Spotify

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

A digital audio streaming service that provides access to a vast library of music, podcasts, and other audio content.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Spotify operates on a freemium model, where users can access a basic service for free with ads, or subscribe to a premium version without ads and with additional features.

Business Overview

Spotify generates revenue primarily through two main streams:

  1. Premium Subscriptions: This is the core of its revenue. Spotify charges its premium users a monthly subscription fee for ad-free listening, offline downloads, and higher audio quality.
  2. Advertising: Spotify also sells ad space on its free tier to advertisers. This revenue depends on listener engagement on the free tier.

The company’s revenue is largely determined by the volume of subscribers it can acquire and retain for its premium service, and ad impressions for free users. The company operates a global platform with customers all over the world, but is heavily dominated by revenue from Europe and North America.

The global music streaming industry is characterized by several key trends:

  • Increasing Streaming Adoption: Streaming is increasingly becoming the dominant way people consume music, moving away from physical formats and downloads.
  • Podcast Growth: Podcasts have seen a surge in popularity, creating an avenue for new content and revenue streams, which Spotify has invested heavily in with the purchase of Anchor and Gimlet Media.
  • Intensifying Competition: Competitors include giants such as Apple Music and Amazon Music, as well as other players like YouTube Music and Deezer. The battle for subscriber share is fierce.

The company’s margins tend to be quite low due to the structure of the music streaming industry which has many stakeholders which require a cut: Music labels, publishers and artists. While subscriber growth has fueled an increase in gross profits, the company has struggled to show consistent profitability, partly due to the cost of royalties to the labels which accounts for the largest expense for the company.

Spotify’s Differentiation

  • User Experience: Spotify has invested heavily in providing a great user experience, and is well-regarded for its easy-to-use user interfaces. This has also benefited from a heavy emphasis on personalization through algorithms which recommend new music to listeners based on their preferences.
  • Podcast Focus: The company has invested a lot into the podcast space, creating proprietary content, and increasing their appeal to new users.
  • Large Scale: The scale gives the company a large platform where artists, podcasts and publishers distribute their content.
  • Global Presence: The platform has an unmatched global presence, allowing users to listen to content not normally available to them.

Financial Analysis

Let’s dive into Spotify’s financials, paying special attention to the latest reports and earnings calls.

Revenue Growth: Spotify has shown a consistent high rate of growth in revenue, with total revenue increasing from $11.72 billion in 2022 to 13.1 billion in 2023. The main revenue driver has been growth in premium subscribers, with ad-supported revenue being more cyclical and inconsistent. The company is forecasting higher growth in ad revenue with their new advertising marketplace.

Gross Profit: The company has been seeing consistent growth in gross profits over the years, mostly due to growth in their subscribers, as well as increases in average revenue per user. Still, the gross margin is quite low as most revenue goes towards paying the record labels and content creators their dues. The company has seen some positive movements in gross margin over the last years, mostly through improvements in their pricing power.

Operating Expenses: Spotify’s operating expenses are primarily driven by Research and Development, sales and marketing, and general and administrative costs. R&D expenses increase because of heavy spending in new AI products, sales and marketing costs have also increased due to global expansion and marketing campaigns. As a result the company still struggles to maintain profitability.

Profitability: Despite its robust revenue growth, Spotify hasn’t achieved profitability. In 2023 the company had a net loss of $562 million. This is a function of high costs relating to operations, research and development, and a high cost of revenue, mostly from royalty payments. Despite the persistent losses, the company’s guidance for a breakeven or profitability is still not in place, even though in the last earnings call the management reiterated that “profitability is their goal”. They forecast that the free cash flow will increase to 1.6 billion by 2025, and the operating margin will have consistent improvement over the next few years as they become more efficient.

Cash Flow: The company’s free cash flow is starting to show a good trajectory as the growth in revenue is starting to outweigh operational expenses. As the company matures, it is starting to leverage its existing infrastructure and is spending more efficiently. The company generated $353 million in free cash flow in 2023, and forecasts $1.6 billion in 2025, which are very positive signs for the company.

Balance Sheet Health: Spotify has a debt-equity ratio that has remained relatively stable in the recent years, but it also has a considerable amount of lease obligations. Although cash flows are improving, the company still isn’t a very profitable business. With debt, leases and other obligations, I’m giving the company a “3” for balance sheet health.

Recent Concerns and Controversies: Spotify has faced controversies in the past, especially about its low royalty payments to artists, however the company has made moves to be more transparent and friendly to artists and content creators.

Another key concern is about the company’s profitability. Despite heavy revenue growth, the company still shows a net loss. This has led investors to question how well the company will manage future growth and how much more investment is necessary to reach profitability. Another issue with the current business model is high dependence on record labels. While Spotify has a massive scale, they depend on record labels for their content. Therefore they have to pay a lot of their revenue to these labels, which makes the company very sensitive to negotiations with labels and to any changes in the industry regarding copyrights and content availability.

Another issue of concern is the intense competition. Spotify is now competing with giants like Amazon and Apple, as well as some popular free platforms like Youtube Music. This puts pressure on the business model and can be a drag on growth prospects. The company also continues to invest heavily into podcasts to try to gain dominance in that space as well, however that market is becoming increasingly competitive. Despite this, Spotify remains the global market leader in streaming music. Spotify has also faced concerns regarding the recent price increase for its users as a way to reach profitability. The company has also faced increasing scrutiny from governments about potential abuses of streaming power, since it is a main gateway for artists to make money, but because the market is fairly concentrated in the hands of few major labels, that power remains in the labels, rather than in the artists or the platforms.

Moat Analysis

Spotify’s economic moat is rated as 2/5. This is for a few reasons. The primary strength lies in its network effect and brand recognition. The company is the global leader in music streaming, which gives them a unique position to acquire content and users. A big portion of their listeners will use the same platform as all their friends, thereby giving Spotify a network effect, and they have done well to brand the app as the best place for music streaming. Spotify also benefits from switching costs which are considerable, because after you’ve spent time curating lists, creating personalized recommendations, and getting used to the platform, it is hard to move to another platform and start fresh. This provides some resistance to customer churn. However, there are clear risks:

  • Low Differentiation: The product is mostly commoditized, with its main function being providing access to the same songs as their competitors for a similar subscription cost. While the company has focused on better UI and personalizations, this may not be enough in the long run to fend off a larger and more aggressive competitor.
  • Intense Competition: The rise of other platforms has made pricing a competitive edge. Competitors are willing to forgo profitability to gain market share, which leaves Spotify at a disadvantage. And given the fact that labels want to maintain power, they give limited exclusivity to the platforms, further decreasing the companies differentiation.
  • Limited Pricing Power: The company has very limited pricing power as music is a commodity. If Spotify was to increase prices, it is likely that users would go to competitors that have a similar catalog.

Understandability Rating

Spotify gets a 2/5 on the understandability scale. While the basic business model of music streaming is easy to understand, the complexities of the music industry make the financial implications difficult to project. The various moving parts and contracts with labels, advertisers, and content providers make it difficult to understand the company’s profitability picture. The lack of profitability also makes it hard to understand the business, how the company will grow, and how much further investment the company might need before becoming a self-sustainable business.

Final Thoughts

Spotify remains the global leader in its market and has built a considerable amount of brand recognition and a network effect, but it is still a vulnerable business because of lack of differentiation, a heavy reliance on record labels, and a cutthroat competitive environment. The company is also not profitable, and requires continuous investment to stay relevant. Therefore, while the company may be valuable in the future, it comes with substantial amount of risk.