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Profits Deferred, Investors Deterred
The market wants Spotify to put up profits. Spotify is taking the long view.
I have one super-trait, and that is I’m insanely patient.”
— Daniel Ek, Invest Like the Best (September 2021)
Ten years ago, the music industry was in dire straits. Physical sales were in terminal decline, and piracy prevented digital downloads (iTunes, etc.) from acting the savior. The industry experienced over a decade of declining revenues.
Enter Spotify and the streaming model. Streaming sharply reversed the trend and drove industry revenue to record highs despite the continued deterioration of physical sales and digital downloads. Spotify led the charge and remains the dominant player.
Streaming works because it’s great for consumers and music rightsholders (the labels and publishers). Consumers gain access to a virtually unlimited library of tracks for free (with ads) or an affordable monthly price (less than it previously cost to download 10 songs on iTunes). Rightsholders receive a steady revenue stream (they make money every time a song is played) and gain the ability to profitably meet consumers online (where it’s most convenient to listen). This increases engagement, which in turn drives more revenue to the labels.
Despite Spotify’s positive impact on the industry, owners of the stock have been punished. Since its direct listing in April 2018, Spotify the stock has declined almost 50% compared to a nearly 50% gain for the S&P 500. In other words, the opportunity cost for an investment in Spotify at the time of IPO is around 100%. Not great.
The fundamentals of Spotify the business reveal divergent narratives. Story One details a broken business model unable to deliver profits because of its dependence on the very labels it helped to save. Story Two points to a company exhibiting consistent growth and investing heavily to capture a large, global market opportunity.
In 2020 and 2021, the market bought Story Two. Now, the bid reflects Story One. Therein lies the investor’s opportunity — if Story Two turns out to be true, investors who buy Spotify today can earn outsized profits over the long-term.
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Unfortunately, Story One is supported by some convincing evidence:
Gross margins have remained flat despite strong revenue growth.
Operating losses have increased from EUR 43 million in 2018 to EUR 435 million in the twelve months ended Q3 2022.
Free cash flow after subtracting stock-based compensation (“SBC”) has declined from EUR 131 million in 2018 to EUR (132) million in the twelve months ended Q3 2022.
This points to a broken business or, at the very least, a poorly managed one.
But maybe not. Story Two also presents a compelling case (if you believe Spotify maintains a long runway for user growth):
Monthly Active Users (MAUs) have increased from 157 million in Q1 2018 to 456 million in Q3 2022.
Premium Subscribers have increased from 75 million in Q1 2018 to 195 million in Q3 2022.
Quarterly revenue has grown from EUR 1.1 billion in Q1 2018 to EUR 3.0 billion in Q3 2022.
The combination of Stories One and Two signals Spotify has developed a repeatable growth engine yet can’t move past breakeven. But is this evidence of a systemic problem or a symptom of the decision to invest in the business?
Management’s commentary would indicate it’s a temporary problem caused by investments in the podcast business. The wisdom or value of these investments can and should be questioned, but the potential profitability of the enterprise has undoubtedly been obscured for the last few years.
To assess the longer-term potential, we can look at (1) the profitability of the core music business; (2) historical trends prior to the ramp of podcast investments; and (3) the forward-looking impact of podcasts.
First, the core music business has performed well. At the Investor Day, Paul Vogel outlined music gross margins have increased from ~25% in 2018 to ~28% in 2021. Importantly, this gross margin expansion has not come from tough negotiations with the labels; it comes from serving the labels’ primary need: effective marketing (the single biggest expense for a label). This Marketplace business is recognized as a direct contribution to gross profit and has grown from $20 million in 2018 to $160 million in 2021, direct proof of the value to labels.
Of course, the improvement hasn’t reached the income statement given the level of investment. But for investors taking the long view, the target for a 30-35% music gross margin long-term remains on track. The market may define “long-term” as 3-5 years (the time from IPO to now), but clearly Spotify’s definition differs, perhaps 8-10 years. That definition suits my investment horizon.
Second, the progression of the business pre-podcasts paints a different picture than the current one. In February 2019, Spotify completed the acquisition of Anchor, which drove its podcast strategy and set the stage for the ramp-up of investments. Prior to this, from 2015 to 2019, gross margin, operating margin, and free cash flow margin improved dramatically.
Substantially all of this improvement can be attributed to 1,380 basis points of gross margin expansion. We can’t count on this type of performance moving forward, but this period is useful to understand the music business’s general capacity for producing cash flow. At ~25% music gross margins, Spotify has proven it can operate at a 6%+ free cash flow margin.
Given the revenue growth and music gross margin improvement over the last few years, it seems reasonable to assume Spotify the music business can reach a 10%+ free cash flow margin. At a 10% free cash flow margin, Spotify would have produced $1.1 billion of free cash flow in the last twelve months. Compared to the market cap of ~$15.3 billion, that’s a free cash flow yield of ~7%.
This theoretical analysis of the music business may be interesting, but at the end of the day, Spotify has made the conscious decision to invest over $1 billion in podcasts, which prevents the business from reaching its potential, at least in the near-term. $1 billion isn’t chump change, and any owner should expect the returns to justify the outlay over time. The trouble is three years have passed and any returns have yet to manifest, which is why the stock has suffered.
Before we dive into any numbers, thinking about the nature of the podcast investment can be helpful. At its core, it’s intended to enhance the customer experience. At no extra cost (even for ad-supported), users can access over 4 million podcasts (up from less than 500k in 2019), some of which are exclusive to Spotify (6 of top 10 shows are Spotify Exclusives). This is a meaningful increase in the value-to-price ratio (a North Star for Daniel Ek) and likely the reason why Spotify boasts the lowest churn and highest engagement of any competitor.
“According to a recent report from Apple, in the U.S., iPhone users spent over 50% more time on Spotify than our next closest music streaming competitor and more than double the time on Spotify than the rest of our competition. In markets like the U.K., Germany, Australia, the gap between Spotify and other streaming services is even larger.”
— Charlie Hellman (Head of Marketplace), Investor Day 2022
“Here's rankings from the third-party measurement company, Antenna, which anonymized transaction data to track subscription services. You can see Spotify has the absolute lowest churn of any music streaming service.”
— Tony Jebara (Head of Machine Learning), Investor Day 2022
Lower churn and higher engagement increases the lifetime value of subscribers, which is good for profits. And although these profits have yet to appear, the underlying trends are positive and indicative of the longer-term value.
At a high level, the podcast market — largely driven by Spotify — is growing rapidly. Prior to Spotify’s entry, annual U.S. ad spend on podcasts was $480 million and projected to hit $1.1 billion in 2022. Now, ad spend is expected to reach over $2.1 billion in 2022 and double by 2024. Podcasts are clearly exceeding expectations and remain in the early innings.
At Spotify, podcasts are growing even faster. The company reported EUR 200 million in podcast revenue in 2021 — 10x more than 2019 — and estimates the long-term market opportunity will approach $20 billion. Engagement — and the associated monetization opportunity — has plenty of room to run.
Only 30% of users listened to a podcast in 2022, up from 7% in 2018; I would be surprised if this metric didn’t gravitate towards 100% over time. Moreover, only 7% of total listening hours were podcasts, and just 14% of that podcast time was monetized. Perhaps most importantly, podcast engagement has proven to be incremental time spent on the platform; it doesn’t steal from music hours, which proves the investment enhances the user value proposition. And to steal a line from Jeff Bezos, “what’s good for customers is good for shareholders.”
The trends may be positive, but as mentioned earlier, we are three years into this experiment and have yet to see any positive impact on the financials. This is where patience is essential.
“You can see very clearly you have to build all the processes; you have to build all the systems in anticipation of that growth because it’s so hard for people to comprehend what exponential growth looks like.”
— Daniel Ek, Invest Like the Best (November 2019)
Spotify has built an entirely new product experience and business model, along with the tools necessary for creators. This doesn’t happen overnight, and it doesn’t come cheap. But if you believe in Daniel Ek’s vision for podcasting, it’s a good bet. And if you can think long-term, podcasts are expected to be a higher margin business than music. With 2022 expected to be the peak negative impact, we should start to see some of the benefits in the next few years.
Markets tend to be forward-looking, which would imply the stock should be priced for the prospect of finally realizing this multi-year investment. But it seems the market simply isn’t listening to Spotify’s song anymore. Mr. Market has heard the talk of investments for years and has decided he wants to see profits now — not next year, in a few years, or in 2030, but this year. Luckily for the long-term investor, this means if you exercise patience (and most importantly believe in Ek’s vision), it could be a good time to buy the business.
To arrive at a reasonable expectation of returns (from the start of 2023 to the end of 2030), we can use management’s long-term guidance from the Investor Day. At the event, Ek called for $100 billion of revenue, a 40% gross margin, and a 20% operating margin in 2030.
When considered alongside the results over the last twelve months ($11.3 billion of revenue, a 25.2% gross margin, and a (3.9%) operating margin), the guidance seems almost ludicrous. For this reason, the potential return scenario here assumes the actual 2030 results achieve just half of the stated guidance.
As such, we can assume Spotify reports $50 billion of revenue (a 20% CAGR); at a 10% operating margin, this implies $5 billion of operating income in 2030. Applying a 10x multiple implies the business would be valued at $50 billion in 2030. Today, the stock trades at a ~$15.3 billion market cap (~$79 per share with ~193 million shares outstanding).
Under this scenario, an investor could expect to earn ~16% annually over the next 8 years. Not too shabby, but it doesn’t account for dilution. Assuming a 2% increase in shares outstanding each year until 2030 (in line with average since IPO), the expected return declines to ~14% but remains meaningfully above the long-term expected return on the market (~8-10% per year).
Despite the objective success this scenario predicts, it implies management looks foolish in the long run as the business falls drastically short of guidance. While I think the targets may be overly ambitious, I certainly don’t believe Daniel Ek (or any other member of management) is a fool.
Ek was (is) a visionary for the music industry, and I wouldn’t be surprised if he turns out to be a similar visionary in podcasting given the early results. Most importantly, he thinks like an owner (long-term) and has held a ~17% stake in the business since IPO.
I’m willing to bet on a guy like that.
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