Daniel Ek has built a great business with Spotify. Now that it has recently IPO-ed in 2018, is this digital music streaming service of his, invest-worthy?

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Introduction

I am sure that by now you would most likely have heard of Spotify before. But I am sure that not many of you know that Spotify was founded and first developed back in 2006 – about 12 years go in Stockholm, Sweden. Yes, the same country as to where Ikea was founded. The Spotify service was first launched on 7 October 2008 – about 2 years after it was founded. It was first launched for users in Europe and after some time, they slowly moved to the U.S.

The founder of Spotify is Daniel Ek who was also the former CTO of Stardoll. Based on Time, Daniel started his first business at just 13 years old. He started by building websites for $100 to $200. A year later, he raised the price to $5,000 a site. By the age of 18, he already had 25 employees and was bringing in about $50,000 per month. Daniel clearly showed entrepreneurial traits from an early age even way before he built Spotify.

About 10 years after Spotify was first launched, they already went for Initial Public Offering (IPO) to list on NYSE under the ticker symbol SPOT in 2018. As of today, Spotify has about 150 million active users with over 50 million subscribers who pay a monthly subscription for an ad-free listening experience.  Based on Digital Music News, Spotify is the world’s largest music streaming service – way more than Apple Music, Google Play Music and other companies such as Pandora. Based on Forbes, if we consider YouTube as a music streaming service, they are at the top of the streaming list with 1.5 billion users followed by NetEase at 400 million and SoundCloud at 175 million followed by Spotify at 170 million users. Spotify has come a long way since they first launched in 2008, but they still have big competitors all around. Today, a lot of people still uses YouTube to listen to songs and Apple Music is up and coming as well. So competition is stiff for Spotify.

The Business Model of Spotify

The official definition of Spotify on Spotify’s website is that they are a digital music, podcast, and video streaming service that gives us access to millions of songs and other content from artists all over the world. Through this definition, we know that there are a few key foci on the Spotify business model. The first is that they are fully digital. Second, they link artists from all over the world to users focusing on not just music – but podcast and video streaming as well.

Spotify embraces the freemium service model. That means that the basic functions of playing music in Spotify are totally free. The caveat is that the free version will have advertisements and there is a limit to how many songs we can skip. What are the advantages of Spotify Premium then? Based on their website, if we go premium, we will have no ads, be able to download music and listen to them anywhere. We also will have unlimited skips. So, for people who hate ads and like to skip songs, they will likely go for Premium.

Spotify business model is not complicated at all. Their basic service is free for anyone to use, this way anyone can try Spotify “risk-free”. I personally have been a user of their free service for a couple of years before I succumbed and switched my plan to the Premium.

I started the free plan a long time back. It is easy to join the free version because I was able to use my Facebook account to directly login to the Spotify free version. So I joined the free version and started listening to their music. The good thing about Spotify is that I am able to search for any songs – new or old – and they will most likely have it there. So that is good. But over time, I started to hear many good reviews from personal friends of mine that they like Spotify Premium. Over time, I got irritated by the ads and the inability for me to skip songs. So I explore Spotify Premium directly from the App. Surprisingly, I was unable to upgrade to Spotify Premium directly from the App then. So I had to go to Spotify’s website to upgrade to the Premium version. So I did just that.

Spotify has two kinds of Premium version of their service. The first one is individual premium version and it is upgradable for about $10 per month. The second one – the Premium Family version costs 50% more at $15 but it allows up to 5 family members to be able to have access to Spotify Premium. I upgraded to the second one because it is more value for money. Long story short, Spotify has successfully converted me from a user that pays $0 a month to pay $15 a month. And I have been using it for some time now, so far, so good, no regrets. This experience also shows me that Spotify has created a good freemium service model that is effective in my opinion of converting free users to premium ones.

Let’s dive deeper. The songs that we play inside Spotify does not come to Spotify for free. Spotify purchases the rights to stream songs from music labels, publishers, artists and other kinds of rights holders directly. This way, rights holders are able to stream their songs onto the Spotify platform digitally. It is reported by the Verge that Spotify uses a very complex algorithm to calculate the amount of royalty per stream to be paid to the rights holders. The Verge says that Spotify admitted the average payout “per stream” to rights holders land somewhere between $0.006 to $0.0084. This means that Spotify earns is the difference between the monthly subscribership that users pay to them and the payouts Spotify pay to these rights holders.

On top of making money through subscriptions, Spotify also makes money by using its algorithms to target listeners with audio ads. They have a couple of different kind of advertisements: display, sponsored sessions, audio, playlists, branded moments, video takeover and homepage takeovers. These ads are varied. More details about their revenue from advertisements can be found here under the heading “revenue from advertisements”. But of course, based on their latest Q3 2018 earnings result, it is evident that they still make almost 10 times more money from the premium members’ subscribership as compared to through ads. I believe showing ads is just a way for Spotify to also monetize the engagement from their free users. Spotify’s main focus is still converting these free users to paid ones – the Premium users.

Does Spotify Have a Competitive Advantage?

Source: Spotify

Often times, a technology company will have a network effect as a competitive advantage. But not with Spotify, I think that their network effect is limited.

Their competitive advantage here, in my opinion, is their economies of scale that comes from having a large user base. Spotify’s large user base (currently at 191 million users), gives them the ability to squeeze their “suppliers” which essentially are the right holders. By squeezing, I mean that Spotify is able to pay the right holders a relatively small sum of money. This allows them to charge their service low enough to the masses (because their cost is low) and propel Spotify to an even more mass adoption.

There is also a slight competitive advantage of stickiness. When a user uses Spotify, they would have created their many personal playlists over time. In the playlists, it contains their favorite songs based on their desires. And it is quite troublesome to search and create another playlist in another service – say Apple Music – if one has many playlists. This is important for the conversion of Spotify users from using the free version to premium one. The concept is that if the free users stick with Spotify long enough, eventually they might just upgrade to Premium. And they will stick with Spotify because they have their playlists with all their favorite songs already in there. An evidence of their stickiness is in the decline of their average monthly churn by 90 basis points based on their Q3 2018 results.

Rationally Assessing Spotify’s Stock Price

Although Spotify is already pretty established at the moment, their financials still looks like a high-growth company’s financials. Meaning that they are still pretty unstable. Based on their Q3 2018 earnings, their revenue is up 31% Y/Y to  €1,352 million and premium revenue is up 31% Y/Y to  €1,210 million. But their average revenue per user which is also known as “ARPU” is down 6% Y/Y. The decrease in ARPU is bad news because that means that they have a downward pressure in their selling price due to the expansion of the business.

Spotify is also a company that has just recently IPO-ed in 2018. And personally, I’d avoid IPO because they are usually overpriced and it will take many years for them to turn a profit consistently and reliably.

Source: YCharts

As you can see from the image above, Spotify started trading in the stock market somewhere in April 2018. And it went up for quite a bit until around August 2018 and as of now, it is trading lower than the price Spotify IPO-ed at. That’s why value investors rarely want to invest in IPO. They are mostly overpriced. The risk to reward ratio is not that good. And as you can see from the image above, I am right.

The reason is that when we assess Spotify stock price rationally, although there is a huge premium for a future potential growth of Spotify, established companies such as Facebook and Tencent still has more. The market capitalization of Spotify is currently $24.62bn – their price to sales ratio is about 4.21. Tencent’s price to sales is 8.09 while Facebook’s 8.18. About twice of Spotify. But there is a big reason for Facebook’s and Tencent’s price to sales ratio premium.

Source: YCharts

The main differentiation between Spotify and other more established companies such as Tencent and Facebook is that Spotify free cash flow generation ability is still sub-par. So as you can see, while Spotify price to sales ratio is half of Facebook’s and Tencent’s, their price to free cash flow ratio is more than 4 times of Facebook’s and more than 2 times of Tencent’s.

Conclusion

Spotify looks overpriced from the beginning. But they have a great service that has the ability to scale well. Their competitive advantage is both economies of scale and stickiness for existing users. The bigger the Spotify gets, the more bargaining power it will have over their rights holders and the more attractive they will be for users due to affordable subscription fees and variety of songs to pick from. But it is no easy feat to gain and scale to get more users in the future because there are other established competitors in the market that are also expanding such as Apple Music. But I think that generally, the churn for Spotify will be low because of their stickiness for existing users especially after they have customized playlists. So Spotify is a good business and I am a fan too. But to answer whether for me Spotify is currently invest-worthy? I’d have to wait further for more margin of safety.