify CEO and Founder

Spotify, we think is an interesting disrupter business. We assess it as such for the simple reason that very quickly we were able to assert that it possesses nearly all of the traits we outlined above that disrupters have in common.

• That is to say, both it and the pirate music streamers that went before it radically challenged the industry status quo
• As a result, they were hugely unpopular/discredited within the wider music industry whilst being hugely popular with the end user
• Not only have they offered phenomenal value for music lovers globally – all the music you can eat on multiple devices for c.$10 a month or alternatively, free! They have also arguably democratised both music creation and its consumption
  • The world’s music catalogue is now available globally (for free) to any one of the c.2-3bn people who have a smart phone
  • Music can also be directly uploaded by thousands of artists for almost no cost

In addition to its 113m paying subscribers, another141 million Spotify subscribers get music for free via an ad-supported subscription platform (they are the only provider that offers this). The result is a super simple to sign up product that offers free unlimited music on a great interface to anyone in the world with a device and email address. It can be personalised; it is free and it is forever. No credit card is asked for and there is no compulsory Google-like identify grab. Every few songs you will hear a 10 second advert, but hey what do you expect for free?! Spotify’s data shows that 60% of its new paying subs come from the ‘freemium’ users as they call them. As we note later such a conversion process makes its runway towards an even bigger and more profitable company easier to foresee.

Fig.1 offers useful context on the music industry’s past sales in the US. It shows the demise of CDs (orange) and how streaming services (in green) have recently revived the music industry’s fortunes, re-starting growth. 80% of Label and Artist broadcast revenues are now derived from streaming services such as Spotify or Apple Music. Looked at against this chart it is easy to see why agents and artists once railed against the pirate streamers. As recently as 2014 Taylor Swift and the Beatles estate threated to stop steaming access to their music. Now many are embracing the channel seeing the growth it generates and the ability to reach a much wider audience.

New Toll Roads + Learning from Errors of Omission

We are firmly focussed on finding businesses and shares that can compound at attractive rates over long periods of time. That means we often look for attractive starting prices – something we have always tried to remain disciplined on. However, but it also means finding long runways for growth that may come from market dominance in an underdeveloped sector.

Fig.1: US Music revenues – the Labels need the Streamers

 Source: RIAA

Long-in-the-tooth value investors might be dismissive of many technology stocks as faddish. Given today’s high PEs in many hard to understand companies in new products/sectors we tend to agree. That said compound return seeking investors need to acknowledge that in the cases of the best companies (i.e. those likely to attain + retain a dominant share in their field) the reason these businesses are hard to value is the same reason they deserve to be understood properly. This being due to the magnitude of growth on offer – which is some cases is exceptional and likely long lasting.

To learn as investors, we occasionally reflect on our investment errors of omission. The biggest of which include not owning high growth businesses like Amazon and Google (we are in good company as Buffett has also expressed regret here too). However, any regret we might have is not centred on the fact that they have been investment ‘successes’ but based on the fact that their business models were analysable to us. Today these businesses are now all powerful, and yet earlier in their life this potential power we could have perhaps foreseen, for one is an EDLP Flywheel business and the other a modern Road Toll – both being business models we understand well. Maybe the shares looked a little expensive at the time, but there were analytical ‘misses’ on our part.

Fig.2: 20/20 vision – Always easy with hindsight

 Source: FT

An aside: Our 2017 work on PayPal (Holland Views – PayPal – Surfing USA, $52, June 2017) is also formative – it being another platform type business that looked to us to offer a good runway of long-term growth. We think that growth assessment has been vindicated – PayPal’s 2018 revenues of $15bn were 50% higher than those of just two years earlier! And yet, whilst we recognised the growth potential, the valuation up-lift we under-estimated (the shares have more than doubled to $116 since we published!). We take the liberty to repeat a Charlie Munger mental model which we used at the time.

“When these new businesses come in, there are huge advantages for the early birds. And when you’re an early bird, there’s a model that I call “surfing” – when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows. But people get long runs when they’re right on the edge of the wave—whether it’s Microsoft or Intel or all kinds of people, including National Cash Register in the early days.” – Charlie Munger, A Lesson Elementary Worldly Wisdom, 1994

This new work on Spotify is designed to try and not repeat these same mistakes. If we think we are looking at a business with powerful compounding characteristics whose future market position will only increase in strength we need to be thinking harder about the business rather than making snap judgements on headline valuations. What follows is us trying a little harder to be open-minded. The longer we looked, the more we liked what we found.

Spotify – Innovator + Surfer

In Spotify, we have a business that:

• Displays many of the industry disrupter traits we are looking for
• Offers a long runway of growth in front of it, especially when we think of it as an audio, not just music, platform (i.e. could it cannibalise radio?)
• Ought to have toll road-type platform traits due to its scale and reach of network + its asset light business model
• Has established a first-mover advantage with c.250m subscribers.
  • It cannot be beaten on price (free is a low price point!)
  • ..Or service – its music collection is vast, it playlist innovation is industry leading and it available on all types of devices in 79 countries
• It is very focused on its target market of audio, seeking to now evolve the music industry
• Crucially also, it is run by its Founder. Someone whom we think is very important to Spotify’s attraction as an investment and likely longer-term success

Regarding the runway for growth, it does seem right to broaden the thinking beyond music and in particular toward the opportunity to cannibalise the radio industry via podcasts etc. We note as Ek observes the US radio industry alone generates c.$17bn of advertising revenues. Were Spotify able to take just a fraction of that and considering the marginal profitability that such a revenue stream would enjoy, it would be very accretive to the c.$1.25bn of gross profit that the company currently earns.

“We can’t rest on our laurels. We believe the market we’re going after is audio. That adds up to 2-3 billion people around the world who want to consume some sort of audio content on a daily or weekly basis. If we’re going to win that market, we’d have to be at least a third of it. We have somewhere between 10-15x of where we are now of opportunity left. We’re still in the early days of our journey.” – Daniel Ek

Daniel Ek – Disruptor + Innovator Personified

We will not waste ink summarising the evolution of the music industry in the last two decades to a well-versed readership. We have all lived through the launch of iTunes, the iPod, the death of HMV and the rise of Taylor Swift. However, we would encourage readers to read some of the articles that our research on Spotify has unearthed (see links at end of piece). Firstly, these articles give nuance to the evolution the Music industry. Equally, the articles shed good light on Mr Daniel Ek, the Founder and CEO of Spotify – an extremely impressive Swedish entrepreneur who almost single-handedly pioneered the industry’s shift to music streaming.

As another aside we are deep into Bob Iger Autobiography and have just found his admission that Disney was 24 hours way from buying Twitter. This was at a time it was looking at distribution businesses to buy, before deciding to build its own. What other Network assets did Disney consider? Iger’s list is surprisingly short: “Snapchat, Twitter and Spotify”

Ek is still just 36 years old and Spotify, the service, was only launched in 2006 (in the US in 2011). Notwithstanding his youth, Ek was in 2017 named “the most powerful person in the music industry” by the trade magazine Billboard – high praise indeed. The more we study him the more impressed we have been. Were Ek from California, not Sweden, we suggest he and Spotify might be held in even higher esteem in more mainstream US circles.

Ek, we think is a very interesting individual and business man. He is someone whom we consider crucial to the continued dominance of Spotify in the world of music. He is an innovator and maverick but also ambitious, and crucially for us he is the founder of not just this company, but of this industry (streaming).

We think he has some very interesting business leadership traits that not only match those we highlight above in our disrupter checklist, but also a number of the growth and innovation centric traits outlined in books like ‘Good to great’. Traits such as:

• Building a core ideology
• Constant Innovation
• Strong competitive positioning

He thinks deeply about the evolution of not just his business but the wider industry, exhibiting good understanding of flywheel re-investment, economies of scale and the need to be the leading innovator in an industry. As part of our research we came across an endorsement of Ek and Spotify from perhaps an unsurprising source – one of its shareholders. We should note that James Anderson and his team at Baillie Gifford are not clients of ours, but from reading some of their publications we greatly respect their business analysis skills (and we do overlap on the shareholder lists of companies like Exor and RyanAir). Anderson recently outlined their case for Spotify in a Barrons interview. The link to it is given later. Anderson specifically observed:

“My take is that Ek will probably be the most important European business leader of the next 30 years” – James Anderson, Bailie Gifford

As Mr Anderson is a competitor of many of you, you may feel not inclined to rely on his assessment. Such a reaction must reflect a bias. Having yet to spend time with Ek we are prepared to accept objectively that Anderson has very astutely backed many successful entrepreneurs and disruptive businesses and, in that context, that he chooses to be so outspoken as to the skills of Ek, we think, is informative.

Ek doesn’t operate alone. We might also give a nod to the depth of the Spotify team. A Board of Directors which includes Ted Sarandos – chief content officer of Netflix, Thomas Staggs who was formerly CFO of Disney and the head of Nike Retail/Nike.com. In 2016 Spotify also added Troy Carter, previously Lady Gaga’s manager to head up its relationship with artists.

The Spotify business model

Spotify pioneered the streaming of music by negotiating an industry-wide licensing agreement with the music label oligopoly (Warner, Sony and Universal Music) who comprise 80%+ of the music industry back catalogues. Doing so by first showing the labels the success of the idea in Sweden and then across Europe. At each point the labels were sceptical only finally allowing Spotify to launch in the US in 2011. It is important to note that the terms of the initial agreement are complex^[3] and remain secret. We do know that the initial agreement included the labels taking/being offered equity stakes in Spotify and we know that post a major renegotiation of terms (ahead of Spotify’s direct listing on NYSE in 2018) Spotify’s gross margins improved from 21% to 26%. In other words, there is evidence that the balance of power has already shifted in Spotify’s favour (as you might expect given its scale).

Indeed, the language of such rights renewals has already shifted to one that talks of a win/win with perhaps better rates creating more growth in music consumption. Our recent readings of UK listed Hipgnosis Songs Ltd prospectus suggests it lawyer came to a similar conclusion!

 – Hipgnosis Songs Fund Ltd, IPO prospectus

Whether Spotify will eat the Labels’ lunch even further remains to be seen but it is clear there remains a battle of power that is ongoing and Spotify surely has the opportunity to work closer with artists directly. In recent years it has created marketplace which is designed to help artists either list directly or to have far greater access to the data about its fans that Spotify controls. Evidence of this is seen from Spotify’s now direct public promotion of some artists.

Spotify’s stated ambition – its mission statement – “is to facilitate 1 million artists to make a living from music by connecting them directly to fans”

We note the two-sided nature of its network: fans and artists. Charlie Munger might call this a ‘win-win for the entire ecosystem.’ Underneath this laudable goal, is we believe Spotify’s unstated ambition to increasingly to cut out the Label middleman and act as the platform of choice that connects musicians/artists directly with their fans. Indeed, they admit the later goal, if not the former one. With 40,000 tracks being uploaded (i.e. from independent artists outside Labels) onto Spotify daily, it would seem that this goal is progressing fast. What Spotify now also offers artists that the labels never could is more insight into fan listening – DATA. Who is listening to what and where? These we think will be powerful tools that artists and those that successful promote them in the future will embrace. They will also surely see the network that develops, collects and controls such data get a bigger share of the industry pie.

The changing face of music

The wider world of music has been changing fast for some time now. For years the agents and the artists they promote hated streaming but now that stance has changed with many artists realising the streaming platforms can connect them directly with fans and broaden their fan base.

• As per Fig.1, streaming has reversed the trend of revenue decline for the labels
• We note too, the valuation of Vivendi’s Universal business was significantly marked-up in the space of two years as evidenced by the recent TenCent investment

The labels, whilst they all have had equity stakes in Spotify’s which were negotiated as part of the original distribution deal, are likely to see their position squeezed further we suspect. The announcement that Universal Music is launching its own Artist Analytics app (which Spotify already provides) is a subtle indicator of the tension that the labels must be feeling as Spotify encroaches further and further on their turf. The artists’ position we see as strengthened however. In other words, whilst Spotify has killed the threat of pervasive piracy and thus revived music growth it is also true that Spotify will derive future profits from eating an increasing share of that revitalised and now growing pie. Therein lies the friction that Spotify is a facilitator of how labels monetise their IP but also a business that is eroding the value of labels erstwhile oligopoly’s. Artists (both developed and upcoming) are adjusting to this new order quickly, but the squeezed labels will find the transition much harder.

Just as the expensive middleman wealth-manager was squeezed out by the low-cost Schwab model we see extravagant and outdated gate-keeper agent services as under pressure. The future surely is already here. It is one where artists have greater direct contact with their fans and greater control over their rights. Crucially it is also a world where artist discovery is less dependent on the whims of label agencies.

As such, it is also one where music is thus democratised and a long tail of good music can find its audience without the need for the fixers and promoters of old getting rich in the process.

What does that new world need? It needs one or two global platforms that will help consumers discover and enjoy the world best music at a stunning price (free or $10). And one that will try to help artists make, distribute and earn from their music in a more open and fair way. Crucially we on the part of the platform we think this requires scale yes, but also an intense focus on helping the industry develop.

When Buffett and Gates were interviewed together many years ago, they were both asked to give just one trait that they thought had made them excel in their field. Without promoting they both gave the same answer – “focus”

Spotify’s achievements in its short life to date

• Dragging the music industry ‘kicking and screaming’ into the 21^st Century by offering a commercial alternative to the pervasive piracy of the early internet days
• Signing the first major cross-label licensing agreement as a new pure-play aggregator platform
• Gaining pricing power over the Labels (as per its renegotiated agreement in 2018)
• Ramping to 250m users
• Changing stripes from outsider to industry mainstream (NB Spotify is now focused on ‘evolving’ the industry, not ‘disrupting’ it)
• Arguably forcing the 800lb gorilla and competitor Apple to shift from its longstanding music model of pay per tune (via iTunes) to rental/Streaming (via Apple Music)

To us the last of these is the most telling. iTunes music was part of the glue that kept Apple users locked into the IOS system and its devices. That a small Swedish start-up was powerful enough to force Apple to change its entire music strategy we think is very telling. Today Apple and Spotify have a similar number of paid subscribers in the US market (35-40m), but Spotify has a further 60m of free users in the US. Readers should note that iTunes was rolled out in 2001 giving Apple a ten-year head start. Spotify was not launched in the US until 2011!

Competitors and Pricing

One of the signs of a competitive moat is surely when your competitors go out of business or publicly admit that they cannot go head to head with you – (See our reflections on this below on Napster and Deezer). On that basis, Spotify in 2020 enjoys a good moat we are happy to claim.

We might also add that the extent of reinvestment (and thus low reported margins) being made by Spotify is a massive detractor for new players looking at entering this market. It is also another trait that the best disruptive companies we have studied engaged in. That is, driving future growth and engagement at a cost to shorter term profitability.

Scale + Those forced into Niches

The key point in network-type assets is, of course, scale and the first mover advantage that captures it. We are very much attracted to the scale of market leadership that Spotify has now established in global audio streaming. As we write, Spotify has circa 248m active users (113m of which are ‘premium’ i.e. paid). Apple has c.60m (predominantly in the US) and Amazon has 50m.

There are regional/niche players too: TenCent Music Entertainment (with whom Spotify notably has a cross-shareholding) has c.35m paying subscribers to its music apps in China. Boompay in Africa has 60m subscribers (but only paying c.$1 per month), Deezer in France has more than 12m and the latest kids’ favourite, TikTok claims to have had its app downloaded 1.65bn times in 2 years.

Despite the noise of this apparent competition: Spotify is the only pure-play branded music distributor of any meaningful global scale. We do not to dismiss its existing competitors but note the difficulty in replicating what it has achieved in terms of brand, customer recognition and product development. In new/fast growing markets there is often a distinction made between who will be the ‘mega’ players in an industry and who will be the ‘niche’ players. The combination of Spotify service, price, ubiquity and strong determination to be at the forefront of audio innovation surely means its position as a future ‘Mega’ is almost secured.

The aforementioned Deezer is interesting for several reasons, not least it was setup by the owner of Warner Music! However, in 2017 he admitted^[4] that it could not compete head to head with Spotify or Apple so it was aiming solely at curated, niche markets (it is #1 in Gospel Music in Brazil!!). Similarly, Napster (acquired out of administration by RealNetworks) has shifted to a B2B platform model and by comparison now miniscule in scale (3m subs).

The relative market share dominance of the major streaming platforms in different geographies is notable too. Apple Music has a stronger share in the US, where its devices dominate (we note that Apple Music is preinstalled on iPhones which are then sold with a 6 months free Apple Music trial). Spotify by contrast is stronger in almost all other continents, including Europe, Latin America and Asia. Importantly, Spotify is far more device-agnostic than Apple Music and perhaps crucially it is seen by consumers that way. Simply put Apple music is used by and seen as a product for those with Apple devices, Spotify is seen and used by those with all devices – Spotify priding itself on the fact it will work on almost any device globally.

Subscription, pricing power and the likelihood of price wars

Investors, we think should think about the pricing of this product in a few different ways:

1. In terms of what the customer gets versus all other forms of media consumption on offer. The price vs. value offering in music streaming is, to us, exceptional. Today a family can listen to hundreds of hours of music a month for less than a single album might have cost them 20 years ago. This might be also compared with say the cost of watching sport or having a fast broadband service which is c.3x the price of audio streaming a month.
2. Therefore, we ask, is there a sensitivity of consumers to even lower prices? Not really, is our conclusion, no. Whilst some might be attracted to the free (with ads) service that Spotify offers (141m actually!), this is more of a tie-in model for those unable or unwilling to part with the $10 price yet. Notably, in a 2018 analyst event Spotify disclosed that 60% of cumulative premium subscribers were previously ad-supported subscribers.
3. In the $10 pricing it is also worth remembering that only circa $3 of that going is to the streaming company and $7 to the intellectual property owners – i.e. the label and artists.
4. Thus, we see little scope for price war as absolute consumers prices are already very low. Nor do we see it being likely to drive faster subscriber growth or much switching due to the stickiness we feel subscribers have to each platform (Spotify or Apple Music).
   1. Finally, nor do we think any discounting type price war would be welcomed by either artists or the labels
   2. Even were a future discounted offer (for say $5 a month) to still guarantee the labels their normal $7 of income (i.e. for a $2 GP loss) they would be unlikely to agree to distribute via such a service we think. The reason being that it can offer nothing that existing platforms cannot already and importantly it cheapens the image of the industries IP – something artists and labels feel very strongly about

That said it would be remiss not to highlight Tim Cook’s thoughts on pricing:

Apple can approach music as a loss leader, or as Cook says directly, “We’re not in it for the money.” – Tim Cook, CEO of Apple^[5]

The above quote is a reminder that Spotify’s main competitors, Apple and Amazon, in effect, can and do, use music as a loss-leader in order to sell hardware, ads or retain customers.

As a thought experiment, if we were to consider how much Apple is making in say, airpods – say $6bn revenue per year and growing at 100% run-rate. Apple is probably making $3bn in gross profit alone just from airpods alone. Let’s also assume it has 50m music subs at $120/y – say $6bn in music revenues. A 70% pay-away on that music is a $4.2bn royalty outlay to the Labels. Apple will soon be able to pay for its entire music royalties just from its airpod profits…. if it chose to.

We do not ignore the competitive threat posed by Apple and Amazon who effectively bundle music streaming into other services. We note however that despite the approaches taken by competitors Spotify is in almost all geographic areas still growing faster (or as fast) as its peers. We conclude that the network it already has in place is powerful for advertisers and customer awareness (a large % of new subs just come from word of mouth). Also, maybe its pure focus on Audio and the discovery and development of it at a compelling and hard to displace price resonates with customers. Its branding is good on NPS score and it is clear what it stands for. As an early disputer it is being challenged but seemingly is winning out against some mighty gorillas.

Playlists and sharing – the glue

A key aspect of the user’s music streaming experience is playlists (the digital version of ‘mix tape’ that some of us made back in the 1980s!). Whilst many of us might enjoy watching a Netflix box set, is it as personal and important to us as the soundtrack of our holiday or wedding anniversary? Or your kids’ playlist from their 18th birthday party? No, absolutely not. There is a great deal of personalisation with the better music streaming apps, not just allowing you to keep your playlists forever, but to see suggestions of others you might like and the ability to share with friends. This was how most Spotify users first used the service, but this has developed further too, with Spotify now using data, new artists and peer groups to help subscribers find new music they will love. NB: Now c.30% of all Spotify listened to music is artists or playlist that Spotify put together for customers.

Personal playlists take time to create and thus are a friction preventing subscribers from switching to alterative platforms (there are apps now available to transfer playlists from one platform to another) but there is just no rational reason to wish do so.

Using such apps to help transfer from say a $500 Apple phone to a $250 Samsung one is worthwhile to some people, but with no cost or service differential we see future audio streaming customers as very very sticky. With investment for growth so high this stickiness is however not visible in current financials but we see good evidence of a core low churn, low maintenance cost customer base.

Scale matters. However crucially we think this scale only needs to be won once. This is why we think the market share fight for audio subscribers currently taking place is more akin to the Google/Yahoo one-off battle for ‘search’ market share rather than that of mobile operators who need to constantly subsidise new handsets to retain customers.

Thus, the current elevated expense at Spotify in areas like sales + marketing we would not expect to be recurring in its current scale. (NB: Investment in customer acquisition costs comprising upfront discounts + free trials are all taken within Spotify’s Sales and Marketing expense). We see these as costs of growth, not costs of retention. Indeed, at the group’s 2018 Investor day the company admitted this exact fact with the FD pointing to the almost halving of marketing cost as % of sales that he had experienced during his time at Netflix.

• We say this cognisant of the fact that Spotify does always disclose its churn rate, but its current level will always be skewed on high side when companies are growing quickly
• But we also say it having discussed the product with many users. There is just no appetite to switch whatsoever. If you are receiving a great service for a great price the only reason you ever look for an alternative is if your provider messes up in some way
• Who wants to go to the trouble of changing platforms, learning a new one and recreating personal playlists just to save maybe $1 a month? (NB: Spotify has matched any discount periods Apple has ever offered)

From our experience, the many diverse users of both Apple Music and Spotify simply LOVE the vast availability of music on offer, its affordability and the personal and social aspect of creating and discovering new playlists. In almost all cases, there is just no reason to change streaming provider. What this might well point to, in time, of course is pricing power.

What’s wrong with being a distributor of third-party IP?

As a company that does not distribute its own IP many may be too quick to dismiss the defensiveness of the market position Spotify holds. Perhaps on a first look, distributing third party intellectual property does not look like a good business model. Indeed, Spotify’s gross profit per user today is only €10 per annum and EBIT margins seem very low. Also, you are ultimately selling a non-exclusive product.

However, we see this a classic example of a network asset whose greater value comes from the value of the network itself and how the breadth and scale of that network only increases over time. We also note that were say Disney to not have sufficient strength in their own content available on its own network its subscribers might choose to not renew. However, in the case of a network with low prices and waterfront coverage of all global music there would seem little rationale for a customer to ever leave unless Spotify makes a significant mistake. In that regard the dominant music streaming platforms are perhaps more like Amazon’s or Costco’s retail operations with customers staying with them indefinitely unless they are given a reason to leave. These are low margin models too, but are also two of the best businesses in the world. They too are loved by customers.

The move into podcasts (and beyond music into ‘audio’) might be seen as an admission/realisation that owning content/IP is actually important. But we see it as a natural evolution of what Spotify is seeking to become, i.e. a global audio platform to solve all customers’ audio needs. As Netflix has shown, viewers might originally sign up with you to see third party content but the broader and deeper you can make what you offer to them the longer they will likely stay and the more you will get them to pay. We note that in only three years Spotify has become the 2^nd biggest podcasting company in the world. Today most podcasts are distributed in maybe only Spotify and Apple compatible formats as most global users will increasingly have access to one or the other.

So, we remind you, the prize on offer here is a toll road, likely one of just two (or three including China) for the entire music/audio distribution market globally. We are not saying “forget today seemingly poor unit economics, it will all be fine”, what we are saying is that the volume growth prospects of this business look so good that unit economics will surely change utterly once greater critical mass is achieved and growth costs subside. In other words, the history of comparable digital toll roads and oligopolistic platforms teaches us that if and when a 250m subscriber base of today becomes say, a 500m of tomorrow then we think early $10 gross profit per user will be a distant memory and not relevant.

A different look at financials

We already mentioned that the Spotify looks at first glance to be a low margin business.

However, with some artistic license, looking at the company’s financials in a different way we see a far more attractive businesses model. We estimate c.70% of revenue being a pass through of royalties (whilst this is not disclosed it is a reasonable proxy – COGS is a combination of royalty fees and network overheads). Looked at without these costs, ‘Spotify the Network’ look a far more compelling business model.

In addition, we also reflect on the likely real maintenance Opex of such a network vs. significant growth related Opex currently being incurred (a fact the company openly admits). This suggests to us that the true cost of providing and maintaining the main aggregation and distribution service (aka the ‘toll’) is potentially very low indeed pre R+D type costs. This might be supported by the fact that Napster, being run as it is as a cash cow is profitable (just) despite only having 3m subs and spending 6% of sales on R+D.

Indeed, one of your authors has been a Napster, subscriber rather than a Spotify one for the last 8 years, paying c.£10 a month for a Spotify-esq product. Why has he not changed onto the same system many of his friends use? (Spotify). He does not want to lose his playlists!

Does the product he has used in the last 10 years change much suggesting high investment – not at all. And how might respond to say a 10% price rise – “I would just pay it.”

Spotify’s reported financial statements show EBIT margins of only c.3%. but that is after Sales and Marketing at 12% of sales and R+D at c.10%. Remember these are percentage of TOTAL sales (i.e. including studio/artist 70% pay-away) so each are c.30% of Spotify’s income. As we stated above arguably a great deal of these costs are either directly related to growth or are investments to create future growth.

Fig.3: Margins – Looked at differently – low GM margins or high?

 Source: Holland Advisors (using Spotify 2018 year end data)

Our point here is that Spotify looks and feels like a digital network/road toll business that is asset light. Such businesses once they reach scale tend to have very good margins and excellent economics attached to the marginal customer. Analogies we could make might be businesses like Rightmove or Hargreaves Lansdown in the UK (or Booking.com). These businesses have EBIT margins of 60-70% which reflect the scalability of their platforms and the low incremental cost of each new customer. If say Hargreaves was required to book as revenue and then pay-away fund manager fees its margins would be far far lower. However, its business model would still be the same with great unit economics and very low asset intensity. Amazon of course has pursued this exact model and we note its c.30-35% ROTE in 2018 from a c.5% EBIT margin.

What is it worth/How to value it?

• Spotify is likely to have 2019 end of year sales at $7.4bn and it is currently growing at 30% pa
• The vast majority of its sales and profits are derived from premium subscribers (113m subs) with very little income (<15%) derived from free subs (135m)
• Were we to grow its sales at 20% (company forecast 25-35%) for five years its sales would reach c.$18.4bn

The bigger question is what level of profitability should be assumed. Looking at the company through our digital network lens as we have above it would be surprising were such a company not eventually able to make a 30% EBIT margin if only reporting its own true revenue (as HL, Rightmove and Booking.com do). This would equate to a c.10% margin in Spotify’s current form, giving a year five EBIT of €1.8bn. As for the right multiple for such a profit stream to trade on? Well again we could look at the same asset light digital networks (coincidentally both HL and Rightmove trade at 27x EV/EBIT). A 25x multiple of €1.8bn would give an Enterprise Value (EV) of $45bn vs. today’s EV of Spotify of $25bn. Additionally whilst the following observation cannot really be considered a valuation ‘yardstick’ for those of us that consider themselves value oriented investors we do however note the following:

• In 2019 Netflix had an EBIT of $2.6bn vs. the $1.8bn we project for Spotify
• Its EV today however is €161bn vs. the €45bn we project for Spotify (and today’s $25bn level)

As an aside we note that the group’s current revenue of $7.4bn represents an average annual income per paid subscriber of just $65 per annum. Were this arguably low rate of income for subscribers to stay constant over the next 5 years Spotify would need 276m paid subscribers to reach the €17bn of revenues we project. Today we note it already has 248m subscribers (but c.60% are currently on the free package).

In an optimistic investing climate such at this many platform assets are looked at/valued for the scale that they might be able to project in adjacent service areas in the future. We thus take some valuation comfort from the fact that Spotify could easily be a good (if not outstanding investment) if it just matures its existing customers into paying ones at today’s blended rates and normalises its profitability via a lower cost of growth investment. Whilst this is no net/net(!) such observations do lead us to reflect that today valuation is likely fair/even prudent. As for what might go right, there are plenty of follow on factors that of course increase the upside further:

• Later years price increases a la Netflix once the competitive environment stabilises (everyone we have asked would pay 10% more without even blinking)
• Opportunities for the long-term addressable audio market could be many multiples of the size we assume in year five.
  • The company observes that 1.6bn people have a payment enabled mobile phone in their current markets and c.12% of them have a music steaming service
  • With c.50% of those being on Spotify
  • Clearly all those figures and percentages are only likely to rise
• Opportunities in podcasts and associated advertising
• Opportunities in radio
• Opportunities in ticket sales or other artist/fan relationship products
• Higher operating margins then that we have assumed. We assume 10% (aka 30% in asset light format). Maybe a higher level of 15% (45%) is achievable…?
  • A driving factor for this might be the group getting a higher (fairer) share of the distribution/agent pie
  • The company expects its Marketplace service for artists to drive higher margins
  • Prior to float the group guided to a longer-term gross margin of 30-35% vs. 27% today. That this target has not been hit in the short term does not mean it will not longer-term once drivers like Marketplace, greater scale and lower cost of growth combine.

A different approach

A different approach might be to consider the likely future value of the groups subscriber base and then make an assumption about the profit they might make from each subscriber irrespective of how this were sourced. This profit could come from any or none of the sources above. Were we to assume that:

• In the medium Spotify had 250m paying subs (vs. 113m today) and c.300m non-paying subs vs. 146m today
• And each paying sub contributed an annual PBT per subscriber of $10 per paying and $4 per free subscriber. This would equate to $3.7bn of PBT vs. current Market cap of $26bn
• In such a scenario a huge number of people would be receiving a wonderful service for a very very low cost

Our readers of old know that we are not known for such looking glass type valuation work. Our approach is only trying to reflect the idea that Spotify has built a loved and trusted global network that we think will be very hard to now displace. At some stage in its life that network will have value, possibly even a very significant one. As such our interest in Spotify does not come from a short-term valuation anomaly but from our attraction to its unique position in what could be a fast growing and long-lasting category. Additionally, its proven disrupter status a commitment to achieve greater scale and industry leading innovation.

Netflix, Disney and many more companies are fighting tooth and claw for the attention of our eyeballs. How that market ends up being shared out is becoming clearer but is still hard to see clearly. The fight for our ears however is seemingly easier to predict with actually very few companies really in the running to dominate. That a small, perhaps underestimated, founder run Swedish company is so well positioned for this we find both impressive and very appealing.

As for valuing it you can see our efforts above – each reader can use their own crystal ball. There is an interesting road ahead for this company and the more we have researched it the more we have found it not just difficult to break, but difficult to not believe it does not end up as one of the ‘mega’ rather than ‘niche’ companies that will be providing audio services to the world in ten years’ time. With such a reflection and by taking a view on what normalised profits might one day look like it is possible to envisage this as a much bigger company than it is currently valued.

https://investors.spotify.com/events/investor-day-march-2018/default.aspx

http://investorfieldguide.com/ek/

https://www.barrons.com/articles/spotify-stock-risk-51555979459

Buy Spotify.

“When these new businesses come in, there are huge advantages for the early birds. And when you’re an early bird, there’s a model that I call “surfing” – when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows. But people get long runs when they’re right on the edge of the wave—whether it’s Microsoft or Intel or all kinds of people, including National Cash Register in the early days.” – Charlie Munger, A Lesson Elementary Worldly Wisdom, 1994

Andrew Hollingworth & Mark Power

The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as advisors to.

Disclaimer

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1. Charles Schwab, Michael O’Leary and Howard Jonas ↑
2. Invested, Michael O’Leary (Turbulent times for the man that made Ryanair), On A Roll ↑
3. For insight into the complexities and intricacies of how royalties are calculated, collected and indeed paid, a glimpse behind the scenes can be had by reviewing the recent IPO prospectus of newly-listed Music IP fund – Hipgnosis Songs Ltd. For those interested in Spotify, we highly recommend a read of this document. ↑
4. https://www.independent.co.uk/news/business/analysis-and-features/deezer-music-streaming-spotify-amazon-apple-subscritpito ↑
5. https://www.fastcompany.com/90452741/research-shows-that-screentime-isnt-bad-for-you-but-something-else-may-be ↑