Spotify: The Future Is Content Creation

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About: Spotify Technology S.A. (SPOT)
by: Richard Durant
Summary

Spotify has struggled to achieve profitability due to the poor economics inherent in the music streaming business model.

I believe Spotify is on a path to becoming the dominant audio streaming platform globally, but scale will provide limited improvements in profitability.

Spotify’s foray into podcasts has the potential to lower costs, increase user loyalty and increase Spotify’s pricing power with suppliers and users.

Spotify’s (SPOT) current share price assumes that profitability will be limited as a result of an extremely concentrated supplier group. I believe Spotify can increase operating leverage and user loyalty by integrating backward through the industry value chain. This will be a difficult transition to manage without alienating record labels but if successful will greatly increase the value of Spotify.

Industry

In a simplified form the pre-internet music industry value chain can be broken into content creation, content discovery and promotion, content distribution and consumption. Record labels were able to capture much of the industry’s value as they performed the essential functions of discovering quality artists and took the risk of financing the production and promotion of content. For many artists revenue would not cover costs but a handful of hit artists would more than compensate for this.

Figure 1: Pre-Internet Music Industry Value Chain

(source: Created by author)

In the internet era consumers became dissatisfied with the music industry as there was a lack of convenience and flexibility in how content was accessed. This led to consumers illegally streaming music, not so much because it was free but because it provided a virtually unlimited amount of content on demand and unbundled. Ultimately, I believe streaming is the best model for consumers and the industry as bundling content can increase revenue for the industry and surplus for consumers. I believe there is also consumer reluctance to purchase digital goods as they are not receiving anything tangible and there is no benefit to owning the good. In this scenario paying for use of the digital good through a service business model makes sense and I believe this is driving x-as-a-service business models.

The internet has changed dynamics in the music industry as record labels no longer have a monopoly on content discovery and the costs of content production and promotion have declined considerably. The digital era music industry value chain remains remarkably similar to the pre-internet value chain though due to record labels having control of back catalogues and relationships with musicians. Record labels have artificially maintained a position in distribution through their ownership of content rights but besides performing some content discovery and financing production, now add little value to the industry.

Figure 2: Digital Era Music Industry Value Chain

(source: Created by author)

Digital distribution has changed the dynamics of all media value chains and where profits accrue. In some industries this has resulted in dramatic changes in market power, like News, and in other industries change is accelerating, like TV and movies. This shift has been slow to occur in the music industry as it is extremely concentrated and a souring of the relationship with even one major label would effectively sound the death knell for a streaming service. This has led to streaming services avoiding direct relationships with musicians and being forced into royalty deals which are virtually impossible to profit from.

Figure 3: Global Music Revenue Share for Major and Independent Labels

(source: digitalmusicnews)

Despite driving a seismic shift in how music is accessed and consumed and single handedly rejuvenating the industry, streaming services have no market power. Figure 4: Global Recorded Music Industry Revenue

(source: musicbusinessworldwide)

I believe a change in the music industry is beginning as the value creating functions of record labels have largely been replaced by streaming services and streaming services are reaching a size where they can begin to wield market power. Record labels will continue to play an important part due to their ownership of content rights and relationships with musicians but going forward I believe new artists will increasingly work directly with streaming services to monetize their content. For most artists this will lead to streaming services capturing much of the value as they will have limited bargaining power, but for extremely popular artists with differentiated content there will be a large opportunity.

Figure 5: Potential Music and Podcast Industry Value Chains After Backward Integration by Streaming Services

(source: Created by author)

Musicians are in many ways in the same situation as newspapers, low content creation costs and zero marginal distribution costs have led to an oversupply of commoditized content and producers of this content should not expect to profit. Value will accrue to those who drive discovery and promotion of content, such as Facebook (FB) and Google (GOOG) in news and increasingly streaming services in music. Creators of differentiated content, such as The New York Times (NYT), HBO and Taylor Swift are not reliant on content discovery and promotion and hence will continue to capture large amounts of value. This is evident in Spotify's streaming data where streaming numbers follow a power law distribution and a handful of songs receive the vast majority of attention. Streaming services play an extremely important function in promoting content from the long tail through curation.

Figure 6: Streams per Week for Spotify's 200 Most Popular Songs

(source: Spotify)

The value of content discovery relative to publishing in the internet era is exemplified by the complaints of European newpapers against Google.

German publishers were taking Google to court to demand compensation for article snippets that appeared on Google News. Instead Google simply removed the snippets, which resulted in such a drop in traffic that the publishers this week came crawling back asking Google to re-add the snippets, no compensation required. The general takeaway is that Google proved it was adding value to the publishers, but I have a different angle: the publisher’s demonstrated that they provide no value to their writers.

source: Stratechery

I believe a similar dynamic will play out between streaming services and record labels and while I don’t believe streaming services are quite at the point yet where their control of the customer relationship and content discovery allows them to make or break an artist, this will not be the case indefinitely. As consumers increasingly get their music online, content discovery through traditional channels like radio will decline, eroding the little remaining value record labels provide.

This shift in the industry value chain will be aided by streaming services integrating back into content creation through podcasts, which has the potential to create differentiation amongst services and increase user loyalty. Although podcasts have existed for a long time the industry is still nascent due to a lack of financial resources, distribution infrastructure and pathways to monetization. Streaming services have the ability to alleviate these problems by providing a user-friendly platform to create and distribute content to a large audience. Content discovery has also historically been a problem for podcasts which can easily be solved by large streaming services.

A large audience on a centralized platform is crucial to monetizing through advertising and is one of the main reasons podcasting has yet to attract significant advertising dollars relative to its rising popularity. To give context, podcast advertising revenues in 2013 were $45 million compared to $40.2 billion for the radio ad sales market.

Figure 7: Podcasting Advertising Revenue

(source: consulting)

In the long run I believe streaming services with music and podcasts will replace radio in the same way video on demand is replacing television. Streaming allows wider distribution and temporal flexibility that radio does not, making it a superior option. While about 26% of Americans listen to podcasts monthly, radio still reaches about 92% of Americans every week, meaning podcasts still have a lot of room to grow. The proliferation of voice devices, wider availability of podcasts on streaming services and natively integrated podcast applications in cars are likely to drive growth in coming years.

Spotify

Spotify is rapidly cementing its position as the dominant audio streaming service globally and although it is yet to achieve consistent profitability, I believe it has a bright future. Unlike most software or online businesses, Spotify has high marginal costs driven by royalty payments which have prevented it from achieving profitability as it has scaled. Spotify’s traditional focus on operational excellence and efficient customer acquisition has put it on a path to low but positive profitability which is ultimately capped by market structure.

Spotify is in the process of renegotiating its contracts with record labels which will impact profitability. At this stage it is unclear whether the terms of the new agreement will be better or worse, although a Guggenheim analyst believes costs as a percentage of revenue could be lowered by 2%.

Figure 8: Spotify Gross Profit Margin

(source: Created by author using data from Spotify)

Spotify’s ability to increase average revenue per user (ARPU) appears limited as the ARPU for premium and ad supported users has been flat in recent periods, as has the percentage of users who are premium subscribers.

Figure 9: Spotify Average Revenue Per User

(source: Created by author using data from Spotify)

Figure 10: Spotify Premium Subscribers as a Percentage of Total Users

(source: Created by author using data from Spotify)

Spotify’s ARPU is lower for both subscribers and advertising supported users than comparable platforms, which I believe gives them some scope to increase ARPU. But given the limitations of an audio streaming platform I do not believe subscription ARPU will approach the level of Netflix (NFLX) or ad supported ARPU will approach the level of Twitter (TWTR) and Facebook.

Platform

ARPU (NYSEARCA:USD)

Facebook

25.0

Twitter

9.5

Snapchat (SNAP)

7.6

Netflix

124.6

Spotify Premium

61.2

Spotify Ad Supported

5.9

Table 1: Platform ARPU

(source: Created by author using data from company reports)

Spotify’s recent strategic moves have the potential to change the music industry’s structure and allow a step change in profitability. This strategy is hinted at in Spotify’s prospectus where they discuss their two-sided marketplace and improving the experience for users and artists.

We continue to invest heavily in developing our two-sided marketplace with new and better product features and functionality for users and creators and believe our investments are leading to higher user engagement and enjoyment. We provide personalization that drives a unique and tailored experience to each user and the tools for artists to reach the widest fan base.

source: Spotify

Podcasts

Spotify’s expansion into podcasting is being enabled by the recent acquisitions of Gimlet and Anchor.

That’s why we announced today the strategic acquisitions of two podcasting companies, Gimlet and Anchor. These companies serve two different, distinct roles in the industry. Gimlet is one of the best content creators in the world, with unique, celebrated podcast shows like Homecoming, which was recently adapted into a critically acclaimed show on Amazon Prime, and the internet culture hit Reply All. And Anchor has completely reimagined the path to audio creation, enabling creation for the next generation of podcasters worldwide — 15 billion hours of content on the platform during Q4. These companies are best-in-class and together we will offer differentiated and original content. Gimlet and Anchor will position us to become the leading platform for podcast creators around the world and the leading producer of podcasts.

source: Spotify

Spotify acquired Gimlet Media for $200 million, a rich valuation given the lack of revenue from the podcasting industry, but it is indicative of the strategic value Spotify is placing on the segment. Gimlet is one of the leading players in premium podcasts and gives Spotify a strong foothold in content creation. Anchor is a service for easily making and distributing podcasts, with a nascent advertising service for monetization that claims to be powering around 40% of new podcasts. Anchor provides Spotify access to a large supply of low-cost content; users record, edit and host content, all Spotify has to do is index it.

Podcasts should significantly lower Spotify’s marginal costs over time, as content ownership through Gimlet will create operating leverage and users creating content through Anchor will have low bargaining power. Spotify’s CEO believes that based on radio industry data, more than 20% of all Spotify listening will be non-music content, which I believe could result in a 5-10% improvement in gross profit margin. Owning content also creates the potential for monetization through other avenues, such as licensing and merchandise.

Podcasts are not just a way to reduce costs though, they have the potential to create an ecosystem where content creators are dependent on Spotify for the viability of their business and user loyalty is increased through access to differentiated exclusive content.

Just as we’ve done with music, our work in podcasting will focus intensively on the curation and customization that users have come to expect from Spotify. We will offer better discovery, data, and monetization to creators. These acquisitions will meaningfully accelerate our path to becoming the world’s leading audio platform, give users around the world access to the best podcast content, and improve the quality of our listening experience while enhancing the Spotify brand.

source: Spotify

By building direct relationships with artists (both musicians and podcasters) and providing them with tools to succeed they are empowering small artists. Although I don’t expect Spotify to attempt to monetize access to these tools, I do believe it will be a source of differentiation which will enable them to attract and retain content at a relatively low cost.

Competitors

Spotify has established itself has the dominant global streaming platform and I do not believe it has any genuine competitors. Other players in the music streaming market are only an important consideration in so far as they provide alternative distribution platforms for record labels, thereby limiting Spotify’s bargaining power.

Figure 11: Music Streaming Subscriber Market Share

(source: Created by author using data from musicindustryblog)

Figure 12: Music Streaming Service User Numbers

(source: Created by author using data from company reports)

Apple (AAPL) and Amazon (AMZN) appear to be the biggest competitors to Spotify but given Apple’s user base is limited to Apple product owners and Amazon primarily uses music streaming as a tool to increase the attractiveness of their Prime subscription I do not believe either are a major threat globally. Spotify's lead in music streaming is clear from net promoter score data which shows users clearly prefer the Spotify platform.

Figure 13: Music Streaming Service Net Promoter Scores

(source: businessofapps)

Spotify is currently suing Apple for what it views as anti-competitive behavior regarding commission in the app store, although I do not believe the outcome is material to Spotify's future. Apparently, Apple does not see the irony of accusing Spotify of profiting off the work of others while taking a 30% cut of Spotify’s revenue.

Spotify’s aim is to make more money off others’ work. And it’s not just the App Store that they’re trying to squeeze — it’s also artists, musicians and songwriters.

source: Apple

It appears as though Spotify has little to gain financially from the lawsuit as Apple claims they only receive a 15% commission on 0.5% of Spotify’s subscribers. I believe Spotify can benefit from being given equal treatment to Apple Music in the app store though.

Every monopolist will suggest they have done nothing wrong and will argue that they have the best interests of competitors and consumers at heart. In that way, Apple’s response to our complaint before the European Commission is not new and is entirely in line with our expectations.

We filed our complaint because Apple’s actions hurt competition and consumers, and are in clear violation of the law. This is evident in Apple’s belief that Spotify’s users on iOS are Apple customers and not Spotify customers, which goes to the very heart of the issue with Apple.

source: Gizmodo

Valuation

Although I believe there are structural changes occurring in the music industry which will allow Spotify to become more profitable, I do not expect these changes to become apparent in Spotify’s financial performance in the short-term. Over time though I believe Spotify will continue to gain more favorable deals with record labels, increase pricing power with consumers through differentiation and lower costs through podcasts, which will drive improvements in profit margins. It appears markets are yet to recognize the significance of Spotify’s strategy and as a result I believe Spotify is significantly undervalued. Based on a discounted cash flow model I believe Spotify’s intrinsic value is approximately $190 per share, assuming they continue to add users and successfully execute their podcast strategy. Continued negative sentiment regarding Spotify's prospects presents a buying oppportunity for investors willing to bear short term volatility for longer term gains.

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.