Spotify's Big Data Spin

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Douglas Adams
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Summary

  • A legal remedy to big data continues to flummox regulators across the developed world.  In the meantime, revenue from digital advertising continues to swell Google's and Facebook's bottom line.
  • In the interim, Spotify is on the ground floor of explosive growth from the capture of just such data on a prime demographic group.
  • Spotify has the potential to top $175/share by the end of the year with its digital ad revenue exceeding $150 million over the same period.

Google (GOOG) (GOOGL) and Facebook (FB) both share the mantra of big data and derive an uber-share of their respective revenue through targeted, digital advertising. Amazon (AMZN) and Netflix (NFLX) also depend heavily on big data harvesting but are less dependent on advertising as a mainstay of total revenue. From that common thread spins an operating platform upon which each builds a rent-seeking colossus of unprecedented market breadth and scope. Google owns 62.7% of browser market share worldwide. Facebook owns 69.5% of the social media space. Amazon owns 49.1% of online sales. Netflix's user penetration of the US streaming market is an astounding 64.5%. Norway ranks second at 62% with Canada, Denmark, and Sweden at 56.3%, 54.9%, and 50.2%, respectively, making up the top five in a current global ranking. In 2005, there were an estimated 100 million people with paid TV accounts. That number is estimated to decline to about 95 million by 2020, providing a literal cornucopia of future growth for Netflix and wannabe Netflixs for years to come.

Advertisers simply salivate. Google advertising revenue came to $31 billion through the end of March, a 15% increase YOY. Advertising revenue comprised a full 85% of total revenue for the company during the period. Facebook advertising revenue is similarly outsized at $14.9 billion, an increase of 26% YOY through the end of March. Advertising comprised a whopping 99% of the company's total revenues for the period. While Amazon does not yet break out advertising revenue as a line item in its SEC filings, the company's "other" category lists $2.7 billion, primarily comprised of advertising sales in an accompanying footnote. Advertising sales through the end of March comprised about 5% of the quarter's total sales. That category grew 34% through the end of March YOY. To date, Netflix continues to list advertising as a marketing expense used primarily for promotional purposes.

The background provides a potent segue to Spotify (NYSE:SPOT), originally Stockholm-based, now decidedly international in reach. The company is registered in Luxembourg with operational offices in Stockholm. Regional offices span the globe - from New York to San Francisco and from Boston to Seattle to Washington DC. Internationally, Spotify leases office space in Australia, Hong Kong, 13 EU countries, and the United Arab Emirates. Spotify has over 12,000 servers distributed across four data centers located in Stockholm, London, Ashburn, Virginia, and San Jose. Its server network has the capacity of pushing more than 700,000 user events half the distance of the globe per second.

The company made its US market debut on 3 April of last year with a first-day closing price just over $147. Already the world's leading music streaming service, given its brief public life, SPOT put up an important milestone in its 1st quarter earnings report. The company broke through the 100 million paid subscription threshold for the quarter, up 32% YOY. Overall, the company claims 217 million subscribers, up 26% QOQ. Total subscriptions for the quarter just missed the midpoint of its 215-222 million 4th quarter projection. Apple (AAPL) Music does not disclose its subscription figures, but industry estimates put the company's total at about 50 million paid subscribers. Spotify's premium (paid) subscriptions continue to be its primary growth metric, comprising 92% of total revenue through the end of March. At €1.385 billion, subscriptions were up 34% YOY. Advertising revenue for the period came in at €126 million, up 24% YOY. The company's advertising revenue is now at 8% of total revenue. Given the market example of Google, Facebook, and Amazon, Spotify's advertising revenue clearly has the potential to grow geometrically moving forward. I see SPOT above $175/share by year's end. SPOT's advertising revenue should cross $150 million over the same period, up from $119 million through the end of March.

Last year was rough for SPOT. After its April market debut, SPOT soared to $196 (green line), outperforming Google (blue line) and largely kept neck-to-neck with a resurgent Facebook (purple line) through late July. All three positions outpaced the Nasdaq Composite (orange area). Facebook took a sharp market dive in late July as did Google, while SPOT continued to outpace the Nasdaq Composite through August before skidding below the benchmark for the remainder of the year. The backdraft whipsawed the company deep into bear territory, down just under 46% by Christmas week from its late July peak. By the end of the year, SPOT had managed to claw its way back by almost half, closing the year with a 23% deficit. By way of comparison, the Nasdaq Composite finished the year down just over 13%. Google finished the year down just over 5%, while Facebook, pummeled by negative news over much of year, finished down just over 25%.

Figure 1: Spotify Technology, Google, and Facebook against the Nasdaq Composite

https://c.stockcharts.com/c-sc/sc?s=SPOT&p=D&st=2018-01-01&i=t1310670102c&r=1560804014490

This year, Spotify has been blessed with better market fortune, up just over 33% through the last week in February before largely see-sawing sideways through the second week of May. The company shed just over 8% in the third week in May. While SPOT has bounced back just under 24% from the 23rd of May and within $2.00 of setting a high for the year, its share price is still down almost 23% from its July 2018 all-time high of $196/share. The Nasdaq Composite (orange area) is up just under 18% through today's (17 June) market close and up just under 7% from the first week in June (see Figure 1, above).

Global economic uncertainty is more likely to increase than recede in the months ahead. The Trump administration appears more than willing to both raise tariffs on $200 billion worth of Chinese imports and to expose an additional $300 billion of Chinese imports to a 25% tariffs regime by summer or early fall-upending international supply chains while impacting a substantially wider array of intermediate and final goods, further pressuring the cost of importing these goods into the US market. The US-China relationship is clearly barreling down an uncharted path, forcing a much wider breadth of companies large and small into a panicked scramble. Meanwhile, hundreds of US businesses are currently testifying in the US Trade Representative's open comment period on just how the administration's tariff plans will impact their businesses - not to mention the purchasing power of the US buying public. In the Middle East, there is a greater realization that the administration's efforts at applying maximum pressure on Iran to squeeze a better deal on the country's nuclear ambitions have instead pushed the two countries closer to direct military conflict that both sides insist they don't want. The probability of unintentional missteps by both countries pursuing their mutually exclusive interests run high in a narrow choke-point of waterway a mere 21 nautical miles in width, through which about a third of the world's oil traverses. Daily freight rates for oil supertankers are up as much as 50% with last week's attacks. The speed of unfolding events pressures thoughtful analysis lending credence to a repeat of the casus belli that led to the 2003 Iraq war. And, waiting it out in hopes of an electoral change of direction in January 2021, given the current state of Iran's economic slide may no longer be politically viable. Tensions are bound to rise as a result.

Defensive market plays like utilities and real estate investment trusts make increasing investment sense. After all, W. P. Carey (WPC) and Extra Space Storage (EXR) are up 34% and 24%, respectively, through today's (17 June) market close. Further, WPC carries a yield of 4.82%, while EXR's yield weighs in at 3.31%. Black Hills (BKH), a South Dakota-based diversified utility company recently reported strong 1st quarter results. The company is up the better part of 27% on the year and carries a 2.59% yield. Hannon Armstrong (HASI), a finance company that funds renewable energy projects, is up 36% on the year with a yield of 4.98%. Solid dividend yield, coupled with outsized appreciation - pretty strong bets, given the level of market uncertainty lurking on the horizon. Yet, for the brazen few, Spotify is an outsized bet on growth, and here is why.

The Spotify platform is quite unique when compared with, say, that of Facebook or Google. Spotify's platform is both emerging and more nuanced. The company's initial draw is the distribution of copyrighted music. About 85% of that content is licensed under agreements with Universal Music Group, Sony Music Entertainment, and Warner Music Group. The three both own shares in Spotify and collect royalties from the company for the content used in its streaming operations. The platform offers two distinct venues - a free, ad-supported venue, with about 117 million active users and a premium subscription (paid) venue with about 100 million users. By design, the ad-supported venue feeds the premium subscription. Currently, about 92% of the company's revenue is subscription-based.

Podcasts have recently added to the platform mix with the launch of Spotify for Podcasters in beta this past October. Since then, about 250,000 podcast files are now available on the platform.

To date, Spotify's advertising revenue is tiny, about $119 million, or 8% of $1.5 billion in total revenue through the end of March. While Spotify is nominally about streaming music and subscriptions, targeted advertising is a more explosive growth engine moving forward. With a projected growth factor of about 25% per annum, Spotify's advertising revenue could just about double to about $233 million in three years' time. Ad revenue will drive total revenues for years to come.

The company's mantra is to soundtrack a user's life - whatever the user is doing or feeling, Spotify has music to enhance that moment. User listening behaviors are then captured, sorted by musical genre, age, gender and location which is then turned into what the company calls taste profiles - compilations of favored artists, musical genres with attached affinity scores quantified by user demand. These taste profiles are then mapped against cultural, geographic particulars and prevailing musical styles, then compared and contrasted with other taste profiles generating similar listening patterns. Curated playlists come from this collective intelligence. The ease of delivering a user-focused musical offering for whatever taste, mood or occasion is limited largely by the imagination. In essence, these digital musical formats have become musical commodities that, unsurprisingly, are equally amenable to algorithmic manipulation - sets of data patterns that compare and categorize users across regions and national borders around the world. The result is what is called dynamic behavioral data, all of which produces highly desirable data for marketing purposes due precisely to its predictive value in the marketplace for the sale of goods and services. Spotify's business model is based on technology and ever-growing sophisticated informational exchanges with targeted advertising market makers. The headline lure of music becomes mere background by comparison.

Spotify's podcasts play, unlike its musical streaming model, is vertically integrated. Where Spotify's musical endeavor is at the mercy of licensing and royalty requirements, podcasts and their distribution are seen as the company's long-term profitability model. Owning its own podcast studios allows the company to avoid licensing fees and royalty payments so intimately involved with streaming copyrighted music content. In October 2018, the company launched its own Spotify for Podcasters in beta, a platform that brought into play the breadth of its big data reach, offering podcasters the demographic tools to tap diverse network audiences worldwide. By the end of the 1st quarter, about 20,000 podcast teams were up and running on the platform, a number that doubled over the six-month rollout period. More than 50,000 podcast offerings had been submitted for publication. More than 250,000 podcast titles are now listed on the Spotify platform. In February, Spotify paid about $340 million for New York-based podcast studios Gimlet Media and Ancor Media. In March, the company added the premier story-telling podcast studio Parcast, spending about $56 million in the shopping spree. Spotify projects spending another $500 million over the intermediate term, further augmenting its growing footprint in the podcast space.

Historically, Apple was the company of record in the podcast space. The Apple platform has no "free" venue segueing to a subscription-based format. Nor has Apple ever augmented its podcasts with targeted or any other form of advertisement. The absence of a free platform and the lack of advertising attached to its podcast segment allows Spotify relatively free rein in podcast advertising, opening up a potentially lucrative income stream in the process. Podcasting is all about finding an audience. While an uninspiring observation at first glance, technological reach and algorithmic patterning truly make the world a stage irrespective of how niche the production might be. Similarly, traditional TV advertising provides a broad medium for name recognition over a particular geographic footprint. Efficiency comes when marketers can target, for example, households with children under a certain age or people shopping for particular goods or services or even send different messaging to different households streaming the same podcast.

In 2019, worldwide digital ad spending will rise by 17.6% to $333.25 billion, accounting for about half of the global advertising market. That podcasting is ripe for algorithmic patterning which paves the way for sophisticated targeted advertising is certainly not lost on the company's forward margin projections.

What about the surge in privacy regulation around the world restricting the collection and use of consumer data? Last year, the European Union launched its own privacy rules bundled into the General Data Protection Regulation (GDPR) which places limits on just how much personal data companies can collect, store, and use for commercial purposes. Companies found violating the terms of GDPR face fines up to €20 million or 4% of their global revenue, whichever is higher. The early impact has been mixed. At the national level, regulators are still hashing out just how the regulation will be implemented with a unified standard across the EU still years in the future. The rules have had a curious impact thus far, making it harder for smaller, third party companies to collect coveted locational data critical for targeted advertising. Ironically, scale has benefited firms like Google and Facebook over European-based digital advertisers as they already possess the necessary relationships and data on consumers that actively use their platforms. Accordingly, Google and Facebook have gained market share in Europe with revenue increasing 20% and 40%, respectively, in 2018 YOY, effectively raising the bar for entry into the EU digital advertising space. Anecdotally, Europe's digital advertisement space increased by about 14% for the period.

Here in the US, California will launch its own Consumer Privacy Act (2018) that gives state residents the right to know what personal data companies operating in the state collect, store, and use and the ability to delete such information on request. The act goes live in 2020. New York and other states are also considering privacy laws.

Last month, the Justice Department announced it is exploring the possibility of opening a case against Google for potential antitrust - rather than privacy - violations, revisiting a 2013 Federal Trade Commission case that looked into how the company prioritizes internet searches. Yet traditional antitrust theory gravitates around the notion of harm rendered to consumers, in the form of rising prices for the goods and/or services under question. Google and Facebook offer their main services for free, which means regulatory angst toward big technology gravitates quickly toward theory rather than the financial. In his 1978 book The Antitrust Paradox, the legal theorist Robert Bork set forth his "consumer welfare standard" that has since been used widely by courts across the country, including the US Supreme Court. What matters is the impact of business practices on the consumer's wallet. Without demonstrating harm being done to the consumer, traditional antitrust cases fall flat.

A more recent antitrust tact comes from a panel discussion recently sponsored by the University of Chicago and a study commissioned by the UK government. Consumers pay for their Google searches or posts on Facebook not with cash, but by providing these hosts with information about their web behavior, age, gender, shopping habits and other personal data gleaned during the course of their zero-price internet excursions. That information is turned into digital profiles that are coveted by marketers for targeted advertising who in turn pay handsomely for such digital footprints. The consumer harm, then, comes not from financial considerations but from the consequence of the exchange between consumers and such free business models provided by digital platforms like Google and Facebook.

Regulators will have to focus narrowly on behavior that is readily identifiable and be presented to a court in such a way that is winnable. Easy to articulate, extremely difficult to assemble, making for a high legal bar to hurdle. Remedies must rectify the harm being done to consumers (the Bork standard) which must stem from anti-competitive behavior, rather than a single act - all without an untoward increase in compliance costs. The remedy could be far too costly - which gravitates toward doing nothing.

The last time Congress passed antitrust legislation was back in 1976. The government's case against IBM that started in 1969 at a time when the company dominated the mainframe business. The case was finally dropped in 1982. The case against AT&T (T) lasted a decade until the company was broken into seven baby bells. The government chased Microsoft (MSFT) for 12 years before a settlement was approved by an appeals court.

A legal and/or legislative remedy to the question of consumer privacy remains years in the future. Over the years, Spotify has assembled - and continues to assemble - a wealth of highly coveted data on an equally coveted age group with ever-expanding purchasing power. SPOT is a ground-floor market move until such time when regulators across the developed world come together with a viable remedy for the collection and dissemination of consumer data.

This article was written by

Douglas Adams profile picture
1.58K Followers
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.
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Disclosure: I am/we are long SPOT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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