Atomic Units: The Story of Spotify's Long Term Margin and Economic Opportunity

Disclaimer: This newsletter is for informational purposes only — its just a place where I share my analysis and thoughts on interesting companies. This is not a recommendation to buy or sell securities discussed. Please do your own research before investing your

This is a follow up to my initial write-up on Spotify, which you can read here: Spotify's Opportunity in Advertising, Podcasting, and Marketplace

In my last article, I discussed why the opportunity for Spotify’s top-line growth opportunity is very underappreciated. This post discusses why based on the company’s atomic unit economics, the long-term margin opportunity (ergo economic returns) is equally, if not more, misunderstood. The company has a made bold and strategic bet on podcasting and spoken-word content that will not only improve the margin profile but will also expand the company’s negotiating leverage and economic moat in the music industry.

Gross Margins

Spotify’s long-term success and outcome of the equity story in many ways begins and ends with how the company’s gross margins will evolve over time. At the time of IPO, the company guided to long-term Gross Margins of 30-35%. Most analysts’ ink is spilt on Spotify’s relationship with the labels and how this will impact their ability to hit those long-term gross margin targets. However, not only is Spotify’s ability to hit the gross margin target not contingent on the company’s ability to hit the 30-35% target, but there’s room for significant upside as the company expands its podcast/fixed content strategy and flexes its pricing power over time.

To understand the margin opportunity we have to understand Spotify’s atomic units: minutes spent listening to music vs. podcast and the cost associated with each of those atomic minutes. Given the zero-marginal cost nature of the podcast content for Spotify, the transition of listening on the platform towards non-music content will be massively accretive to the company’s gross margins.

“It's still early days. Obviously, that's the thesis we're trying to prove out. You mentioned Amy Schumer and we have Joe Budden. And obviously, we signed with the Obamas in Higher Grounds, which is exciting, and most recently, The Ringer. So we have some stuff on there that is unique and it should prove out.

When you start to build up a fixed cost base, the economics is going to be different, right? So there's going to be a cost upfront, and we've talked about this, the potential for cost to increase on the fixed cost side as we build out the podcasting business, and that's likely to occur. And it could actually be a short-term drag on margins, short to immediate term, to be honest with you. And over the long term, you add more fixed-price content into the mix, you expect that the long term, that actually benefits your business a lot. And we've been very open at talking about this” — Paul Vogel (Sept. 2019)

The company’s long-term goal is to drive “spoken-word” content to ~20% of listening on the platform. It’s important to note that Spotify has ambitions beyond podcasts (i.e., audiobooks and meditation) but those bets are far more nascent than podcasting.

“Today, audio is only 1/10 of the size of the video market, so there is a massive opportunity for audio to evolve into more personalized, more immersive experience, much like how the video industry has evolved. We believe that, over time, more than 20% of all listening on Spotify will be non-music content, and we strongly believe that this opportunity in audio starts with podcasting” — Ek (Q4 2018)

Based on the company’s disclosures, industry data, and current trends we can build a simple model to understand the gross margin trajectory over time excluding the impact of price increases and label negotiations.

The forecast of podcast penetration is driven by a few but key assumptions: podcast’s share of the ear of on Spotify’s platform converges to current radio usage (Figure 1 in Appendix) and RoW platform usage converges to U.S./Europe usage. Additionally, the sense check here is that the forecast converges to management’s long-term platform usage target of 20% spoken-word. The key takeaway is that if the company can achieve its goal of ~20% of the platform’s usage going towards non-music content, the path is >40% gross margins is squarely within the company’s reach.

From a product perspective, keep in mind that because of Spotify’s “algotorial” ability, data, and recommendation engine, the company can effectively drive usage to that “20% spoken-word” KPI through its curation and use of its digital shelf-space. Additionally, the strategic aspect of driving spoken-word usage on the platform is that Spotify’s reliance on the labels for content decreases overtime at the same time that Spotify’s importance to the labels increases.

Spotify’s Latent Pricing Power

The second part of the upside case is the company’s latent pricing power, which I discussed in my last post. How material is the pricing opportunity? Take a look at the global music industry’s revenue per capita spending over the last 20 years.

Unadjusted for inflation, per capita spending has fallen >36% over the last 20 years even though consumer purchasing power has increased substantially and music consumption has actually gone up over this period of time. Consumers are spending more than ever on content/entertainment as evidenced by the fact that during the same period of time, per capita spending on video and gaming content has increased multiples of 2000 levels. Spotify obviously recognizes this and has indicated they’re a strong place to increase prices.

If engagement and/or our listener value per hour is high, it gives us the ability to selectively increase our price.

So here's how I think about it. While our primary focus remains user growth based on our maturity in certain markets and the increasing value we provide to our subscribers, including, of course, enhanced content, we've seen engagement, and more specifically, value per hour grow substantially over these past few years. And I believe an increase in value per hour is the most reliable signal we have in determining when we're able to use price as a lever to grow our business.

And while it's still early, initial results indicate that in the markets where we tested increasing prices, our users believe that Spotify remains an exceptional value, and they have shown a willingness to pay more for our service.

So as a result, you'll see us further expand price increases, especially in places where we're well positioned against the competition and our value per hour is high” — Daniel Ek (Q3 2020)

If Spotify is able to help the industry return consumption patterns to 2000 levels, the company’s gross margin will be in excess of >50% as I expect they will capture a disproportionate share of the incremental dollars.

Summary of the Gross Margin Opportunity


Figure 1 — Share of Ear Trends:

Atomic Units Model Assumptions:

  1. Revenue per Month per MAU: Implied based on Q3 2020 figures and MAUs. A recovery to 2000 levels, would result in ARPU for Premium of MAUs of ~€6.55. Given the value that Spotify is creating to drive the price increases, I expect them to capture a disproportionate % of the incremental ~€2.40, which drives the step-up from ~40% Gross Margin to ~50% Gross Margins

  2. Percent of MAUs Listening to Podcasts: Disclosed by management on a quarterly basis and using industry estimates ~3% annual growth in podcast penetration, we can forecast that by 2030 ~48% of MAUs will be listening to podcasts

  3. Penetration growth estimates based on Magna estimates for podcast listener growth and extrapolation of current “share of ear” gains made by podcast/spoken-word content