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The Scoop On Spotify

Evan Niu, CFA, The Motley Fool

Spotify is going public, and soon investors will be able to buy into one of the biggest music-streaming platforms in the world. In this episode of Industry Focus: Tech, analyst Dylan Lewis and contributor Evan Niu dive into what we know about Spotify's business at this point, and why the streaming company finally decided to enter the public markets.

Find out how Spotify's different tiers and packages affect the company's metrics, the most important risks that investors should keep an eye on, some of the promising areas that Spotify could potentially expand into in the next few years, and more.

A full transcript follows the video.

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This video was recorded on March 9, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 9th, and we're talking Spotify. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, I think this is going to be a good one. Not only is this a hotly anticipated stock listing, but this is a company that we both know pretty well.

Evan Niu: Yeah. It's been a busy couple weeks, all these IPO filings. I think the Spotify one is going to be a little bit more interesting than the Dropbox one.

Lewis: I'm a Spotify user. I think you are a Spotify user as well, right?

Niu: I am. I actually recently switched to Spotify. I switched my entire family away from Apple (NASDAQ: AAPL) Music to Spotify, which is notable because I'm a big Apple guy, so I have Apple everything. But very specifically, we started buying Amazon Echo devices and started getting more of these Alexa devices, and Apple Music just isn't supported, and Spotify is. That was really the catalyst for us to switch, but we're pretty happy with it.

Lewis: And I think with me being an individual account user and you having a family plan, and me formerly having been a Free user of Spotify, we kind of cover all of the bases for different user types that this company has. This is a company we know well. They're the leader in the music streaming space. We probably have some listeners that are not super familiar with them, though. What does their service look like?

Niu: Spotify was really the first big premium on-demand music streaming service. The big difference between Pandora (NYSE: P) and Spotify historically was that Pandora wasn't on demand, it was, you set a radio station, and you don't pick what you listen to. But, Spotify was one of the first companies to really offer on-demand service, where you pick specifically what song you want to listen to and then you get it. They were a first mover in that space. And they inked a lot of direct licenses with the record labels to offer this service. I think that's really helped them grow to the place they are now, which is the No. 1 service in the world.

Lewis: And in some ways, they've benefited from some of the other players in that space moving slowly. You think about Apple, a company that revolutionized the way that people consume songs and being able to buy them individually and create their own playlists, that seemed like a space that was ripe for them, and yet they waited on creating their own streaming option. That's allowed Spotify to get a huge lead in their overall user counts.

Niu: Right. And to bring Pandora back, Pandora now has on demand service, but they only launched that a couple years ago, I think in 2016. They were very late. So, that first-mover advantage was huge, I think, in this context.

Lewis: Looking at their user base, they have that ad-supported model, like you mentioned, and it's exactly what it sounds like: free access, you can choose songs, but you hear ads, too. They have some limited mobile functionality with that ad-supported system. On the Premium side, you get rid of your ads, you have offline listening from mobile devices, and you can get full control of your listening experience there. Their plans run from $9.99 a month for individuals up to $14.99 for family accounts, and they have student plans for $4.99 a month. Those are all dollar-denominated. I think a point of order for the rest of the show is, Spotify's financials are stated in euros. Going forward, unless we say otherwise, we're talking euros, not dollars. For some context, currently, €1 is worth $1.23. I thought that might be helpful background, and a good disclaimer to get out there before we get into the financial metrics discussion of the show.

Niu: Yeah, you always have to remember what currency you're talking about.

Lewis: Before we get to currency, why don't we talk a little bit about some of the core business metrics? I think MAUs is probably one of the easiest places to start.

Niu: Sure. Right now, they have 159 million monthly active users, of which 71 million are Premium paid subscribers subscribing to any of the plans you just mentioned above.

Lewis: And that rate is actually higher than it was a couple years ago. You go back to 2015, I think 30% were Premium, and now we're seeing about 44%. Some of that, I think, is the popularity of the Premium offering. Some of that is how they calculate that Premium number. That's something that we're actually going to hit on in a minute or two. 

Something that's incredible to me, Evan, looking at the breakouts of their different user types is, up until 2017, Spotify was actually losing money on their ad-supported customers.

Niu: That's pretty standard, considering the industry that we're talking about. Music streaming is notoriously an industry that has really tough economics. And Spotify, because they've had these direct licenses with the record labels for many years, those costs are higher than what a company like Pandora faces, because Pandora uses statutory licenses as a way to minimize their costs. Since Spotify has direct licenses, which they've also recently negotiated, which we'll talk about later on, the costs are just huge. Then, when you're trying to monetize a service with ads, it's not a good experience for the users, because listening to ads constantly is really kind of obtrusive. At the same time, you're not really making a lot of money, either. So, it's not really a great solution for anyone.

Lewis: There have been times when I've been at someone's house and we've been hanging out, cooking dinner or something like that, and we've been listening to Spotify on their account, and you immediately know when it's a free account when you're listening to two or three songs and then all of the sudden you're blasted with an ad for something that has nothing to do with the music you were just listening to.

Niu: Like tires. [laughs] It's just random.

Lewis: [laughs] Yeah. It's certainly a different user experience. And when you think about that price point of $10 a month, it's a pretty compelling offering, given how big their library is.

One of the other metrics, and this one might have people scratching their head a little bit with Spotify, is Premium ARPU. This is something that's actually trending down for them. It helps to look at the mechanics of how these numbers are calculated, though. In 2015, we saw just under €7 a month for ARPU. 2017, we're at just over €5 per month. And I think this calculation, as well as some of the user growth that we talked about earlier, are classic examples of why it's good to read the prospectus and read company conference calls, because you get the explanation of how these numbers are calculated and what is going on with these metrics.

Niu: Right. Certainly, a lot of these bundled plans have helped them really grow their Premium subscriber base, particularly these family plans, because any person that's a part of a family plan is included as a separate Premium user.

Lewis: Yeah. They might have one family plan with three, even up to six, people on the account, which would all count as Premium users for them. So, that might be something that warps an ARPU number, just because you have more users in that denominator. And that's something that management has been super open about and talked about plenty in the prospectus. 

One number that's maybe most impressive to me in the prospectus is their churn. It's obvious to me that Spotify has put together a business that people love, and people are not leaving.

Niu: Right. They've put up some really good improvements with bringing churn down, which really helps their retention numbers. These are all related. In the statement, the filing, they note that while ARPU has come down as a result of them introducing these other products like family plans and student discounts, the natural effect is that ARPU is going to come down a little bit. 

But the upside is, not only are they helping grow their service because they're getting more people in, their retention of those products is really high. Overall, those products are helping them improve retention across Premium overall. And if you think about it, think about a cellphone family plan, the retention for those are really high, too, because it's a pain, it raises the switching costs, if you're trying to switch everyone over from one service to another. But, unlike cell plans, which are still mostly commoditized, Spotify is heavily personalized. Each person has their own very personal account. The more you use it, the more it knows you, the more personalized it is, and the more entrenched you become with it over time, because it understands your music preferences. Now, multiply that by four or six people in your entire family, and now it's a huge cost to switch an entire family plan to a completely different music streaming service that you have to get to know completely again, you have to retrain their algorithms and all that stuff. So, I think it's good for the business in that sense. It does bring down ARPU a little bit, but I think it's well worth the benefit of higher retention.

Lewis: Yeah, it keeps things sticky. And when you're talking about a product that costs $15 a month, you'd have to be saving a lot of money to overcome all of the painful switching costs that we mentioned. If you want the actual churn figure, it was 5.5% in 2017, down from 7.7% in 2015. So, less people are cancelling relative to the overall number of Premium subscribers out there. 

Evan, looking over at the financials, I think the first place you start here is the top line. The growth has been pretty strong there. The company pulled in €4.1 billion in 2017, which is up 39% year over year. When you look at the breakouts, it's pretty clear that this company is reliant on the Premium side of their business for most of their top line.

Niu: Right. Premium subscriptions represent about 90% of revenue, which is pretty telling. If you look at that user base breakdown, 71 out of 160 million. It's less than half, but they're carrying 90% of revenue.

Lewis: And something encouraging, also in the financials, is when you look at what's going on with gross margin. It's currently at 21%, up from 12% two years ago. Some of that is that mix of profitability we were talking about, where even though most of the money was being made off of Premium users, the fact that Free users were losing money for the business obviously weighed on what was going on in the gross margin side. Now that they are gross margin positive on the Free side, that's obviously going to help a little bit, too.

Niu: Right. The royalty cost of the record labels is really the big piece that we're talking about here. That was about 80% of revenue in 2017. These costs are enormous, which is really tough to squeeze out any type of profitability, because you don't have a whole lot of money left over to cover all your operating expenses.

Lewis: Yeah, even for that increase in gross margin that we're seeing, that still means that licensing costs and royalty payments are eating up about 80% of the top line. That means that a lot of the cost savings, even as they renegotiate deals and get more favorable terms, aren't really coming down to the bottom line, because as a percentage of sales, you look at the research and development costs, their sales and marketing, their general expenses, all of those were up in 2017.

Niu: Right. That's what's so hard about this industry. The cost structures are just not very favorable to these services, whereas the record labels, they have a very strong bargaining position in there.

Lewis: And trying to paint a picture for what profitability might look like for this business is kind of tough. We saw an operating loss for them in 2017. Then, on top of that, they had a huge line item hit with their finance costs, which took them even further into the red and took them to €1.2 billion in losses for 2017. Most of that is related to this very complex structure of the company's debt and convertible notes. Evan, you have some experience with that. Do you want to try to give a quick explanation there?

Niu: Without getting too deep into it, I would say, it's important to note that those finance costs, which I think were about some €970 million last year, that's a non-cash charge that's primarily related to the change in fair market value of these convertible notes that they issued a couple years ago. They raised some debt in 2016 and issued these notes. As value of these notes fluctuates, which is also a function of their private market share price, which more than doubled last year, then that increases the interest cost associated with these notes. But, these are non-cash charges. It's not like Spotify is paying out this much in cash.

Lewis: But it is an expense that they have to recognize for the purpose of GAAP accounting, right?

Niu: Correct. Though, technically, Spotify is on IFRS, International Financial Reporting Standards. Which is the international version of GAAP, but, a different standard. So, on an IFRS basis, they do have to account for it.

Lewis: So, when you look at everything that's going on with them as a business, it's kind of hard to suss out, how much of this is a permanent expense that's the steady state of what's going to be the future for them? How much of this is tied to the capital structure that they've chosen with these convertible notes? We talked about how margins are only going to give them so much money to work with, and how much is really going to come down to the bottom line there? The financing is going to be an ongoing question with this business. And Evan, I know that we didn't want to spend too much time talking about this on the podcast, because it really doesn't lend itself to go to audio, but you're planning on putting a piece together explaining what's going on with Spotify's convertible debt, right?

Niu: Yeah. I'm going to take a deeper look at their capital structure. The big piece of it is really this debt financing and convertible note structure.

Lewis: And depending on how they handle that over the next couple years, that might be something that either weighs on profitability or makes things a little bit easier. Of course, there are a lot of other moving parts there as that disappears as a line item. That's all to say, listeners, once Evan gets that piece out, if you're interested in this, write into the show, and we'll be sure to send it out. 

And on that note, actually, knowing that we were going to be chatting Spotify, we asked folks on Twitter if they wanted to hear anything in particular in the discussion, and we have a few listener questions about the company and this issuance. Casey asks where they plan to deploy the money raised from the offering, and is it an exit strategy for initial private investors? And I think this is a good point to address, because there might be some confusion about what's going on with this issuance, Evan.

Niu: Spotify, in this direct listing, are not issuing any shares whatsoever. They will not be receiving any capital, will not be receiving any proceeds. So, they're not even using the proceeds since they're not getting any of it. I would say, generally speaking, remember that, in traditional IPO's -- and this is not a traditional IPO -- in most IPO's, it's kind of a mix of both most of the time. Most of the time, a lot of initial private investors, including insiders, co-founders, etc., it's partially an exit strategy, a way to let them get a payday, but also to raise money for the company itself. That's how most IPO's are structured. In this case, for Spotify and this direct listing, it's primarily an exit strategy for the initial private investors.

Lewis: Austin asks -- and this is listener Austin, not our producer Austin -- he wrote in and said, "What's the long game for Spotify? It can't be their current model." Austin goes on to throw out a couple ideas. "It could be leveraging data and machine learning, expanding on their personalized playlists, maybe even hyper-focused ads, possibly some sort of packaging with podcasts as an option." Evan, I know you have some thoughts on what this business could morph into and the optionality they have there.

Niu: Right. I'm not a huge fan of the cost structure as it is because those royalty costs are so astronomically high. 80% of revenue, how do you pay for things? It's really hard to envision them being a profitable company. But, an early Spotify investor had mentioned in a recent interview that there's this idea that Spotify can basically create this marketplace that connects artists directly with listeners, which has this potential to cut out the record labels all together, because the record labels are basically just middlemen. Not to say that record labels are going to die or anything like that, because they certainly have their place in this industry, particularly at the high end of the value chain with prominent artists. But, if you think about little guys, little up and coming artists, if you can remove the middleman and just appeal directly to your users, you have a pretty good opportunity there. A, Spotify can cut out this huge cost. B, directly connecting artists and users has a lot of potential. 

And, they are actually very specifically looking at some things that Austin just mentioned, because they are using machine learning, because all of their curation algorithms that are meant for content discovery are all built on AI and machine learning. At the same time, they're helping artists be able to target other users not with ads, but trying to find users that might like their music. And they also deliver analytics to artists. They've even started to provide creative tools. They just started this new lab last year to create a bunch of tools artists can use to make their music. 

If you look at this from that perspective, I'm seeing Spotify in the future as having this potential of being a new, modern, digital distribution platform of streaming. Think like YouTube, but just for music. YouTube is another platform that got big by connecting people directly and providing all these different types of tools to help content creators build their business. You get analytics, you get all sorts of stuff.

So, I think that's really exciting. And they make some references to this in their filling, but nothing really concrete yet. Certainly nothing that's financially meaningful quite yet. But, if we take a step back and zoom out five or 10 years in the future, that would have me excited.

Lewis: Yeah. And actually, I think Austin makes a very interesting point with the podcasts, with the last bullet there. You think about ad fulfillment for podcasts. A lot of organizations use some third party to handle that, or they have an internal sales staff that handles all that. I would think that Spotify would have pretty robust user data that would allow for hyper-targeted ads on podcasts on the platform. The difficulty there is, they are not the sole distributor of podcasts, in that a lot of people get them through some third-party app or through the Apple Podcast app or something like that. But I think there might be something there, too, where they work on the ad side within audio advertising.

Niu: Yeah. So, even though I'm not super thrilled about the financials right now, I do see a lot of potential for Spotify in the future as a really vibrant distribution platform for artists. It's the biggest one in the world. If you're an artist and you want to reach the biggest audience, that's where you go.

Lewis: And this leads us into what I would like to end the show talking about, which is broadly, what do we see with Spotify's business right now? What are the risks we're worried about? And maybe, what are some of the opportunities? We haven't talked too much about the competitive pressures, but one of the things that has me most worried about this company as it currently exists is, there's not a lot of pricing power in the streaming music space, and there's also not a lot of cost control, either.

Niu: Right. And between the two of those, you get squeezed pretty hard. On one hand, Apple Music is humongous, and Apple does not need to make any money on this. $10 a month is kind of table stakes right now, but I wouldn't be surprised if going forward, that comes down even further, just through competition. Because like you said, if it's commoditized enough, these companies have to compete on price. 

I do think Spotify has other ways that they can differentiate themselves. For example, they're ubiquitous. They have so many third-party integrations, from gaming consoles to phones to cars to high-end audio receiver. Spotify is literally everywhere. It's also cross-platform. While Apple is only targeting iOS and its own userbase, Spotify targets everyone. And that scale really gives them the amount of user data that they need to be able to personalize these things and target these things we were just talking about. So, I do think they have some advantages.

Lewis: Yeah. It's certainly a business that, in five years, could look a little different than it currently does. For the sake of people who currently owns shares, I kind of hope it does, because we've seen a lot of companies struggle to make it work in the music streaming space. I think Pandora is probably the biggest one. We've talked about some of the more music industry relevant things that Spotify could do. Those are things that Pandora tried to do. They acquired Ticketfly and tried to branch more into the event marketing side and ticket fulfillment side of that business, and then they later divested those assets.

Niu: It didn't work out very well.

Lewis: That could be Pandora's execution. That could be that, simply, tying those two worlds together is maybe a little bit more difficult than people give it credit for. But, I certainly think that those options are there for Spotify.

Niu: Right. I think there's some potential to really expand this. The ticket booking thing with Pandora, I think that was kind of a misguided effort to pivot into this other area where they thought they could make more money, when they didn't even have their core music streaming business down very well. [laughs] That was kind of a weirdly timed move on Pandora's part. I do think this idea of Spotify becoming a more direct distribution platform has a lot of potential and is much more directly related to its core competencies.

Lewis: And this is probably going to be one of the more fun companies to watch over the next three to five years for a variety of reasons. We talked about the optionality they have with their business, but also, this direct listing, and it not being a capital raising event but an opportunity for shareholders to have liquidity, that's something that we haven't really seen for a business that has this much drummed-up interest for it. So, there's that. And there's also the incredibly complex capital structure that they've chosen. So, there are a lot of elements that make this a super interesting story for 2018, and certainly for the next couple years beyond it, too.

Niu: Absolutely. There's a lot going on here. It's going to be a lot of angles to focus on, if people are considering investing in it.

Lewis: And as we get closer to the actual listing date and we get some more details, we're definitely going to follow up with a show. This is something that's fairly new to a lot of people, and I think, one, it's interesting, and two, it's a great opportunity to talk about a concept that people really aren't all that familiar with. Look out for more shows on that. Like I said, Evan's going to be writing that piece on the capital structure. If you want that, just write into the show. Evan, anything else before I let you go?

Niu: No, I think we're good.

Lewis: Alright. I just want to give listeners a quick heads up about two things. I'm going to be in Austin next week with Chris Hill, Dan Boyd, and a few other Fools for South by Southwest. We have a listener meetup planned for Monday, the 12th. If you're going to be in the area, shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus, and we'll make sure that you get all those details. 

Also, all of next week's shows are going to be tied to our time in Austin. We're planning on getting some cool interviews, getting some dispatches on all the fresh tech and the new ideas that we're hearing at South by Southwest. I think Simon Erickson is going to be hopping on the Healthcare show. We're super excited about that. We have some fun stuff in store for you. If South by Southwest is not your shtick, maybe a week to skip on the show.

Otherwise, that does it for this episode of Industry Focus. I mentioned our handles, @MFIndustryFocus and industryfocus@fool.com. If you ever have any questions, shoot us an email over there and we're happy to answer them and talk about them on the show. If you want more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Rick Engdahl for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of AMZN and Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends AMZN, Apple, Pandora Media, and TWTR. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.