Previously we looked at Pershing Square Tontine and Universal Music Group (UMG). Subsequently, the SPAC deal got pulled due to SEC concerns. Instead, Pershing Square announced to go ahead with the purchase of a 5-10% stake in UMG by itself. As mentioned in the prior post, Spotify has played an important part in today’s music industry. Being the largest and most popular music streaming platform, the company has more or less single-handedly revived the once-declining music industry, that had suffered from file sharing and piracy issues until the mid-2010s. Today we will take a deeper look at the company.
Introduction
As of writing, Spotify stock has come down from $350/share at the start of the year 2021 to roughly $200/share. Or a valuation of €31bn. I am sure most people have heard of the company and may be even loyal fans of its streaming platform. Some people investing in the company draw parallel to Netflix, with Spotify being the Netflix of music streaming. They think the company is attractively valued because it remains one of the few global platform companies with a valuation still below $50bn. Netflix, for example, is valued at $250bn. In general, video companies in aggregate have much higher valuation than audio companies combined.
As Daniel Ek, founder of Spotify, once commented, “we spend as much time watching video as listening to audio; video is a trillion dollar market, but audio (including radio etc.) is only a hundred million dollar.” I don’t know what the updated numbers are today. The market they are after is audio. On the latest earnings call, he thinks they are still in the second or third inning to the growth trajectory.
Narrative and analogy are important tools in investing, particularly when looking at disruptive companies. It helps us “see” the future before it happens. But at the end of the day, it’s the economics of the business that drive value. We’ll start with a comparison of music streaming vs. video and then dive deeper into each of the components.
Music Streaming vs. Video
First is the revenue model. Spotify offers Freemium payment plans. They charge a monthly subscription fee for ad-free premium plan and a free plan with ads. Netflix offers only paid subscription plans. However, there are various free ad-supported video streaming services, such as Peacock by Comcast, Hulu and HBO Max with ads. In general, the average revenue per paid user (ARPU) in music is quite a bit lower than in video. Spotify’s ARPU is around low-$4, which has been in decline for years before stabilizing in 1H 2021. Netflix’s ARPU is around low-teens and has been increasing over the years.
Second is the content cost, which is by far the biggest cost item for both video and music streaming. The biggest difference is that video content cost is for the most part fixed, while music content cost is truly variable. In video, as long as an adequate amount of TV shows and movies are being produced and made available to the subscriber base, every incremental subscription dollar drops all the way to the profit line. Netflix, for example, has seen meaningful improvement in its gross margin from high-20% to 40+% as the company scales up.
On the other hand, in music streaming, companies pay out royalties in proportion to the revenue it earns for each time a song is played. This means its gross margin stays flat however big its subscriber base gets. In fact Spotify’s gross margin has remained at ~25% even as its revenue has been growing at 20-30% a year. Increase in gross margin will be contingent on negotiations with record labels, which control lion share of songs played on the platform. And we will get back to this later.
The lower ARPU and the lack of fixed cost leveraging should explain why music streaming in aggregate is valued lower than their video counterparts.
Competitive Landscape
In terms of competitive landscape, I do believe music streaming is similar to video, where a handful of players are likely to dominate the space. Spotify, like Netflix, is by far the category leader with ~32% market share, twice the size of Apple Music at say 16%, and Amazon music at 13%. And then you have Tencent, YouTube Music and others. There is real advantage from being the first mover, economies of scale and brand recognition, while all providing relatively similar end products. Furthermore, the company thinks that the data (i.e. subscribers’ music tastes) that it has been collecting allows them to offer personally curated playlists, differentiating itself from competition and adding a major hook point to its subscribers. Either way, I don’t have much doubt that they will maintain their market leading position.
Revenue Potential
As we think about valuation, we’ll start with revenue potential. There are ~3bn internet users globally ex-China. Assuming everyone listens to music online, whether it’s paid subscription and free with ads. And assume Spotify to maintain its market share of ~1/3. That would be 1bn total monthly active users (MAUs) for the company. This aligns with the company’s plan towards billion plus MAUs. As of quarter end of 2Q 2021, there were 365mm MAUs. So it implies a 2.5-3x growth from today’s figure.
ARPU, as mentioned before, has been in decline. It has to do with various bundle plan discounting, such as family, student and duo plans, and inclusion of more international subscribers, who pay lower prices. In April 2021, the company did finally announce price increases, stabilizing the ARPU in 2Q 2021 results. Perhaps the company may be able to increase prices a bit further. So let’s say the company can do 3x current revenue run rate of ~€10bn. That’s €30bn revenue at some point in the future, assuming the mix of premium subscription and ad-supported revenues staying roughly the same.
For the last 3-4 years, both MAUs and revenue have been growing at 20-30% a year. I do expect future growth to slow down. This means it may take 5-10 years to get to this revenue potential.
Margin Profile and Valuation
As mentioned before, the company’s gross margin has been staying flat at ~25-26% over last couple years due to proportional payout to record labels. Important to note is that, prior to its IPO (direct listing to be precise) in 2018, it had even lower gross margins of 10-20% in 2015-2017. What happened was that record labels signed deals that allowed the company to increase gross margins before going public.
At the time, the top 3 label companies all have equity stakes in Spotify and have vested interest in seeing Spotify succeed in some way to compete with Apple. Since then, Sony Music, which had initially taken the largest stake in Spotify, sold half in 2018. Warner Music sold everything. UMG, the largest of the three, maintained its stake but is going through its own sale process, as evidenced by the Pershing Square Tontine SPAC deal. From now on, negotiations can get tougher.
That being said, as the clear market leader that brings not only significant revenue but also growth to all of the label companies, I do believe Spotify has increasing negotiating power. Management believes over the long run gross margin can expand to 30+%. Assuming that is true, perhaps the company may be able to do 10-15% EBITDA margin on the €30bn potential revenue, or €3-4.5bn EBITDA. Applying a 15-20x, that would be a €45-90bn valuation, versus current enterprise value of €31bn. Current valuation is not too crazy. Upside case however will be contingent on gross margin expansion, which in turn requires concessions from label companies.
UMG vs. Spotify
Label companies for the most part own the content on Spotify, while Spotify owns the end consumer relationship. Which one drives more value? Unfortunately I think it’s a tough call. Alternatively, let’s take YouTube Music as an example, YouTube pays label companies a small fraction of what Spotify is paying. The key here is that YouTube offers a lot more than just music. Spotify is aggressively building out other audio related verticals, such as podcasts, live events, discussions, news as well as building direct relationships with artists. They are important to bolster its market leading position, but it’s hard to see them alter the core economics and value drivers in any material way. Still, given a choice to invest in either UMG or Spotify at current prices, I would probably take Spotify but not an easy choice.
