Spotify Equity Research Report: Outlook Dims as Profits Lag (2024)

Outlook Dims as Profits Lag

Table of Contents

Investment Opinion

• Saturated TAM

• A Freemium Model That Won’t Translate

• ​Lack of Negotiating Leverage

• Absent Bottom Line

Overview of Spotify

• Company Description

• Business Model

• Key Performance Indicators (KPIs)

Industry Overview

• Macroeconomic

• Recorded Music Industry

• Five Forces Analysis

Valuation

• Discounted Cash Flow Analysis (DCF)

• Trading Multiple Analysis

• Final Valuation

Key Disclosures & Risks

Appendix

Disclosure

Investment Opinion

Saturated TAM

Based on historical growth rates and penetration rates, we estimate that 7.1B devices will be in use globally by 2029. This includes smartphones, tablets, laptops, and desktops. We believe Spotify can capture 20.33% of these devices as users, representing 1.45B total MAUs by 2029. This user growth is primarily driven by the increasing number of devices in emerging countries, a market Spotify has yet to capture. Spotify’s current markets, in which it operates and holds a dominant market share, have become saturated. Markets like North America, Europe, and Central Asia.  

​At fiscal year-end 2023:​

• Europe, Central Asia, and North America comprised 47% of Spotify’s total MAUs

• ​Europe, Central Asia, and North America comprised 64% of Spotify’s premium MAUs ​

YoY growth from 2018 to 2019:

• Europe and Central Asia’s total MAUs grew by 26.7%, while premium MAUs grew by 29.2% ​

• North America’s total MAUs grew by 17.7%, while premium MAUs grew by 29.2%

YoY growth from 2022 to 2023: 

• Europe and Central Asia’s total MAUs grew by 15%, while premium MAUs grew by 15% as well

• North America’s total MAUs grew by 10.7%, while premium MAUs also grew by 10.7%

As you can see, Spotify's growth has slowed in its most prevalent markets. These markets have matured and become saturated. Competitors like Apple Music, Amazon Music, and Google Play have presented worrying competition for Spotify. Because of these factors, Spotify’s future success depends on whether it can capture a dominant market share in emerging economies. 

​A Freemium Model That Won’t Translate ​

Spotify’s freemium model uses its ad-supported plan as a funnel to convert free users into paying subscribers of the platform. Historically, this has worked for the company, and Spotify has been able to convert ~50% of monthly active users into premium subscribers within 36 months. However, we believe this number will drastically decrease in the future. As Spotify’s growth becomes more dependent on emerging economies where household spending is less than in developed economies, we believe this will result in a lower conversion rate. This will bring problems for Spotify, as Spotify’s success is primarily driven by the premium side of the business. In fact, at fiscal year-end 2023, Spotify’s gross margins were 29% for premium and only 4% for ad-supported.  

Lack of Negotiating Leverage ​

Spotify’s most significant expense is predominantly in royalty and distribution costs related to content streaming; these are the main components of Spotify’s ‘Cost of revenue’ line item. Spotify’s ‘Cost of revenue’ has consistently been ~75% of the firm's annual revenue since 2018, and this ratio isn’t likely to change. Large labels still hold negotiating leverage over Spotify, which is why we haven’t seen any decrease in these costs relative to the total revenue generated. Because of this lack of bargaining power, Spotify hasn’t realized any significant financial benefits from reaching economies of scale. 

Absent Bottom Line​

Up until this year, Spotify has been in pure growth mode. Spotify has disregarded bottom-line performance to chase top-line revenue and user growth. However, as we just mentioned, Spotify hasn’t realized any significant financial benefits from reaching economies of scale, which has forced the company to undergo a restructuring to achieve profitability. Spotify’s best path forward to reach profitability is through decreasing operating expenses, which is precisely what they’re doing. Spotify has gone through three rounds of layoffs to lower operating costs. However, it is still unproven how this will affect the firm's revenues, margins, and other aspects of the business.

Overview of Spotify

Company Description

Spotify was founded by Daniel Ek (CEO & Chairman) and Martin Lorentzon (Director) and incorporated as a private LLC in Luxembourg in 2006. On April 3rd, 2018, the company went public, opening on the New York Stock Exchange at $165.90, giving Spotify a market value of $29.5B.

Spotify is a platform that has revolutionized the way digital content is streamed. Spotify’s platform is available in 184 countries and allows its users to stream 105M+ music tracks, podcasts, videos, and other content through computers, tablets, and mobile devices. Spotify offers its users the choice between two plans when using the platform: ad-supported or premium. As of fiscal year-end 2023, Spotify has 602 million monthly active users. The breakdown includes 223 million premium users and 379 million ad-supported users.

Spotify is undergoing a restructuring, and they are trying to embrace a leaner organizational structure to achieve profitability. They are doing this through cost-cutting initiatives like layoffs. In 2023, Spotify underwent three rounds of job cuts, which totaled ~2,300 layoffs. This has left the company with approximately 8,000 employees spread over 23 countries.

Before Spotify, the music industry was vastly different. The music industry offered consumers two ways to listen to music. Users were either given a transaction-based experience or a preset experience through music channels. The transaction-based experience meant users needed to buy music to listen to it. The preset experience was through traditional radio stations, which was a ‘linear model’ and left the users with no choice and a preset channel to listen to. Spotify revolutionized how music and audio content is streamed through an ‘access-based model.’ Spotify allows its users to stream audio content without having to own it.

Business Model​

Spotify’s business is comprised of two segments: Ad-Supported and Premium (EX. 4).

Spotify Free: Spotify Free is a limited version of the Spotify platform that lets listeners use the platform subject to advertisement breaks incorporated into the experience.

Spotify Premium: Spotify Premium gives its users access to the full Spotify platform and charges its users on a recurring basis. Spotify offers a variety of premium plans:

• Individual (Free for 3 months, then $10.99/month): 1 premium account ​

• Duo ($14.99/month): 2 premium accounts

• Family ($16.99/month): Up to 6 premium accounts and access to Spotify Kids

• Student (Free for 1 month, then $5.99/month): 1 premium account and access to Hulu

Spotify utilizes both these segments to operate on a ‘freemium’ business model. Spotify offers basic access to the platform at no cost and then offers supplemental features for a subscription fee. Spotify Free is used as a funnel to acquire as many users as possible, and then Spotify attempts to convert these ad-supported users into paying customers. Approximately 50% of Spotify’s monthly active users become premium subscribers within 36 months. This approach of onboarding users at no cost and then attempting to convert them into paying customers reduces the friction of getting users to the platform.

Key Performance Indicators (KPIs)

The KPIs for Spotify are quantifiable metrics used to gauge the company’s performance. The KPIs Spotify monitors to evaluate trends and make strategic decisions include Monthly Active Users, Ad-Supported Users, Premium Subscribers, and Premium Average Revenue Per User. ​

Monthly Active Users (MAUs): Spotify defines MAUs as “the total count of Ad-Supported Users and Premium Subscribers that have consumed content for greater than zero milliseconds in the last thirty days.” For the fiscal year ended December 31, 2023, Spotify’s MAUs were 602 million.

Ad-Supported MAUs: Spotify defines Ad-Supported MAUs as “the total count of Ad-Supported Users that have consumed content for greater than zero milliseconds in the last thirty days.” For the fiscal year ended December 31, 2023, Spotify’s Ad-Supported MAUs were 379 million.

Premium Subscribers: Spotify defines Premium Subscribers as “users that have completed registration with Spotify and have activated a payment method for Premium Service. Premium subscribers include subscribers in a grace period of up to 30 days after failing to pay their subscription fee.” For the fiscal year ended December 31, 2023, Spotify’s Premium Subscribers were 223 million.

Premium Average Revenue Per User (ARPU): Spotify defines Premium ARPU as “Premium revenue recognized in the quarter indicated divided by the average daily premium subscribers in such quarter, which is then divided by three months. Annual figures are calculated by averaging Premium ARPU for the four quarters in such fiscal year.” For the fiscal year ended December 31, 2023, Spotify’s Premium ARPU was €4.39.

We believe these are effective indicators to monitor. However, we believe there are three other key metrics to pay attention to: Content Hours Streamed, Churn Rate, and Operating Expenses as a Percentage of Revenue.

Content Hours Streamed: Spotify monitors the total number of hours users spend streaming content on the platform. This metric is valuable as it provides insight into user engagement and activity. For the fiscal year ended December 31, 2023, Spotify’s content hours streamed was 165 billion hours.

Churn Rate: Spotify’s churn rate is critical as this metric determines if Spotify's user base is growing or shrinking. If Spotify’s MAU growth outpaces the company’s churn, Spotify will continue to grow. Spotify is relatively quiet when it comes to releasing exact figures for the company’s churn and retention. However, at the end of 2021, Spotify’s then-CFO, Paul Vogel, released the first churn figure since 2018. At the end of 2021, Spotify’s monthly churn was 3.9%. This is equivalent to an annualized churn rate of ~30%. This means that, on an annual basis, about 30% of Spotify’s subscribers are expected to cancel their subscriptions.

Operating Expenses as a Percentage of Revenue: Spotify’s cost of revenue consists predominantly of royalty and distribution costs related to content streaming. Because of the nature of these costs, they aren’t likely to vary much. Since 2018, Spotify’s cost of revenue has consistently been ~75% of total revenue. As a result, Spotify’s operating expenses are a more revealing figure. Spotify’s operating expenses include R&D, Sales and Marketing, and General and Administrative costs. Historically, Spotify has operated unprofitably. However, with the new restructuring Spotify is undergoing, Spotify’s operating expenses are likely to diverge from historic levels. If Spotify’s restructuring is successful and they are to become a profitable firm, it is likely to come through a decrease in operating expenses. For the fiscal year ended December 31, 2023, Spotify’s operating expenses represented 29.01% of the total revenue for the period​.

Industry Overview

Macroeconomic

According to estimates from the International Monetary Fund (IMF), global real GDP growth is forecasted to increase at a consistent rate of +3.2% YoY from 2024 to 2026.

When looking at Emerging Economies, real GDP is forecasted to increase at a rate of +4.2% YoY for the years 2024 and 2025, then slightly slow down and increase at a rate of +4.1% YoY for 2026.

Spotify’s revenue by country is broken down in the attached exhibit. As you can see, 48.8% of Spotify’s 2023 revenue came from the United States, United Kingdom, and Luxembourg. Also, it’s important to note that there are no countries that individually make up greater than 10% of total revenue included in “Other countries.”

'EX. 6' shows a chart that overlays the United States real GDP growth YoY percentage change and the YoY percentage change in Consumer Spending. 'EX. 7' shows a similar chart but overlays real GDP growth and Household Consumption for the United Kingdom. 'EX. 8' shows the same data points as 'EX. 7', but for Sweden.

Note: Estimates are derived from the International Monetary Fund (IMF).

As you can see, from a broad overview, economic outlook appears to be healthy. This reduces the potential systematic risk faced when evaluating investment opportunities.

Recorded Music Industry​

The global recorded music industry is comprised of several different categories, including physical content, streaming, downloaded and other digital, performance rights, and synchronisation. The total global recorded music industry revenues have grown consistently since 2014; in 2023, this figure totaled $28.6 billion. Of this $28.6 billion in revenues, 67.3% is derived from streaming (18.5% ad-supported and 48.9% subscription streaming). By the end of 2023, there were 667 million users of paid subscription accounts globally. Spotify’s 223 million premium subscribers reflect a 33.43% market share​.

Five Forces Analysis

When evaluating Spotify, it’s important to zoom in and look at the digital music streaming industry separately.

We did this by performing a five-forces analysis on the digital music streaming industry, we classify streaming platforms as players, individual consumers as buyers, and producers/license holders as suppliers.

The threat of new entrants is low. Current players with deep pockets and a strong brand name make it extremely difficult for new entrants in the industry. Companies looking to enter the industry are also likely to be deterred when they see the competition in the industry. They will be forced to compete with some of the most dominant firms in the world in Google, Amazon, and Apple.

The bargaining power of suppliers is high. This industry operates as an oligopoly, and the suppliers are multinational, powerful companies. Universal Music Group, Sony Music Entertainment, and Warner Music Group comprise approximately 68% of the total recorded music market share and 58% of the publishing market.

This gives these firms significant control over music content and the associated fees. However, there has been an increase in the popularity of independent artists and emerging companies that are looking to disrupt the current music model. It’s a growing trend and worth monitoring, but it still isn’t meaningful enough to disrupt the industry and shift the power dynamic, which leads to the bargaining power of suppliers being high.

The bargaining power of buyers is moderate to high. Consumers in the industry face no switching costs and have various undifferentiated streaming platforms to choose from. The main differentiator between players in the industry is in brand name and brand loyalty, but not in the product itself. These factors lead to the bargaining power of buyers being moderate to high.

The threat of substitutes is moderate but increasing. The two biggest substitutes for the digital music streaming industry are vinyl and YouTube. Both these substitutes have seen explosive growth in recent years (EX. 11 and EX. 12). Vinyl sales have increased 1,672% since 2010, totaling 49.6 million vinyl albums sold in 2023. And YouTube has grown from ~800M users per month in 2012 to ~2.49B users per month in 2023.

Rivalry among competitors is high. Competition in the industry is highly concentrated between a small number of firms, such as Spotify, Google, Amazon, Apple, Pandora, and a few others. The lack of differentiation in products within the industry, paired with virtually no switching costs, stimulates competition from within the industry. These companies offer an extremely similar streaming platforms with little noticeable differentiating factors. The main difference between these companies is the business model and if there is a corresponding device.

Business model: Apple (Music), Google (Play), and Amazon (Music) have a digital music streaming platform as a segment of their respective businesses.  While for Spotify and Pandora, the music streaming platform is the business. This provides Apple, Google, and Amazon an advantage because they face less risk as their revenue is diversified. This segmented approach also opens up the ability for the company to use profits from a different segment of the business and invest in its streaming platform. Apple is the only one of these companies that hasn’t implemented a freemium model and only offers a paid subscription. The rest of the companies listed operate under a freemium model where they onboard users for free on the ad-supported plan and then attempt to convert them into paying subscribers.

Corresponding device: This is where companies like Spotify struggle against the big-tech competition. Firms like Apple and Google have corresponding devices, such as the iPhone and Google Pixel, which come with their respective music streaming platform preinstalled. This provides an enormous advantage for these firms.

These factors put Spotify at a competitive disadvantage when compared with firms like Apple, Amazon, and Google. This can be seen through their financial performance as they've had to invest extensively into areas like marketing and advertising to acquire users.​​

Valuation

Discounted Cash Flow (DCF) Analysis​

A discounted cash flow analysis was performed to assess Spotify’s valuation. This analysis included various assumptions related to growth rates, margins, churn, and capital structure. This DCF analysis was leveraged off a corresponding operating model that utilized a top-down approach to project Spotify’s future performance.

Target Price: Spotify’s outlook appears to have promising upside given the recent restructuring, but it isn’t enough to justify the current valuation given in the public markets. Based on the discounted cash flow analysis we performed, we arrived at an implied share price of $180.59 for Spotify.

Trading Multiple Analysis

The choice of comparable companies for assessing Spotify’s valuation was done carefully by evaluating factors such as growth rates, capital structures, margins, industry, business model relevance, and profitability metrics.

Sirius XM: When looking at Spotify’s direct competitors like Apple Music, Google Play, and Amazon Music it is impractical to use these as comps because they are tech giants with a music streaming arm of the business. Because of this, they warrant different valuations. However, Sirius XM is a solution to this. Sirius XM owns Pandora, and unlike the big tech companies, Pandora’s streaming platform is a significant segment of Sirius XM’s business. This allows for a meaningful comparison between two alike companies.

Netflix: Although Netflix operates in the digital video streaming space, it has a business model similar to Spotify, which allows for valuable comparison. Like Spotify, Netflix’s revenue is primarily driven by paid subscribers. Netflix and Spotify also have growth rates that resemble each other.

Roku: 86% of Roku’s FY23 revenue was derived from its platform segment. The platform segment generates revenue through the sale of digital advertising, as well as a few other offerings. This provides an insightful comparison to Spotify’s ad-supported segment. Of all the comps listed, Roku also has the most similar profitability metrics to Spotify.

Tencent Music Entertainment: TME is the leading online music and entertainment platform in China. This company was chosen as a comp because as Spotify looks to expand into new markets, they can look at TME, which already dominates many of these emerging economies. TME provides a good baseline. Spotify also owns ~16.47% of Tencent Music class A ordinary shares, and TME owns ~8.6% of Spotify.

Warner Music Group: WMG was included as they are a part of the ‘big three’ record labels that control 68% of the total recorded music market share and 58% of the publishing market. They also have similar growth rates to Spotify.

The Relevant Multiples: Due to no two firms being identical, we incorporated four different multiples that we believe best assess Spotify’s value:

1. EV/Revenue ​

2. EV/EBITDA ​

3. P/E ​

4. PEG Ratio

The reference period chosen for valuing the target is 2024E. This emphasizes forward-priced multiples and will account for the effects of Spotify’s restructuring. The analysis resulted in a range of value of $190-$220, which can be seen below in 'EX.15':

Final Valuation

The price target we arrived at for Spotify was $205. This is the mean of the range computed in the trading multiple analysis. We decided to focus on this valuation over the DCF for one key reason: Spotify is currently unprofitable and hasn't realized the effects of the restructuring. This has led to various assumptions related to Spotify's revenues, expenses, and margins. Because of this, we feel a trading multiple analysis for Spotify is more applicable.​

Key Questions & Risks

Can Spotify reduce operating expenses?

As we covered, Spotify’s ‘Cost of revenue’ isn’t likely to decrease as large labels still hold negotiating leverage over them. The key to Spotify becoming profitable is if they can reduce operating expenses. They have already begun a restructuring to decrease these costs. The success in this restructuring will be critical in determining the future success of the firm.

Can Spotify capture a dominant market share in the emerging markets?

Spotify has been seeing slowed growth in the developed economies for some time now. Capturing a dominant market share in the emerging economies is key. These are the economies that are realizing the fastest growth and are essential for Spotify to outpace churn.

Will Spotify’s freemium model translate?​

Spotify’s freemium model has been extremely successful in developed economies where consumers are more likely to spend money on subscriptions. In emerging economies, consumers have less disposable income. This is important to note as it potentially could affect Spotify’s conversion rate from ad-supported to premium users.​

Appendix

Disclosure

This equity research report on Spotify is based on limited research during an academic assignment. Nothing in this report is intended to be financial advice. This report was prepared on the purpose of an academic assignment and should be treated as such.

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