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Should You Believe Spotify's Daniel Ek?

On June 8th Spotify held an Investor Day, its first such event since the company became public through a direct listing four years ago.

It was a well-produced affair. Up-front, Ek acknowledged that the investment has been challenging (the stock is trading at all-time lows):

“Some may also think that we’re a bad business or at least a business with bad margins for the foreseeable future. […] Today, we’re going to say the quiet part out loud and directly address these assumptions.”

The perennial bear case for Spotify goes something like this: Spotify operates in an industry with few barriers to entry. Anyone can license music from the labels and create an app for distribution. This product might even be a loss leader bundled with other products. Amazon Prime, for instance, bundles a subset of 2 million songs for free with its namesake subscription. And there are plenty of other players in the market: YouTube Music, Apple Music, Tidal and others.

Then there is the question of margins: Spotify and its competitors must pay royalties to music labels and Spotify’s gross margins will be forever stuck around 25 percent. Whenever the streamers’ contracts with the labels are renegotiated, the labels will make sure to extract all the economics they can, relegating Spotify and its competitors to being low-margin businesses forever.

If pressure from the labels don’t force gross margins down, industry structure might: every meaningful Spotify competitor is part of a larger company. Spotify might need 25 percent gross margins for its business to breakeven, but Apple, YouTube, Amazon and Block (Tidal’s owner) might decide to run the business at lower gross margins. First, because they can, and second, because they want to pressure Spotify, their biggest and most successful competitor.

This, of course, is not the future Ek promised when Spotify listed in 2018.

During that investor day, held before the listing, Ek told a story of David versus Goliath, of taking down the label gatekeepers.

He pointed out that Spotify had five times the amount of data than its closest competitor, and that this would drive the machine learning flywheel for better discovery. Spotify’s free ad-supported tier was touted, with its impressive ability to convert listeners to the premium plan, acting as an efficient acquisition funnel.

He talked about the Spotify Marketplace, aimed at creating tools for artists. This would, eventually, create new revenue streams and raise Spotify’s gross margins.

On unit economics, Spotify touted its improving churn and a lifetime value to subscriber acquisition cost of 2.7 times. Not spectacular, but respectable enough to ensure that every new customer increases Spotify’s enterprise value.

Then-CFO Barry McCarthy took the stage and pointed out that Netflix stock went up 10x since he’d left the company and that gross margins went from negative to 35 percent as the company scaled.

As far as Spotify, McCarthy predicted revenue would grow 25-35 percent per year and that gross margins would reach 30-35 percent.

The bull case could be articulated as such: revenues would grow at least in line with user acquisition, which would be robust. Gross margins would steadily improve, as would the bottom line. Eventually, Spotify might even become so powerful, it would have a stronger bargaining power against its suppliers (the music labels).

Fast forward four years, and the stock has gone nowhere, despite revenues and users growing at 26 percent compounded. The problem? Gross margins.

In this year's event, Ek noted:

“There are two possible explanations for this lower gross margin result. One might be that Spotify just isn't that good of a business, and the other is that we're investing behind the strength of our business to make the business bigger, stronger and more resilient. And I will share with you today that the music business is doing much better than you think, but we're also investing and expanding what Spotify is.”

This is the problem that has plagued Spotify since its listing: lack of transparency.

The company’s earnings calls are littered with metrics investors don’t really care about. One example from last quarter:

“At Spotify, we are constantly testing and experimenting. And in Q1 alone, we ran almost 2,000 experiments, which is a 5% increase over the previous quarter”

Meanwhile, the margin progress Ek is referring to remains buried in the consolidated numbers.

To an extent, investors are looking beyond this. Despite the share price being at all-time lows, Spotify still trades at 72 times free cash flow. This is because gross margins remain depressed at under 27 percent and free cash flow margins are only 3 percent. Investors are still betting on growth and margin expansion.

Ek gave us a peek behind the consolidated numbers:

“When you isolate music, thanks to our Marketplace products, its gross margin has been steadily climbing. And we are performing much better than you probably suspect, roughly 28.5%, which is significant progress in reaching our 30% to 35% long-term goal. What's been dragging it down is our move into podcasting.”

Ek predicted that podcasting itself would eventually have a “40 to 50 percent gross margin potential.”

The concept of lifetime value (LTV) was also touted throughout the presentation. Presumably, LTV/SAC (lifetime value to subscriber acquisition cost) has improved from 2.7x, although no update was provided.

But the main thrust of this investor day was two-fold: first, to convince investors that under the hood, the economics of the business are better than expected, and will continue to improve. And second, to paint an expansive vision for becoming the world’s largest audio platform.

Ek and his team made some bold predictions:

- The company will achieve 1 billion users, up from 422 million currently

- Those users would be monetized at a rate of €100 per year, up from around €25 today (that would mean €100 billion in revenues, up from €11.6 billion expected this year)

- The company would generate 40 percent gross margins and 20 percent operating margins

To get there, the company will expand from its current offerings of music, podcasts and audiobooks (following its recent acquisition of Findaway) into news, sports and education.

This bundling strategy would add incremental ARPU (average revenue per user) on the premium side.

On the ad-supported side, Spotify expects to dramatically increase ARPU from €5.5 currently to… a much higher number. They showed a slide with other “platform” comparables, the highest of which was €36.5. This looks to me like Facebook.

The comparison with Facebook—whether that was the actual comparison or not—is interesting. Facebook (now Meta) generated $119 billion of revenue over the last twelve months, almost entirely from ads, from 2 billion daily active users and 3 billion monthly active users.

Spotify believes it will reach similar levels of revenues from just 1 billion monthly active users and a mix of ads and subscriptions.

Implications for Investors

Setting aside whether one should believe Daniel Ek’s projections or not, some back-of-the-envelope math can tell us what the investment case might be for Spotify at current prices.

Let’s make some assumptions. First, take the scenario we had before this Investor Day. Analyst expectations were—these are rough numbers—for about €29 billion of revenues by 2030. It’s possible to get there with nearly 1 billion MAUs and ARPU of €30. These are not heroic assumptions: average revenue growth until then would be around 12 percent, well below the company’s historical average.

Let’s assume gross margins march upwards every year and reach 31.2 percent by then. Operating expenses, guided by Spotify, should be 10-13 percent for R&D, 6-7 percent for S&M, 3 percent for G&A (all as a percentage of revenue). This leaves us with an operating margin of 8 percent assuming the high end of those ranges.

If the stock trades at 15x earnings, and share count dilution progresses at 1 percent per year, we get a 10 percent compounded return from the current stock price of $98. The ending stock price would be $189.

Now let’s assume Daniel Ek’s upside scenario from the recent Investor Day: €100 billion in revenue, 40 percent gross margins and 17 percent operating margins (again using the high end of his operating expense range for each line item).

This would require compounded growth in revenues of about 26 percent through 2030. It’s not an impossible number.

In this case, the business would be worth north of $200 billion and the compounded return would be 41 percent (the stock price would be $1,105). This assumes the same 15x exit multiple.

An important note: historically, stock dilution at Spotify has been 6 percent per year. These IRR numbers would be 4 percent and 36 percent respectively if we modeled 6 percent rather than 1 percent. I reached out to Spotify and they confirmed they have not given future dilution guidance.

Should You Believe Daniel Ek?

This brings us to the crux of the problem: should you believe Daniel Ek?

Currently, sell-side analysts don’t seem to. There are seven analysts estimating revenues out to 2030 and so far they have not updated their models. The estimate remains at around €25 billion.

But the real question is: can Ek deliver? Can he deliver even the base case scenario, given that over the last four years, gross margins have improved much less than expected?

It’s possible. But is it likely?

Absent from consideration are competitive pressures. If the prize is really that big, will competing services sit idle and allow Ek to capture it all to himself?

Apple just signed a 10-year deal worth $2.5 billion to stream Major League Soccer games on Apple TV.

Apple has not made meaningful investments in adjacent Apple Music categories. But could it throw similar amounts of money into the verticals Ek is targeting—news, sports and education—and complicate his plans?

What about Amazon and Alphabet?

The ranges of potential return above look relatively asymmetric. If things simply work out as envisioned, the compounded return isn’t too bad; if things do work out, they’ll be spectacular.

That, I think, brushes away a lot of potential pitfalls, such as the opportunity cost of owning Spotify in a slowing macro environment in which nearly every stock is down.

Put differently: given the execution challenges—even for the base case—is Spotify worth the bet?

The Conjunction Fallacy

One mistake investors often make—and I’ve made this mistake several times—is what’s known as the conjunction fallacy.

Its most simple statement sounds too obvious: when it is assumed that specific conditions are more probable than a single general one. The canonical example is believing “Linda is a bank teller and is active in the feminist movement” is more likely than simply “Linda is a bank teller.” Obviously, being a bank teller is more likely than being a bank teller and active in the feminist movement.

I’m referring to a more subtle version of the fallacy: when investors believe that an outcome seems probable, but forget that in order to get there, a number of steps—some of which might be long shots—need to be taken, in conjunction.

In Ek’s upside case for Spotify, the company would need to (a) build out its ad business (b) prove the economics of audio advertising so that ARPU increases many-fold from the current €5.5 (c) build entire new verticals in news, sports and education and monetise those (d) prove out the economics of podcasting, which hasn’t been done before since podcasting is a new medium and (e) put it all together to deliver on the revenue and margin targets.

A purely rational (and over-simplified) model using probabilities might look like this: each step has a 70 percent chance of success; there are five steps; the probability they all happen is 17 percent (0.7ˆ5).

A more sophisticated approach might use different probability weights, and give the company credit for partial achievement. After all, the upside case has such a high IRR (compounded return) from the current price, even if the company doesn’t succeed fully by 2030, returns might look compelling.

Another way of framing this optimistically would be to adopt what James Anderson, manager at Baillie Gifford, called not being “sufficiently radical”: that in his investment career, he should have believed even more in exceptional people and upside scenarios.

What Spotify Should Do

Companies are often reluctant to give investors too much information on a quarterly basis for fear of competitive pressures. In Spotify’s case, rather than breaking out Music, Marketplace and Podcast gross margins, Spotify simply reports the consolidated number. Investors are left guessing.

But the benefits of giving investors more information probably outweigh the drawbacks.

Companies that have broken out their segments often see their stock price increase. When Amazon broke out its AWS segment, for instance, the stock reacted positively. Investors were surprised to see how profitable and fast-growing it was. The same thing happened when Alphabet broke out its “Other Bets.” Investor saw how much money Other Bets were losing, and how profitable the core business looked in comparison.

Meta’s (née Facebook) stock did the opposite when it broke out the $10 billion losses in its incipient AR/VR segment, Reality Labs. But I contend that wasn’t because of these losses—which were widely expected—but rather because of the $10 billion revenue headwind as a result of Apple’s ATT.

But breaking out Reality Labs probably instilled additional discipline on Meta’s expense management, particularly since Mark Zuckerberg promised in the company’s earnings call to continue funding it, but only if it allows Meta to grow its overall profitability.

Spotify should follow suit: give investors a breakdown of gross margins beyond just “Premium” and “Ad-Supported,” which currently includes all podcast investments. Instead, clearly itemize revenue and cost of revenue for Music, Marketplace, Podcasts, and all future verticals.

This additional disclosure will serve as a forcing function for Spotify to deliver. Analysts and investors can judge whether the company is moving in the right direction. It also better aligns investors and Spotify employees, since everyone will have access to the same metrics.

Segmenting the business and showing gross margin progress will likely result in a lift to Spotify’s share price, or at least will allow investors to value the pieces better. It’s a win for employees and a win for shareholders.


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