Description

The #1 hardware is worth $2Tn. The #1 search is worth $1Tn. The  #1 social media is worth $290bn. The #1 SVOD is worth $140bn and yet you can buy the #1 music asset for only $12 billion.

Pluto posted a good long write-up on SPOT back in March/2022 and although I could post our thoughts on his write-up, it would just be too long of a comment. So I decide to write a new LONG on SPOT, and also because SPOT is one of our highest conviction names. It is the type of position that if the stock price goes down, we would be significantly adding to. Unfortunately, we think Pluto’s timing was a bit too early (in hindsight we always do). The tech sell off was just getting started and the expected CRB ruling on the Phonorecords III appealed which ended up being ruled against the platforms this July 1^st, impacted the publishing rates and triggered the retroactive payments on higher rates all the way back to 2018 (which is largely why SPOT missed Q2/Q3 margins). However, we believe the setup is now quite favorable for a new investor. The Phonorecords III was a key headwind we were concerned before, because no one knew the true impact of these retroactive payments and now that overhang is out of the way, and the financial impact ended up being considerably smaller than we initially thought. Spotify is now at an inflection point, going from peak negative margins in 2022 driven by these short-term headwinds and a year of heavy Podcast investments, into a year where Podcast margins will start to aggressively inflect upwards and the acceleration of new product/feature adoption (i.e. Podcast, Audiobooks, Tickets), all while there is still a good amount of negative sentiment on the stock à Many investors still don’t believe Spotify has a viable business model that can turn a profit and that they are at the mercy of the major music labels. We think this view is egregiously wrong. This is the core of the bear thesis so we want to focus mostly on addressing this point, and I do hope to get pushback on this.

The key bear argument on SPOT – The Music Labels have all the leverage

The bear case on Spotify in one paragraph à “The issue with Spotify is that their record & publishing agreements are based on direct % split with right holders. That’s why they’re trying to get into advertising and podcasts.  I’m just not sure you get much operating leverage on the pure music streaming, if any.  And if you don’t get a couple hundred basis points of operating leverage, these guys don’t make any money (fcf) for a few more years.”

We think this bear view is simply wrong. Here are a few reasons why we think Spotify has more leverage than most people think:  

1. These are private agreements, so no one really knows the exact details. We don’t know if there are thresholds where the % split changes. However, even if we agree the split is fixed, those agreements usually have a 3 to 5 year time horizon before they go up for renewal. Who’s to say that Spotify has zero leverage asking for a few bps more over the next 5 years?
2. It's important to understand that the music labels don't only care for revenues. Data insights are just as important to them. If you are a record label, your business model is predicated on being constantly looking for the next up and coming artists and making sure you are looking in the right direction (genre, geography, etc). Spotify can provide the broadest and most granular amount of data for a record label to get those valuable insights. What are the genre trends, what are the changes in user's listening behavior, what are the undiscovered up and coming artists. The labels recognize the value of such data insights and are willing to give Spotify a few bps in exchange for ongoing access to those data insights, that Spotify is best positioned to provide.
3. Streaming is now 60% of the major label’s total revenues (from 30% in 2016) and Spotify is ~2/3 of that. Back in 2016, Spotify renewed much higher rates as they were preparing for the 2018 IPO (their gross margins gained 13pts from 2016 to 2018) and the labels allowed because they knew their revs would be growing DD despite lower % split, and they also had a stake on the company, so they wanted Spotify to have a sucessfull IPO. The labels ended up making the right move to give Spotify higher rates! Each of the label’s streaming revs weren’t impacted and they all grew DD, despite giving a signifcantly higher split to Spotify, and label's margins weren’t impacted either because those revenues have high incremental margins for them, as Spotify bears all the CAC cost. The last thing the labels want is to create friction with Spotify because they might be asking for ~1-5pts higher split to be cyclically implemented over the course of the next ~3-5 years.
4. Labels also have new revenue streams that didn’t existed before (royalties from short-videos from TikTok, Instagram Reels, Youtube Shorts, Snapchat etc). All these apps now have direct licensing royalty agreements with the major labels.
5. At the end of the day, the record labels want to protect their margins and keep growing revenues. As long as SPOT is delivering on that, everything else is very acceptable, especially coming from a company that can say “hey you have your +20% ebitda margins and we don’t".

Interesting case. The South Korean K-POP label Kakao had to settle a licensing dispute with Spotify in 2021. Of course, this is not one of the 3 majors (Sony, Warner or Universal), but we view as a clear sign of power shifting from label to platform. 

Let’s hypothetically imagine that one of the major labels decides to pull their catalog off Spotify over some renewal licensing dispute. Without a doubt, this would absolutely have an impact on Spotify! But honestly, ask yourself, who will this impact more? Spotify or the label who is now off the platform? This is how we see such hypothetical scenario taking place:  

1. The label would instantly lose 30-40% of their total revenues (~60% of their revs comes from streaming, and SPOT is ~2/3 of that).
2. The impact on the label’s bottom-line margin would be significantly higher, as these revenues have very high incremental margins.
3. All the 3 major labels are now publicly traded. Imagine the hit on their stock price.
4. What about backlash from their artists. It’s not even about royalty revenues that these artists would really care at first, but the marketing/visibility they get by being on Spotify. While some big artists may support the label's move, we think the vast majority of artists would be furious and threaten to leave the label immediately if they don't return to the platform.

In summary, the label would take a huge hit to their sales, to their profitability and their stock price and have the risk of losing a lot of clients. Meanwhile, Spotify impact wouldn’t really be felt so fast. Spotify can and would probably lose some MAU over this, as users could cancel their subscription and go to Apple Music or Amazon Music if they find out such catalogs are only available in competing platforms. However, there is an interesting overlook point here, which is that much of the listening and discovery within Spotify is done through their algorithmically curated playlists. During SPOT 2022 investor day it was disclosed that 1/3 of all new artist discoveries happen on curated-playlists. Goodwater Capital (an early investor) has shared publicly that 30% of the total listening time in Spotify comes from curated-playlists. Anecdotally, I’d agree with those stats based on my own personal use of the app. This overlooked user behavior makes the impact on Spotify on this hypothetical scenario even lower than most people would expect.

How they can Spotify drive higher margins?

• Renewing higher % rev split – We strongly believe Spotify will have no issues renewing their splits higher, in exchange of continue to improve their data insights they provide the labels with. Another driver is local/smaller independent labels have been growing as a % of the total global mix of artists (this is more significant on International markets). Those smaller labels have less bargaining power. As Spotify grows their mix of international users, and as international independent labels grow their global mix, that's an additional driver of higher gross margins for Spotify. We still think Premium subscription gross margin will be the key driver of incremental gross profit dollars. We estimate it will represent 70% of incremental gross profit by 2025. 
• Spotify Marketplace – besides data insights, Spotify allows the labels to spend money to promote key artists (add them to playlists, giving specific songs/artists more visibility within Spotify) which is just another driver to margins.
• Podcasting (ad-supported) – Launched in 2015, but only getting serious in 2019 and even more so in 2020 when they signed a $100m agreement to get Joe Rogan’s exclusively on the app, and the fact that Spotify has done a lot of strategic acquisitions in the space over the last 2 years, buying some tech players to vertically integrate their Podcasting segment. Those acquisitions weight on short-term margins. However, the strategic is more than working as they overtook Apple as the #1 largest podcast platform in 2021. SPOT disclosed -57% negative podcast gross margins in 2021 and said that 2022 would be the peak year in terms of podcast impact. The way to grow margins here is to grow advertising dollars faster than  investments. We think the bulk of investments has already been done (i.e. Spotify pays $100m to Joe Rogan for 11 years of exclusive content). I’m however, admittedly a bit skeptical of how many ads they can insert into each episode without disturbing the user’s experience, especially the Premium users who are paying a monthly subscription not to listen to ads, and that's why we estimate gross margins here below their targets. However, it seems like everyone is so far accepting ads being inserted into Podcast and it doesn’t seem to be impacting user’s experience as their MAU net adds had even accelerate in Q3 to 19.7% YoY vs 18.6% in Q2 and 18.5% in Q1, while the % of users listening to Podcast just keep on growing. We think podcast will be an imortant contributer to margins in 2023, but still in roughly -10% negative gross margins (vs -57% in 2021 and 2022) and only going to positive margins by 2024.
• Audiobooks – while Podcast seems to be the focus at the moment, we think Audiobooks provide one of the biggest upside to incremental margins. This is already a much larger TAM than podcast, and still growing DD. Spotify says it’s $9 billion TAM, while other sources says ~$5bn. If we take the lower end of $5bn and assume Asia is ~40%, leaving a $3bn current SAM for Spotify, and growing. Audible (owned by Amazon) is the clear #1. Amazon doesn’t give any information about Audible and sell side analysts don’t seem to care ($3bn too small for AMZN) but on Quora.com we can find some author’s feedback. They say Audible take anywhere between 50-90% of the top-line (depending on if it’s an independent author or thru a publisher) and the gross margins should be +80% as this is mostly tech infrastructure, and there isn’t really much operational costs. Spotify says Audiobooks will be +40% gross margins. Amazon’s Audible is a very simple app! We see Spotify gaining a lot of share since Spotify is already the #1 choice for Podcast, thus users are already accustomed to spending time listening to non-music content. Unfortunately, the current bottleneck is Apple’s App Store terms of use that doesn’t allow Spotify to even instruct the user to go outside the app (i.e. to the mobile browser or desktop) to purchase the audiobook. This is a major roadblock. Audible suffers the same issue but they have Amazon, the largest book store in the world with the option to purchase a digital audio format and be downloaded via the Audible app. We think that if this Apple bottleneck is removed or eased (i.e. allowing Spotify to at least instruct the user inside the app on “how to buy audiobooks”), we think Spotify will take significant share.  We see 2 scenarios that can playout. (1) Spotify can offer higher tier subscription options including credits for audiobooks or (2) Apple’s terms of use change and starts allowing Spotify to at least be able to tell its users “how to acquire credits”. If Today there is a $3bn SAM growing DD, where the vast majority goes to Audible, we think is not unreasonable to estimate that by 2025 this can be a $1bn+ business to Spotify with 40%+ gross margins. We think Audiobooks will only start to more significantly contribute to margins in 2024/2025.
• Tickets (not in our model) - We are not underwriting any contribution here. But I just want to highlight this is a very interesting new feature. If Spotify is our main go-to-music app and they know all my listening behavior, it makes total sense that at some point in the future, if they wish to get serious in the concernt ticketing business, they can become the largest music concernt ticket selling company. Music ticket sales is a $8.5bn market in the US (based on Statista). Live Nation is generating $2.1bn in tickets revenues this year. Currently, Spotify just started selling tickets (by adding a 3rd party modal to its own app). Mgmt haven't given much color on the economics, whether they are getting any commission and how much, but we think this can be significant revenue line in the future. Right now is not even easy to find within the app, so clearly the company is not prioritizing this atm. That's why we decided to leave this out of our forecasts, but we do think this can be upside to our numbers in 2024+.  

As a recap, here is mgmt targets for Gross Margins

The criticism on Spotify’s gross margin is not fair. We can see that they’ve been able to grow their margins every year. The company missed guided margins in Q2 due to some one-offs (i.e. they’ve stopped manufacturing the car device, affected Q2 margins by 109 bps), and in Q3 due to the Phonorecords III which was appealed by the platforms and was finally ruled against. Effectively moving publishing/songwriter rates from 10.5% to 15.1%, but that it was retroactive to 2018, so Spotify had to expense all the previous 9 Q’s into this Q3 (Spotify has been paying some of the higher rates already, that’s why they didn’t have to expense all the way back to 2018). Going forward, the Phonorecords IV has set the publishing rates from 2023 to 2027 growing only ~5-10bps per year. The overhang is now done and the new rates offer greater cost visibility going forward.

Publishing rates - Phonorecords III

New Publishing rates - Phonorecords IV

Spotify has a big product moat

Structurally, Spotify has a huge disadvantage against Apple, Amazon and Google. Apple controls the hardware and have an install base of ~200-300m people that loves their product (active users who own an iPhone or Macbook). Google stats is way crazier! Roughly 4.5bn people use Google every month. Amazon have ~150m prime users in the US alone and over 300m active customers worldwide. All these 3 companies have all the more reasons to beat Spotify (a lot more cash, more users with free CAC opportunity, stronger brand) and yet, Spotify continues to emerge as the victorious every single year. Even more impressively, Spotify can take share from them, as it’s been the case with Podcasts. Very few companies, if any can say they have “a product moat” against the largest and more profitable companies in the current world, despite these structural disadvantages.    

In fact, we think is truly amazing that Spotify despite being the largest music streaming app, can till generate more downloads than the competition in every geography.

These charts are a few months old  (data source: Sensor Tower)

North America App Downloads

International - LATAM 

International - Africa

International - Europe

International - Middle East

Becoming #1 Podcast App 

Apple's monopolystic behavior should come under more pressure in the future - will be positive for Spotify

Example of what the user see at an audiobook page within the mobile app. (How crazy is this? -- there is ZERO information on how to buy this audiobook, thanks to Apple's monopolistic terms)

Apple's 30% tax topic is definitely a lot more in the radar now compared to when Epic initiated their battle. We believe more companies will join forces in the years and regulators will have to do something. 

Just today 

https://open.spotify.com/episode/1FUh3nKX2QQIgKXZA9GxLD?si=kLVVxpfZQ0ebdWmNU8CSaQ&nd=1 

Elon Musk a few weeks ago

https://twitter.com/elonmusk/status/1597301968208556032?s=20&t=sybFZDn9ArwZEAvpge9V0w 

Valuation

At a high level, one way to think about valuation is that you are paying $28 for each Spotify MAU that generates ~$6.6 GP/User per year. That compares favorably with other major tech platforms. Only META trades at a cheaper valuation in this comparison. In our view, Spotify’s positioning in the music industry is significantly better than Pinterest and Snap in the social media industry.

SPOT is trading below 6x our 2025 ebitda target of $2.1 billion (vs cons $596m). We think consensus is way too low on the gross margin side for every year going forward. They are estimating 25.8% in 2023 and only 26.8% in 2024. SPOT already did 26.8% in 2021, a year where Podcast had -57% negative margins. Mgmt is saying Podcast is inflecting margins rapidly next year, and we think it should turn positive in 2024 (possibly earlier in 2H’23). The higher publishing renewals rates which was a headwind this year is pretty much done at this point. We would be surprised if SPOT doesn’t at least recovered their gross margins by 2023, and even surpassing their prior peak of 26.8%. We think they can do 27.5% next year. We aslso believe opex will surprise on the downside, especially on the S&M line, where mgmt. has said they have the most leverage. They’ve significantly increased S&M spending from $800m pre-covid to $1.5bn this year. We think they can cut at least $250m but potentially even more next year. However, bigger picture is looking out into 2024/2025, where we think incremental ebitda margins will accelerate with contribution from Audiobooks and Podcast turning profitable, and higher renewal rates with the major labels.

DCF also looks interesting

Full model

Catalyst

• opex coming in lower than expected
• beating consensus EBTIDA in FY23