What do they do?

Spotify provides its users the audio experience that many have come to know and most have enjoyed over the last few years. Most people under the age of 80 know and understand the product and understand the value it brings.

Spotify has a huge expansive library of hit music for its audience to enjoy and ways for discovery to happen in the music that is tangential to what its listeners like (aka discovery). Recently, the company has bet big in expansion into podcasts, live events and other audio domains that are growing in popularity. Evidence of the podcast investment has been demonstrated by the acquisition of exclusive rights to the extremely popular “The Joe Rogan Experience”.

There are two options for listeners, the “freemium” model with limited choice for user selection and ads as well as the ever increasing premium paid version which offers an enhanced listener experience with ad-free experience and other perks such as unlimited skips for around 10 bones a month.

Do they make money?

Yes. Although reporting earnings have been negative, this is mostly attributable to money invested in research and development. The business has been generating free cash flows for the past few years and the gross margins have been increases as the revenues soar. The top line revenues have grown at 20-40% for each of the last 5 years. Given that the gross margins have been getting better, this is a good sign that eventually the business will reach consistent high earnings in the future, as long as it can fend off competition.

Are there reinvestment opportunities?

Yes. The business continues to reinvest heavily in several avenues.

Firstly, the markets and genres it is reaching is continuing to grow. It is expanding across the globe which is initially expensive but should reap rewards down the road if it can repeat the first mover advantage it is currently enjoying in the western world. It is also expanding into the growing podcast universe where it looks to lock up talented stars and production companies that can be a very profitable business as it is not expensive to produce generally and with a worldwide audience, should not be low margins (think of the economies of scale with millions of potential listeners to a fixed cost audio production).

The paid premium product initially seemed expensive when compared to streaming TV and movies such as Netflix but now that Netflix has shown it has the ability to raise prices once it scales and its customers are fairly sticky, I would not be surprised if Spotify eventually followed suit (especially as the content library grows and podcasts grow increasingly popular).

Is there a risk of a blow up?

Currently, the company has more cash then debt. This is a good sign as it appears that the future growth is well funded and the free cash flow and soon to be reporting positive earnings should allow the company to grow safely. That being said, there is opportunity for the company to do foolish things while riding a wave of success that could jeopardize the future so that would be a good thing to keep an eye on.

The altman-z score of 5.2 shows a minimal risk of default in the near term and the Beneish M-score of -2.58 demonstrates that it is an unlikely fraud, at least in terms of accounting manipulations.

Is management sketchy?

Not really. Daniel Ek, the co-founder and CEO has about 9% of the ownership at this point and while not a insanely high number, it is still significant and having a founder lead company who is still under 40 is a potential amazing combination for long term investors. So far, he has been focused on the right things and continues to reinvest in the growth of the company without too much harm to shareholders along the way.

The company’s share count has been growing over the past several years but not at an insane rate (around 2%). While not uncommon for a young company, this is mostly due to the employee/management stock compensation and benefits package and while dilutive, should only be a concern if it grows while the business does not. Eventually, shareholders should see the dilution reduce as the business matures and this is something that should be closely monitored as it could easily ruin returns if left unchecked.

Does it have a moat?

Yes - The business model is a good one. Recurring revenue with decent margins. The gross margin expansion is a good sign that the moat is healthy. The churn rate as of 2020 was reported to be below 4% (not bad - perhaps helped with the “work from home” resulting from COVID). What will be interesting to see is how sticky these customers are once more normal work/life routines take hold.

Spotify also enjoys somewhat of a first-mover advantage (first to do it well, I mean) and also has a healthy recognizable brand. The moat should strengthen as long as they can retain music licenses (they are an important client for distributors/labels that own the music rights and invest in the artists). The companies forays into podcasting and having exclusive content (live events, podcasts, etc.) should only strengthen this foothold on the audio world.

A true test of the moat will come when they eventually and slowly increase pricing. It will also be interesting to see if they can integrate the app/service into other products (I’m thinking the video game industry would make a lot of sense but what do I know).

Is it cheap?

Hard to say. The stock price has come down significantly since the high in February 2021 above 350$. By traditional metrics, it is expensive (P/E, etc.). At a price to sales of just over 4 as of the time of this writing (June 2021), it doesn’t seem extreme given the margins continue to expand and the business is still growing at above 20% per year on the top line revenues. It doesn’t seem that outrageous to imagine the company having double to quadruple the revenue streams in 10 years as it continues to expand its market internationally, explore other revenue streams and potentially increase its pricing higher than inflation. That being said, it is not screaming cheap at any quantitative measure so it is really a question of what is the real TAM and will Spotify dominate the TAM or not?

Final thoughts:

A great business could be in the making with Spotify. A young and focused founder with a decently sticky service business model that has a strong start and with at least some defined moat offers the opportunity for long term investors for those willing to take on some uncertainty. The future competition is somewhat unknown and the future growth is anything but certain. This is one that is well known but maybe not well understood. Probably worth a deeper investigation given these opportunities don’t come along every day.

What do you think? Let me know what you think and share/subscribe if you enjoyed.

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