Spotify Reports Strong Q2 User Growth; Likely to Continue in Q3; FVE $187; Shares are Attractive

Business Strategy & Outlook

Swedish-based Spotify is the world’s leading music streaming service provider. The fast-growing digital streaming space has become the primary distribution platform of choice within the ever-changing music industry. Spotify can benefit from various network effects that will help the firm increase its users and amass valuable intangible assets associated with user data and listening preferences. However, it faces intense competition and has a (mostly) variable cost structure that may limit Spotify’s future operating leverage and profitability. Thus, one does not have sufficient confidence that it will generate excess returns on capital over the next 10 years. Spotify may be at the mercy of the record labels in the music industry, as it will need access to content to continue attracting more listeners. While the distribution side of the industry (Spotify, YouTube, Apple, terrestrial and digital radio, and so on) is fragmented, over 80% of licensing is controlled by the big three major record labels: Universal Music Group, Sony, and Warner Music Group.

As these licensors gather royalties from Spotify and its peers, they maintain pricing leverage as content remains king. The firm’s entry into the podcast space. However, while the firm has become the market leader via content acquisition, which further diversifies its revenue, one does not expect its dependency on labels to be lessened much. Spotify is ahead of the pack in the growing music streaming and podcast markets, but it faces stiff competition from behemoths such as Amazon, Apple, and Google. Unlike Spotify, these firms don’t rely solely on streaming music or podcasts to drive profitability and can potentially run at break-even, or even as loss leaders, while monetizing users via other products and services. It might also be harder for Spotify to steal share from these competitors over time, as Apple Music and Apple Podcasts listeners are probably entrenched with other Apple products, Amazon Music with Echo, and so on. Thus, they might be relatively more loyal to these music and podcast platforms than the users an operating-system-agnostic platform like Spotify can capture.

Financial Strengths

As of the end of 2020, Spotify did not hold any debt on its balance sheet. Spotify’s cash balance at the end of 2020 was $1.7 billion. Spotify has continued to generate cash from operations since 2016; although the firm has incurred hefty operating losses in recent years, cash flow has been better as a good portion of these costs, which are accrued fees to rights holders, have not yet been paid out in cash. While Spotify remains an asset-light business since it uses Google’s cloud platform for data storage and computing, one does expect the firm’s annual capital expenditure to be EUR 75 million-EUR 100 million, likely necessary to provide additional services and tools on the creation side especially for new, up-and-coming, or independent artists. The firm is also likely to take the M&A route with similar objectives, as displayed by its various podcast acquisitions. The free cash flow to equity/sales, to average around 6% the next 5 years.

Bulls Say

Spotify’s listener growth may help it negotiate much better terms with record labels over time.
By investing in more services and tools for artists, Spotify may attract artists away from record labels and toward independent distribution, which may allow the company to pay lower royalties over time.
Revenue growth during the next 10 years should accelerate as Spotify keeps investing in different content such as podcasts and video, attracting more users and advertisers.

Company Description

Spotify, headquartered in Stockholm, Sweden, is one of the world’s largest music streaming service providers, with over 150 million total listeners. The firm monetizes its users through both a paid subscription model, referred to as its premium service, and an ad-based model, referred to as its ad-supported service. Revenue from premium and ad-supported services represented 90% and 10% of Spotify’s 2017 total revenue, respectively.

(Source: Morningstar)

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