Introduction

Founded in 2006 by Daniel Ek and Martin Lorentzon, Spotify has evolved into a dominant force in the music streaming industry, but it finds itself at a crossroads as market sentiments shift. While Spotify's growth trajectory and profitability have been impressive, skepticism surrounds its long-term viability against formidable tech giants like Apple, Google, and Amazon.

Market Sentiment: A Tale of Two Theses

The current market (2022) landscape is sharply divided. On one hand, a bearish outlook prevails as Spotify's stock price hovers near its initial public offering (IPO) value, casting doubt on its future prospects despite a significant user base and revenue growth. Critics argue that Spotify is vulnerable to competition from major tech players, which can leverage their resources to offer more competitive pricing. Moreover, with the music industry largely dominated by oligopolies—Sony, Warner, and Universal Music Group—holding approximately 70% of music rights, Spotify's gross margins remain under pressure. Detractors suggest that the lack of a competitive moat and the continuous erosion of average revenue per user (ARPU) will stifle profitability, contrasting sharply with the business models of companies like Netflix.

Conversely, the bullish thesis highlights the expanding Total Addressable Market (TAM) for music streaming. The proliferation of smartphones in emerging markets such as China, India, and Africa, along with a decline in music piracy, suggests substantial growth potential. Proponents argue that as Spotify invests in original content and scales its platform, its gross margins are poised for improvement. With a reputation for strong user engagement and double-digit growth rates, Spotify is viewed as a leader in an industry undergoing significant transformation.

A Historical Context

The music industry has witnessed dramatic changes over the decades, from Sony's launch of the Walkman in 1979 to the advent of digital formats like MP3s. In the early 2000s, the industry hit an iceberg, experiencing a severe downturn characterized by a significant shrinkage in the music industry, exacerbated by piracy from platforms like Napster and BitTorrent. This led to a staggering shrinkage of 54% between 2000 and 2014, an era described as "The Rise of Gotham." However, the truth is that this crisis ultimately benefited the industry by accelerating the transition to digital, reducing reliance on physical discs.

The rise of streaming services like Spotify and other key players has been a game changer. By 2020, the market rebounded dramatically, growing from $5 billion to $13 billion, fueled by an attractive value proposition and the widespread adoption of streaming. Despite this resurgence, piracy remains a challenge, with many users still turning to illegal sources to discover new music. Additionally, radio continues to play a significant role, accounting for about 50% of music consumption today.

Understanding Spotify's Business Model

At the core of Spotify's operations are its unit economics. Revenue is divided primarily between creators—such as artists—and record labels. For instance, artists who write their own songs retain about 20% of the royalties, while labels claim the remaining 80%. This revenue split exemplifies the broader challenges Spotify faces in maintaining profitability amidst high royalty costs. Investors like Bill Ackman argue that market power and value are in the hands of the record labels. The companies that hold the copyright or the 'gatekeepers'—Sony, UMG, and WMG—control about 80% of the music rights in the world, a percentage that is gradually decreasing.

How do they operate? A bit like a venture capital fund, they invest in seed rounds as well as regular M&A (but for artists). Bulls believe that Spotify has more power than it seems, as the company is improving its terms with the labels with each new contract signed. Essentially, Spotify is gaining more pricing power against those labels, and soon they may need Spotify more than Spotify needs them.

The global Total Addressable Market (TAM) for music streaming is expanding rapidly, driven by rising smartphone adoption. With only 12% of the estimated 467 million paying music streaming users worldwide subscribing to premium services, significant growth opportunities remain. While music competes for consumer attention against social media and gaming, it retains its status as the most time-intensive entertainment activity, with the average person consuming 26 hours of music per month. In comparison, they spend 14 hours on platforms like Facebook and Instagram and slightly less on gaming. This indicates that consumers invest the most time in these platforms, which cost them the least, highlighting an opportunity for monetization in music streaming.

Revenue Streams and Growth Drivers

Spotify's dual revenue streams—advertising and subscriptions—are critical to its business model. While advertising contributes around 10% of total revenue, subscriptions yield a higher ARPU of $51, although this figure has been declining due to growth in lower-ARPU markets. Key performance indicators, including user growth, ARPU, and smartphone penetration, remain essential to monitor.

Spotify has consistently grown its user base at an impressive 30% annually, reaching 381 million monthly active users (MAUs), with 45% of them being paying subscribers. While ARPU faces downward pressure, robust smartphone adoption and user growth continue to paint a positive picture for the company's prospects.

(2024 update)

A promising advertising segment, particularly through Spotify's entry into the $17 billion radio advertising market with its product "Car Thing," could significantly enhance its gross margins. Additionally, the podcasting market, valued at $1.3 billion and growing at 22% annually, represents an under-monetized opportunity for Spotify. The company has invested heavily in this space, acquiring various firms and partnering with high-profile personalities to enhance its content offerings.

Competitive Landscape and Differentiation

As Spotify navigates a competitive landscape dominated by major players like Apple and Amazon, it faces significant challenges. Amazon boasts 55 million users and a 13% market share, while Apple commands 78 million users and 19% of the market. YouTube, with 50 million paying subscribers, poses a growing threat with its rapidly expanding subscription model. Despite these challenges, Spotify currently leads the market with a 38% share.

One of Spotify's differentiating factors lies in its data collection capabilities, which feed into a sophisticated recommendation algorithm. Spotify gathers twice as much data as its competitors, enabling it to create an incredibly amazing user experience. The discovery feature enhances user engagement, and as users interact more with the platform, additional information about them is added to the algorithm. This flywheel effect ultimately improves the lifetime value (LTV) of users, as they are significantly more engaged than those on other platforms.

Looking Ahead: The Vision of Daniel Ek

Spotify's ambition, articulated by CEO Daniel Ek, is to become the "Google of audio," transcending music to encompass podcasts, audiobooks, and the broader creator economy. If successful, Spotify's current TAM and gross margin estimates may significantly underestimate its long-term potential.

Daniel Ek, who founded Spotify at the age of 23 and holds a 17% stake in the company, brings valuable experience from his previous roles in the tech sector. His vision and leadership will be pivotal as Spotify seeks to navigate the complexities of the music streaming industry and leverage emerging opportunities.

With Spotify proving to be one of the standout performers in recent years, investors remain cautiously optimistic, ready to reassess their positions should valuations escalate beyond reasonable expectations.

Today (October 24')

Spotify has been one of our biggest winners. The bullish thesis has become a reality, with the market reacting quickly and aggressively, resulting in a 200% return since then. Why is that? The market has begun to understand Spotify's moat and value proposition. The company has demonstrated strong free cash flow, stable growth, and numerous growth opportunities. Even with the recent stock uplift, we continue to believe in its long-term potential and plan to partner with this business for many more years to come.

(Media: BBC, Pitchfork, Boson Blog, Millennial Entrepreneurs)

Disclaimer: This article is for informational purposes only and should not be considered financial advice. Our hedge fund may hold positions in the companies discussed and may actively trade in these securities. Our views are based on publicly available information and our internal analysis, which are subject to change without notice. We encourage readers to perform their own research or consult with a professional financial advisor before making any investment decisions. We assume no responsibility or liability for any errors or omissions in the content.