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
Spotify is one of my conviction longs and will prove to be one of the most compelling growth stories of this decade. Driven by the company’s continued geographic expansion and increased market penetration, Spotify will grow top-line by 2-3x, establish itself as the dominant entertainment platform, materially expand gross-margins and continue to expand its reach and consumer/artist use-cases. The company is early in the global consumer adoption lifecycle and has not come close to monetizing the value of the media/entertainment platform it has created.
Additionally, I believe Ek & co. will continue to find opportunities to reinvest in the platform to expand the reach and scope of the platform. The company constantly experiments and innovates new ways to create value for all of its stakeholders: customers, artists/creators, and label partners. As a by-product of Spotify and Ek’s vision and relentless focus on improving the value of the platform to all stakeholders, shareholders stand to benefit greatly over the next decade. Understanding, Ek’s vision for audio and Spotify’s role in the market is key to grasping the scale of the company’s ambitions.
“Consumers spend roughly the same amount of time on video as they do on audio. Video is about a trillion dollar market. And the music and radio industry is worth around a hundred billion dollars. I always come back to the same question: Are our eyes really worth 10 times more than our ears? I firmly believe this is not the case. For example, people still spend over two hours a day listening to radio — and we want to bring that radio listening to Spotify, where we can deepen engagement and create value in new ways. With the world focused on trying to reduce screen time, it opens up a massive audio opportunity.
This opportunity starts with the next phase of growth in audio — podcasting” — Daniel Ek (Feb. 2019)
Overview of the Market & Monetization Opportunity:
Starting in 2001, driven by piracy and digital distribution, the music industry entered into a decade long decline. Consumption of music had not fundamentally changed but the experience of actually legally buying music was so much inferior to piracy that consumers opted for the latter. The emergence of streaming and Spotify was the industry’s saving grace. Streaming restored the industry to growth after its decade-long malaise — but the story of streaming, digital music consumption, and Spotify is just getting started.
Spotify currently has ~17% penetration of its addressable users (~1.8bn payment-enabled smartphones) and the long-term opportunity is ~3bn smartphones, which is its estimate for the number of smartphones that the company intends to launch into. Based on the current penetration and my expectations, the company can 2-3x its MAUs in ~5 years, conservatively.
By 2025, Spotify will have ~750mm MAUs, which would make it one of the largest consumer media platforms globally. This is where the story gets exciting and why it’s important to conceptualize the upside case of Spotify in terms of MAUs moving forward as opposed to focusing narrowly on Premium Subscribers. Spotify’s platform, content, and marketplace strategy have significantly matured since the company’s IPO. Initiatives in podcasting, original content, discovery, and the Marketplace have substantially improved the company’s monetization levers.
The monetization opportunity can be bucketed into three components:
Premium Subscriptions — well understood part of the business. Given the steadiness of the company’s freemium to paid conversion metrics, the key questions for this business line moving forward will be: (a) what is the long-term margins for the business? (b) what is the steady-state churn for the business?
Advertising — most underappreciated part of the business. Currently represents ~10% of the total company revenues but will be a key driver of the upside opportunity for the company’s financials
Marketplace — most nascent of the business model. The two-sided marketplace will allow consumers to Artists/Labels to use the Spotify platform to better understand their customers and advertise to customers
Summary of Revenue Pools for Each Monetization Component
Deeper dives into the business and upside opportunity continue below. The sections are ordered by my perception of how ‘underappreciated’ the opportunity is. But before going into the weeds, it’s always helpful to conceptualize the long-term upside opportunity — so extending the model a bit.
Advertising and the Podcast Opportunity
The opportunity for Spotify, streaming services, and podcasting to take share from terrestrial radio advertising represents a ~$28bn opportunity. Terrestrial radio advertising in the U.S. alone is a ~$13bn market. Between 2014 and 2020, streaming + podcasting’s “share of ear” grew by 11 percentage points from 13% to 24%. Naturally, the advertising dollars have followed. Spotify has invested aggressively in tooling, analytics, and acquisitions (i.e., Megaphone) to further unlock this market.
Given the current growth trajectory, streaming + podcast as % of total audio time should reach ~40% of total U.S. audio time by 2025. As the platform with the largest reach and really only real advertising player with scale, Spotify will capture ~75% of the incremental digital/podcast growth. This translates to ~$2bn of run-rate revenues in the United States. Global radio advertising will follow similar trends and represents an incremental ~$1.2bn. In aggregate, I believe there’s a short-term opportunity of ~$3bn of advertising dollars that Spotify is will capture.
How does podcasting fit into all this? Podcasting is strategically and financially valuable to Spotify in a few ways
Podcasting is not a variable cost for Spotify so as it increases ad-loads on podcasts through mid-roll, pre-roll, and dynamic insertions, those dollars fall directly to its bottom-line
For its owned/operated content, the fixed costs that it spends is amortized over >300mm users. More importantly, the owned and operated content allows the company to provide an inventory of high-quality ad slots to “jump-start” its advertising marketplace. This is evidenced by the company’s acquisition/production of pricey, but well known, podcasting content (The Ringer, Gimlet, The Obamas, and Joe Rogan)
The real moonshot-case is that Spotify’s scale platform/tools/scale unlocks incremental podcast (i.e., supply) and advertising spending by advertisers. Ben Thompson has written about the “Aggregation Play” in a much crisper fashion. The upside opportunity here is large when you consider how nascent the ecosystem is and how engaging podcasts are for listeners compared to other forms of advertising (see: In Practice’s thread for some insights)
Additional upside opportunities in advertising:
National Advertising: Historically, radio ad spend has been ‘local’ dominated market (~90% of the radio ad spend is local). The lack of scaled distribution in the radio station market meant national/brand awareness advertising was fairly challenging to allocate towards radio advertising. However, given Spotify’s reach and scalable platform, I expect that Spotify will be able to meaningfully expand this market. The company signed a $20mm advertising deal with Omnicom in Summer 2020, which is likely an opening salvo for the brand/agency advertising market
Video Advertising: Spotify rolled out “vodcasts” or video podcasts in H1 2020 and announced that as part of its deal with Joe Rogan, the JRE will exclusively do their video podcasts on Spotify. Video CPMs are typically 3-6x their audio peers so as the company drives vodcast usage/penetration, there should be a substantial step-up in the advertising spend
While the “Two-sided Marketplace” is a very nascent business it will be strategically key long-term and a source of “power” over the labels in future negotiations.
Historically, labels served as the key distribution channel for artists to get onto “the scene” and launch new music. But in the digital/smartphone/social age, that service in many ways is becoming less and less relevant. Fundamentally, the best place for artists/creators to engage, market to, and find new fans is to go to where the fans are listening to or discovering music. Right now that is a combination of Spotify, YouTube, and TikTok. Spotify has exhibited its influence at a massive scale, its curated playlists are “hit-makers” and have the power to vault unknowns into stardom.
“XO Tour Llif3” also made history on the May 6 Billboard Hot 100 as one of five hip-hop songs in the top 10, only the second time that Billboard’s preeminent chart featured five rap songs. Strikingly, these songs were getting little to no airplay on the nation’s hit-driven radio stations, traditionally, along with sales, the most powerful factor in determining a song’s Hot 100 placement. “Let’s be honest,” says a top major-label executive: “No cool kid is listening to top 40 radio.” Instead, those kids are glued to streaming services.
Spotify, which launched in the U.S. in 2011, may be the most effective and efficient new platform to promote and monetize recorded music since the advent of MTV in the early 1980s…
“RapCaviar reminds me of Hot 97 in the early ’90s,” says Joie Manda, executive VP at Interscope Geffen A&M Records, referring to the powerful NYC radio station. “When Hot 97 played ‘Protect Ya Neck’ by the Wu-Tang Clan, that was it. It went all over the country. RapCaviar has that influence right now. A song goes in RapCaviar and everyone pays attention. And lucky for us, Tuma’s an expert. He knows what kids want.” — Vuture (2017)
Spotify and its digital peers have usurped the “we can provide you reach” component of the labels’ pitch to artists and have fundamentally democratized the music industry. Spotify’s two-sided marketplace is a way to monetize this platform and reach the same way that Google did when it added paid search at the top of search results.
Through Marketplace and “sponsored recommendations”, Spotify sells artists/creators/labels the opportunity to advertise to fans. We’ve all seen these:
The CPMs for these ads are likely not going to move the needle for Spotify in the near-term but what is going to move the needle is the company’s ability to leverage this “shelf-space” for improved economics on streaming royalties in the future. Here’s what Spotify said about the ‘Sponsored Recommendations’
To ensure the tool is accessible to artists at any stage of their careers, it won’t require any upfront budget. Instead, labels or rights holders agree to be paid a promotional recording royalty rate for streams in personalized listening sessions where we provided this service. If the songs resonate with listeners, we’ll keep trying them in similar sessions - Spotify (11/02/2020)
It’s unlikely that Spotify is going to stop at ‘Sponsored Recommendations’. Over the years, Spotify has aggressively experimented and innovated new ways to allow users to discover music on its platform. Through this process, the company has basically expanded the surface area on which sponsorships can be placed.
Spotify’s influence and reach are only going to grow over the next decade as it expands globally, adds ways to engage and its competitors get marginalized out of the ecosystem. The net impact of this is that Spotify will capture some incremental value in the form of improved gross margins / reduced royalties to labels.
The story here is fairly well understood with the key questions really being:
What does the long-term gross margin profile look like for the business? For premium customers, Spotify is currently paying out ~30% of revenues in royalties. There are near-term and long-term drivers of that going down:
Near-Term: Driven by both secular listening trends and Spotify’s curation/content push, podcast listening as a % of the premium user’s time grows over the next few years. Given the fixed cost/free nature of the podcast content, the cost per the premium user listening hour will decline
Long-Term: Spotify’s power and influence in the music industry will grow overtime (see: Marketplace Discussion), which will provide it leverage in label negotiations. Additionally, the quantum of Spotify’s payouts to labels and its contribution to the labels’ revenue will also grow over time — this in of itself will provide Spotify significant negotiating leverage. An impasse between Spotify and Warner Media Group in ~5-7 years from now, will have a more detrimental impact on WMG’s stock/investor psyche than on Spotify’s
We still are pretty optimistic that, that target [30-35% Gross Margin] is a good target to have.
We think the growth of podcast and having podcast content and some fixed cost content around podcasting will be important for us. Growth in Marketplace is another area. A third area will be continued growth in advertising and bringing the advertising gross margins up to levels that are equal to our premium gross margin over time…
We have a partnership with the labels and we'll see how that evolves over time…I would say, I think there will be -- like anything else, there's been an evolution over the last 10 years. There'll be another evolution on how that relationship goes. I think there's a partnership there that will work for both parties that could potentially help both of our businesses going forward. So that will be a component of it — Paul Vogel (March 2020)
Finally, based on the consumer’s historical willingness to pay, Spotify has latent pricing power and when the company decides to flex that pricing power, it will massively accretive to the bottom-line. The company has experimented with price increases in its more developed markets and has seen little no impact on churn.
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)
Given the complexity of the streaming market, the price increase story will likely be a long-term driver of the gross-margin story. Additionally, it is preferable for the company’s long-term strategic goals to unambiguously dominate consumer reach and music distribution before deciding to optimize pricing.
Premium churn has materially improved over the last few years. The effective churn of the company is ~30% lower since ~70% of the customers that churn return within 3 months.
It is important to keep in mind that 1/3 of the company’s churn is driven by payment failure. As the payments infrastructure in the markets Spotify operates in mature, the churn number should materially improve. Based on these metrics, I expect that long-term churn will likely be ~2%, which is fairly in-line with estimates for Netflix. Additionally, as the company grows the advertising side of the business, the impact/pain of a customer churning into the free-tier will be less meaningful.
Spotify is one of the most underappreciated internet/consumer growth stories of the next decade. The company has a clear runway to 2-3x its revenue in five years and become a once-in-generation media platform.
Spotify and Ek are just getting started.
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Deep-dive into the unit economics/long-term margins for Spotify