Spotify, all for music

Spotify (“No Moat”), a company based in Stockholm, is one of the largest music streaming service providers in the world, with a total of over 150 million listeners.

The company monetizes its users through a paid subscription (premium service) model, and an ad-based model.

Revenue from premium and ad-based services accounted for 90% and 10% of Spotify’s total revenue in 2017, respectively.

Streaming in the music center

We anticipate the rapidly expanding digital streaming space to become the leading distribution platform of choice in the ever-changing music industry.

Spotify can take advantage of various network effects that will help the company grow its user base and accumulate valuable intangible assets related to user data and listening preferences.

However, companies face stiff competition and have (mostly) variable cost structures that can limit operating leverage and future profitability.

We are not reasonably confident that these businesses will be able to generate excess returns on investment over the next 10 years.

We believe Spotify can rely on the music industry’s record labels because it will need access to content to continue to attract more listeners.

Record label domination

Although the distribution side of the industry (Spotify, YouTube, Apple, terrestrial and digital radio, etc.) is fragmented, over 80% of licenses are controlled by the three major record labels: Universal Music Group (“Narrow Ditch”), sony (“Without Moats”) and Warner Music Group (“Narrow Ditch”).

Because these licensors collect royalties from Spotify and its peers, they retain pricing influence as content remains king.

We applaud the company’s entry into the podcast world.

However, as the company has become a market leader through content acquisition, further diversifying its revenue stream, we don’t expect its dependence on labels to diminish much.

Compete on many fronts

Spotify leads the growing music streaming and podcast market, but faces stiff competition from giants likeAmazons (“Wide Moat”), Apple (“Narrow Ditch”) and Google/Alphabet (“Wide Moat”).

Unlike Spotify, these companies don’t rely solely on streaming music or podcasts to be profitable and could accept to break even, or even use streaming as a loss leader, while monetizing users through other products and services.

It may also be harder for Spotify to pick up on these competitors over time, as listeners to Apple Music and Apple Podcasts tend to be fans of Apple’s other products, so are Amazon Music users with Echo, etc.

These users are probably relatively more loyal to these music and podcast platforms than users of independent platforms like Spotify.

Fair value has not changed

Our fair value estimate is $170 per share, based on a $1.00 exchange rate as of October 25, 2022.

This implies a multiple of the company’s 2023 value/sales of 2.3.

We expect strong revenue growth from Spotify with an average annual growth rate of 18% over five years.

We expect the company to increase its operating margin to almost 9% in 2026 and 12% in 2031.

Revenue growth will be driven by growth in the company’s total user base for premium and ad-supported services (including podcasts and audiobooks), as well as continued growth in online advertising spending.

Over the next five years, we expect these users to grow by 11% per year.

As the company’s user base grows stronger, we expect fewer discount offers or more price hikes, especially for potential premium customers.

For this reason, we expect premium ARPU (revenue per subscriber) to grow at an average of 4% annually over 10 years.

With increased sales of ad inventory, as well as growth in freemium and podcast users, ad-supported ARPU could grow at an average annual rate of 20% through 2031.

We also estimate that the gross margin level will increase over time, from 25% in 2022 to 33% in 2031.

The portion of a company’s cost of revenue, label royalties, remains variable as it is a percentage of revenue and we don’t expect it to decrease or change much over the years.

Regardless of the revenue generated from premium subscribers or advertising, Spotify must pay royalties to record labels and publishers for the content served to its users.

Part of the gross margin expansion that we model is coming from the premium side.

However, he assumes that premium ARPU is more likely to increase due to rising prices and subscriber growth.

We also believe that ad revenue growth (driven by more ads placed on podcasts and audiobooks and overall user growth) can increase gross margin ratios.

© Morningstar, 2022 – The information contained herein is for educational purposes only and is provided for informational purposes ONLY. This is not intended and should not be construed as a solicitation or inducement to buy or sell listed securities. Any comments are the opinions of the authors and should not be construed as a personalized recommendation. The information in this document should not be the sole source for making investment decisions. Be sure to consult a financial advisor or financial professional before making any investment decisions.

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