Spotify Bull Thesis
How an incredibly sticky app and pivot into podcasting have set this company up for massive profitability
What Are the Best Businesses To Be In?
My personal opinion is that two of the best business models ever created are software companies and media companies. Why? Well, both are extremely scaleable and easily distributable. Once a piece of software is created, or a piece of content is recorded, it can be distributed digitally across the entire globe at virtually no incremental cost. You don’t have to worry about logistics, supply chain problems, inventory expiring or any of the problems that come along with shipping “atoms”.
That brings us to Spotify. What’s better than a software company or a media company? How about one that’s both.
What Is the Most Valuable Real Estate In the World?
According to Google it’s Buckingham Palace. To make this piece of real estate yours you’d either have to fork over an estimated $4.9 Billion or marry the Queen.
But Google is wrong.
The real answer to that question is the fixed bar of apps at the bottom of your iPhone/Android shown here:
As you can see, mine contains my texts, my email, my web browser and Spotify. So how much is this real estate worth? Let’s use a similar example to try and come up with an estimate.
In 2020 Google paid Apple $10 billion dollar to be the default search engine on all iPhones. That’s a whopping sum of money but analysts predict it was even higher in 2021 at around $15 billion and may even have reached $20 billion in 2022. It’s even crazier when you realize Google is paying that much only to be the default for the Safari browser when users can still download Firefox, Opera, or even Edge AND users can easily change the default Safari search engine in their settings. Still, Google feels like the exposure and increased search traffic is easily worth this steep price tag.
So what could Apple get if it sold the space at the bottom of all out of box iPhones so that an app such as Spotify would be automatically down there post-setup? I think it’s pretty reasonable that it could fetch a fee of around $5 — $10 billion to own one of those slots. But Spotify is doing this for WAY cheaper currently.
For the sake of this thesis I asked 25 of my friends and family who I knew were Spotify users if they had Spotify as one of the fixed apps in that bottom row. 9 of them told me they did. Obviously thats not statistically significant data but that response rate was MUCH higher than I anticipated and my theory is that this brand loyalty and stickiness is key to the future success of Spotify.
Spotify is in the Habit Creation Business
Humans are creatures of habit. Once we get into a routine it is very hard to break that. Spotify’s main goal right now is to increase the minutes users spend in their app so that it becomes an even stickier product and ultimately so that it has more data on us. One of the best ways to do this is to be featured prominently on a device that the average American picks up 63 times per day and uses for more than 5.4 hours daily.
Another metric to show Spotify’s stickiness is this quote from the Q1 2020 Shareholder letter:
“We also know that roughly 70% of churned users are back with Spotify within 45 days of leaving, which includes coming back through either our Premium or Ad Supported experience.”
That is a pretty incredible stat that makes Spotify’s actual churn rate effectively 1/3 as high as the reported number since most of the churned users are back by the next quarter.
Once they have you, Spotify is pretty confident you won’t leave or even look for other options.
So How Does Spotify Become Profitable?
I know what you’re thinking. “Yea, yea this is all good but at the end of the day a business needs to make MONEY and Spotify is good at doing the exact opposite”. I hear you. I actually thought the same when I first started writing this thesis. However, I realized upon a deeper look that for them to be doing anything besides growing as fast as possible and spending money to do so would be a complete failure by management to capture the opportunity in front of them.
There are 3 main ways that Spotify is currently set up to flip the profitability switch:
- Pricing Power
- Ad-Supported Business Growth
- Margin Improvement
Factor #1: Pricing Power
Fun fact. Spotify has NEVER increased its price for its Premium subscriptions since its introduction in the US in 2011.
This means accounting for inflation Spotify has technically lowered its price every year by keeping it at this fixed rate. As the purchasing power of the dollar has decreased by roughly 34% over that time ($1 in 2011 is roughly $1.34 today) Spotify has not budged its price even slightly. As the saying goes, death, taxes, and Spotify Premium costing $9.99
So what would happen if Spotify were to increase its prices and how much can they do so before the churn rate makes it not worthwhile to do so. My estimate is they can do so by 30% over the next decade to achieve the maximum revenue possible from subscriptions.
Where did this number come from if Spotify has never increased prices?
While Spotify has never increased prices in the US, they have in markets such as UK, Ireland and Norway which shows they are willing to do so in regions which they consider “fully saturated”. Unfortunately, Spotify doesn’t break out the churn by region only reporting the overall rate.
Below is a chart showing Spotify’s churn rate each quarter as reported in their Quarterly Shareholder Letters:
Its been steadily decreasing reaching a flatline Annualized Churn Rate of about 15.6% at the end of last year.
So let’s see how this compares to similar company. Below is the monthly chart for Netflix showing price increases and their effect.
This graph shows the three price increases for Netflix ($1, $2, and $1.50 respectively) and their impact on the churn rate afterwards.
Taking the average churn rate increase and then taking into account the dollar amount of the increase, it appears that a $1 increase in price results in a roughly 25% increase to the churn rate over the next quarter. As you can see, however, the effect pretty quickly subsides. This should give us a solid relative comp to estimate the impact of Spotify increasing prices and find the point where too steep a price increase hurts overall revenue due to lost customers.
The Math
First, we need to figure the Average Revenue Per Premium User. Luckily, this is a number Spotify gives us directly.
What they don’t give us, however, is how this number is broken down between Spotify’s four plans: Individual, Duo, Family, and Student, which all have different prices and number of users per plan.
To estimate the impact of a $1 increase to each of these plans on the ARPU number, I had to come up with a reasonable estimate for the breakdown of these plans. This is what I came up with:
Setting up our model so that each $1 increase in price increases our churn rate by 25% and then also factoring in that 70% of those users reportedly return by the next quarter, we are able to use the Solver function in Excel to find the price increase that maximizes Revenue through 2030. That number would be an increase of $3.10 or 31% versus current prices.
Since we want to keep the numbers round, we will say that a $3 increase is the optimal price increase. To minimize the effect on the consumer, we will also assume the price increases are broken up into three separate raises of $1 each over the next decade. This gives us the following predicted churn graph:
Increasing prices in such a manner will allows Spotify to capture the revenue growth potential from raising prices while minimizing the number of users who leave the platform as a result. Assuming that the price raises are uniform across each plan, each $1 increase in price will increase the Average Revenue per User by $0.49. At the end of the 3 increases we will have the following ARPU:
Factoring in ARPU increases, projected growth rates, and the effect of price increases on those growth rates allows us to make the the following forecast for Spotify’s revenue through 2030
Hopefully you can zoom in to read that but if not, our model is predicting 463 million Premium subscribers and $30.1B in revenue from Premium by 2030 which would be a CAGR of 17.8% and a 150% increase from current Premium revenue. This presents pretty significant upside for the company and its stock price.
Factor #2: Opportunity in Ad-Supported Business
There is a three-pronged approach to the opportunity Spotify is viewing in the Ad-Supported part of their business:
- Grow Users through Ad Supported Tier
- Improve Ad-Supported Margins
- Increase Time Spent on App (Through Podcasts & Audiobooks)
Grow Users
As I mentioned before, Spotify has been prioritizing growth at all costs but they are starting to hit peak saturation in some of their mature markets. Don’t believe me? Then look at this chart Spotify released themselves
Here in North America, and in Europe, Australia, and its home region of the Nordic countries Spotify has already begun to reach peak saturation and adoption so growth potential through new users is limited. However, there is still a massive opportunity to grow users in some of the emerging markets such as Asia, the Middle East, and Africa where not only is music streaming still in its infancy, Spotify itself doesn’t have much of a presence there.
Since users in these territories are much more price sensitive than in the established markets, the main way Spotify will try to onboard new users is through its ad-supported “free” plan with the hopes of later converting them to higher margin Premium customers.
The model expects a 19.6% CAGR for the Ad-Supported Business which will grow even faster than the Premium business resulting in 674 Million MAUs by 2030.
Improve Margins
From Spotify’s latest earnings report you can see they are operating at a healthy 25.2% gross margin overall, but the Ad-Supported margin is actually negative and has been for Q1 of three of the last four years.
Now a pessimist may say that’s bad because of the whole making money thing, but me, the eternal optimist, is here to say “What a huge opportunity for improvement!”. And improvement is not only a possibility but a likelihood. Here’s why.
First, you can see in the footnote that the profitability of the ad-supported music and podcast segments actually increased year over year which just happen to be the two most important things for the Ad-Supported segment. Podcasting boasts even higher margins than music so this should only continue to improve as more users start listening to their podcasts on Spotify.
What really hurt them is an increased Cost of Revenue which is from an increase in marketing and promotional expenses as well as paying for exclusive content. However, these are temporary expenses that play right into my first point about Spotify changing people’s habits now to reap the benefits in the long term. If you can convince people to stop using Apple Podcasts or some other service and start listening to the Joe Rogan experience on Spotify, then even after the exclusivity runs out they are likely to stay on the platform unless someone else pays to make that content exclusive on their platform. It also get people in the habit of opening Spotify more which in turn which should help the music business and audiobook business as well as people start to see Spotify as not only a music streaming platform, but a primary source of entertainment when they have some free time. I think this is overall a very good use of money by Spotify as it will set them up well in the long term.
Increase Time Spent on App
A major part of this thesis relies on Spotify’s ability to increase the time each user spends on the app, especially in the Ad-Supported plans, and become the major destination for audio entertainment.
According to a report by Business of Apps, the average daily usage time by each Spotify user in the US went from 124 minutes in 2020 to 140 minutes in 2021, good for a growth rate of 12.9%. Using a very conservative CAGR of 6.2% and projecting it out to 2030, we arrive at 240 minutes per day on the app in the US. This may sound like a lot but as Spotify continues to carve out more of the podcasting market and also adds more entertainment options such as audiobooks this should become a reality. Additionally, the average time spent watching TV in the US has been steadily declining as people tend to prefer entertainment option that allow them to multitask (listening to a podcast at work or an audiobook while cleaning) so the industry trends tend to agree with this prediction.
The average American reads less than one book per year, but that very well could be due to the fact that we have already shifted to an audiobook and podcast world for our information and Spotify is very aware of this and well-positioned to capitalize on this trend in the US and will likely see similar results in many other countries around the world.
Factor #3: Cost Structure Improvement
As discussed briefly earlier the Premium segment of the business operates at around a 28% gross margin but the Ad-Supported business loses money. While its pretty reasonable to assume the Ad-Supported business will start turning a profit as they lower their Cost of Revenue, I think there is still plenty of opportunity to increase gross margins in the Premium Business as well.
First, as Spotify is still the largest player in the music streaming market by a wide margin, they have a ton of bargaining power with labels to renegotiate royalty deals. Currently, 70% of revenue from streams goes to music rights holders (labels, producers, artists, etc) and Spotify only keeps 30%. This number scales with number of users and even with the potential price increases mentioned earlier. As a result, while price increases and more users can increase profits, they won’t really matter for margins with costs directly scaling. I believe that Spotify can renegotiate these terms in the future as labels now need Spotify more than Spotify needs them. In fact, I believe it is much more likely that Spotify could create its own label and block out the middle man in the near future than it is for labels to pull their music from Spotify. The latter would be incredibly damaging to all parties involved as it would cut out about 1/3 of all music streamers in the world with a much lesser effect on Spotify.
In the June 2022 earnings call, Spotify CEO Daniel Ek stated that by 2030 they plan on achieving a 40% gross and 20% operating margin in the overall business and project over 1 Billion monthly active users. For the base case, this MAU projection is actually inline with ours but we didn’t quite get to the 40/20 number instead getting to 32% and 12% (gross and operating respectively). Still, even with less than projected margins the model predicts Net Income of $1.9B in 2030 and $4.1B in 2031
If we were to plug in the 40% and 20% for the extreme bull case those profits balloon to $4.3B in 2030 and $8.4B in 2031.
Biggest Challenges
One of the largest challenges has always been and will continue to be competition in the space. People will say that music is a commodity, and that Spotify doesn’t have any significant moat. They say eventually competition will begin to eat into their market share, however, year after year Spotify continues to defy these critics. As more and more competitors such as YouTube Music or even Amazon enter the conversation, Spotify continues to hold its 30ish percent market share.
Here is a nice chart showing that these new players tend to cannibalize each other while Spotify remains largely unaffected.
In Q1 2023, Spotify just reported a MAU growth of 22% year over year which significantly outpaced the growth of the streaming industry and shows Spotify still is going to continue to dominate the market for the foreseeable future.
One legitimate worry that I have though is the potential for TikTok to enter the music and audio content game. They are the one player who I believe has both the attention from Gen Z and Milennial users as well as the proven algorithmic based recommendations to become a threat to Spotify in the future.
Another worry I have is that the Cost of Revenue just never comes down in a significant matter and that Spotify has to keep spending as they have been to retain this market share and attract new users and new content creators. If this happens, obviously the margin improvements which our valuation depend very heavily on would be inaccurate.
Conclusion
TOO MANY SPREADSHEETS AND WORDS. GIVE ME A PRICE TARGET DAMN IT!!!
Spotify has a tremendous opportunity in front of it to capitalize on potential price increases, ad-based listening through music and podcasts, and potential operating margin improvements.
The stock price has already been on a pretty solid tear since first beginning this research back in March, but I believe it still has a good amount of room to run in our Base Case valuation and in the Bull Case it can more than double.
- Bull Case — $336 per share (10% chance)
- Base Case — $158 per share (80% chance)
- Bear Case — $35 per share (10% chance)
Using a weighted average of all three scenarios and our projected likelihood gives a Price Target of $164 per share
Obligatory Disclaimer:
Please note that the views and opinions expressed herein are solely my own and do not constitute financial advice. They are provided for informational and discussion purposes only and should not be relied upon as a recommendation to buy or sell any particular security, commodity, or financial product. I am not a financial advisor. Investing in stocks, commodities, and other financial products involves a high degree of risk, and you should consult with a qualified professional before making any investment decisions. Always do your own research and consider your own risk tolerance and financial situation before making investment decisions.
