Spotify: Is this market leader on sale?
Spotify is the market leader in music streaming and the stock is trading way below its all-time high at $364. Does it mean that it is time to add Spotify to your portfolio? In this analysis I will share my opinion.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
This analysis will be a bit different from what you are used to read in my blog. Spotify did their IPO in April 2018, meaning I don't have access to the historical numbers dating back longer than that. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to easily get the numbers you need from various companies.
Before I start with the analysis, I should mention that I do not currently own shares in Spotify. However, I do own shares in Tencent (individual shares and through Prosus) and Tencent Music Entertainment that both owns shares in Spotify (Approximately 7,5 % combined). Spotify in return owns approximately 9 % in Tencent Music Entertainment. If you would like to see or copy my portfolio, you can read how to access it here. Even though I own shares Tencent and Tencent Music Entertainment and because of that has some skin in the game when it comes to Spotify, I will keep this analysis unbiased.
Spotify was founded in 2006 in Sweden. Spotify describes itself as an audio business and is most known for streaming music and podcasts. They are the company in the music streaming sector with the highest global market share, as their market share is 31 %. It is quite a lot higher than the runner up Apple Music with 15 %. By the end of the first quarter in 2022, they had 422 million monthly active users. There are two ways that their users can get access to Spotify's products. One is through a paid subscription and the other is through a subscription that is sponsored by advertisement. The paid customers segment has higher margins than the advertisement sponsored customers segment. By the end of the first quarter in 2022, they had 182 million paying subscribers, meaning that most of their subscribers are sponsored by advertisement. Spotify is a well-known brand, but we have seen Spotify losing market shares lately. And while losing market shares not always mean that the company doesn't have a moat, I don't think Spotify has a moat for the time being. They might develop one in the future though.
Their CEO is Daniel Ek. He is not only the CEO but also the co-founder of the company. I like when founders or co-founders are still in management, as they usually more concerned about growing their business than their wallets. Daniel Ek is a natural entrepreneur and started his first business when he was 13 years old where he made websites from his home. He later recruited students from his class to make websites from the school computers by bribing them with video games. As he turned 18 years old, his monthly salary was $50.000. From his first business until he founded Spotify, he held roles in different companies and founded another company that he later sold. Looking at his educational background, he started studying engineering at the KTH Royal Institute of Technology but later dropped out to focus on his own ventures. He has shared some his view on leadership, and he describes his leadership style as authentic. Instead of copying other leaders, he believes that one need to focus on what is true to oneself, and that a leader must invest time in building self-awareness of their values, beliefs, and strengths. In the latest conference call, he talked a bit about his leadership, and said his job is to come into office every day pushing teams to think bigger and work harder. No doubt that Daniel Ek has a very ambitious leadership style but according to Comparably he has a high employee rating that rates him in top 5 % of similar sized companies. Personally, I really like his entrepreneurial mindset, and I believe he has proven that he is the right man for the job.
I don't believe that Spotify has a moat for now. I really do like the management though. Later I will do a discounted cash flow model to calculate a price for Spotify but before I do so, let us just have a look at some key financial metrics.
Down below we see some key financial metrics Spotify over the last three years. First thing that comes to mind is that they have been able to grow revenue each year, which is always nice to see. I'm not too impressed with the gross profit margin but it is nice to see that it is growing year over year. They finally achieved a positive operating margin in 2021, even though it is very low. And while EBITDA and EBIT are both positive for the first time in 2021, we see in the net income that Spotify has yet to turn profitable. They are getting close to being profitable, but they are not quite there yet. Honestly, I'm a bit disappointed with the numbers of Spotify, and I had hoped and believed that we would see better numbers than these. However, the good thing is that the numbers improve year over year and maybe 2022 will be the year where Spotify is profitable.
Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Spotify. One risk is Competition. Spotify is operating in a highly competitive sector and are up against companies that can offer more than music/podcast streaming in Apple, Amazon, and Google. It has resulted in Spotify losing market shares in the last couple of years from a 34 % global market share in 2019 to a 31 % global market share in 2022. At the same time, Spotify doesn't have a moat that protects them from these competitors. Growth is slowing. As I wrote previously, Spotify has higher margins from paying subscribers than advertising sponsored subscribers. In the last year, the growth of paying subscribers has slowed each quarter. In the first quarter in 2021, paying subscribers grew by 21 % year over year, and in the first quarter in 2022, paying subscribers grew by 15 %. Spotify estimated that paying subscribers will grow by 13 % in the second quarter in 2022. It will impact margins, and in the first quarter in 2022, gross profit margin was 25,2 %, which was lower than in year 2021. Capital spending. Spotify has yet to be profitable despite their name recognition, and because of that I believe it is somewhat of a questionable move to decide to sponsor FC Barcelona. Financial terms of the contract haven't been disclosed but the deal is believed to be around $308 million a year for sponsoring FC Barcelona. While management was enthusiastic about the sponsorship in the latest conference call, I believe it is up for question if a nonprofitable company should spend this much on a sponsorship. However, it is just my own personal thoughts, I could be wrong.
There are also potential for Spotify moving forward. New markets. In the latest earnings call they talked about seeing a big potential in growing monthly active users (MAU) in Southeast Asia and India They talked about how the large populations will be "a massive, massive opportunity from an MAU perspective". And while core markets will still be the main contributor to revenue a while longer, management believes that emerging markets will pick up on that pace of growth. Podcasts. Podcasts are different from music streaming. In music streaming Spotify has to pay the labels and the artists per stream, and since most of their users are still have advertisement sponsored subscriptions and not all songs come with adds, the margins are much lower on advertisement sponsored users. Podcasts is another thing, as all podcasts comes with advertisement, and as audience grow for a podcast so does advertising revenue. However, the largest podcasters are on a fixed contract, meaning the growing advertisement revenue goes directly to Spotify. Hence, it isn't surprising that management in the latest earnings call stated that "podcasting should be better business model than music from a gross margin perspective." Marketplace. Management talked a lot of about Marketplace in the latest conference call. According to management, Marketplace "allows creators to grow their audience and engage their audience and monetize their audience in a new way." Spotify will naturally take their piece if the creators are successful in monetizing their audiences. They said that about Marketplace is everything from live events to merchandise and even NFT's. Marketplace is still in early days and Spotify is doing a lot of experiments on Marketplace and nothing has been rolled out so far. However, management believes that this type of creators and consumer interaction will be something that will grow profitability in the future.
I have now investigated the financials, risks, and potential of Spotify. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2021 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 3 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with an option in the middle. The chosen discount rate of 12% is because it is usually between 9-12%. I decided to go with the highest one because of the current market conditions. Remember that all the numbers made in these calculations are in millions.
I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I decided to use an EBIT growth of 10 % year over year. It might be a bit conservative as the music streaming sector is supposed to grow just under 15 % a year but I prefer to keep it conservative. I calculated with a growth in Depreciation & Amortization of 10 % a year as well. Finally, I decided to keep the Net Working Capital at the 2021 numbers at -2.553 because it is record high. I haven't found a smart way to share all my spreadsheet here but once I did my calculations, I found that the intrinsic value of Spotify to be $165.
Having investigated Spotify, I find the company interesting. I'm particularly curious if they can launch Marketplace successfully and at the same time, I like that they are focusing on building their podcast business. However, there are too many things I don't like about Spotify as an investment now. I don't like that they haven't yet been able to be profitable even though, it will probably happen soon. I don't like that margins are relatively low, they are losing market shares, and I'm not sure I understand the decision in spending so much money on a sponsorship. If Spotify manage to be profitable and grow their margins, I could be interested in the future but for now, I will not invest in Spotify. Nevertheless, if you believe in Spotify, I think it can be bought at a good price now.
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