Spotify stock has gone on a huge tear lately, almost quadrupling its stock price from a recent low around USD 70-75 to currently over 271. I’m sure this has to do with several consecutive earnings reports in which they demonstrated that they could:
- Increase the number of subscribers and even re-accelerate growth despite their huge size
- Squeeze more money from subscribers and increase ARPU, despite growing quickly outside of Europe and the USA where revenue per user tends to be lower.
While this is positive news and doubling premium subscribers since 2020 (while facing heavy competition) is impressive, I’m struggling to see how they will ever turn this revenue into profit.
The problem is twofold:
Spotify is totally beholden to major music labels which operate in an oligopolistic market. Spotify pays royalties to labels whenever a song is played, and they cannot at all afford to lose any of the labels. No one would use a music streaming service that is missing the entire catalogue of all major artists signed to one of the labels. So as Spotify gets more users, not only do they automatically have to pay more money for more plays, the labels can renegotiate and demand more money. This problem becomes apparent in their gross margins (more on that later).
Spotify is the only major pure play music streaming service. Their competition is Apple Music, Google/Youtube Premium, Amazon Prime. Excluding China, these make up well over 90% of the global market, but all their competitors have far more ability to bundle their services/subscriptions and run the music streaming at loss/breakeven by increasing royalty payments. Now, Spotify holds about 30% of the global market share compared to Apple Music at 13.7%, Amazon at 13.3% and Google at 9% (according to MIDIA Research). So they are the market leader by far which has its benefits. But switching streaming providers, while not totally painless, is easy enough that I believe they would lose a lot of subscribers if they raise prices too high.
A few numbers that seem to underline my thoughts:
In 2023 they raised premium prices for the first time ever(!) in the USA, to 10.99. This is the same exact price as Apple and YouTube Music (without YouTube Premium). While a good deal for customers, it shows they have no pricing power.
Their gross margin in the last quarter was 25.6%. Not only is this in fact lower than their gross margin right after their IPO 6 years ago (25.7%), it is a margin that doesn’t seem to support their valuation of 3.6 currently.
Premium subscriptions are their main source of revenue at 86% of total revenue. This number has not changed in over 2 years. Ad supported revenue not only has a terrible 11.6% gross margin but is not growing in a meaningful way.
Their other initiatives like podcasting and some hardware experiments have mostly failed. In fact they decided to release the Joe Rogan podcast on other services despite sinking several hundred millions into it. they are now trying to push audiobooks and merch sales as new profit drivers. Those are nice to have but I doubt they’ll make a meaningful difference. It seems to me if you are enough of a fan of an artist to buy their merch, you will just do it on their Website.
Their one positive seems to be increasing free cash flow, which has roughly doubled in the past three years. They seem to be succeeding at generating some operating leverage. However with a 26% gross margin their biggest cost driver by far remains royalty payments.
I guess the stock has some appeal as the market leader and main pure play publicly listed music streaming company, but to me it seems like a short candidate. What am I missing here?
