Good visibility on Recurring Revenue Growth
Tracking Streams – We have analyzed billions of streams across Spotify’s major markets. Streamed tracks on Spotify were increasing at compound monthly growth rates between 1.5% in the U.S.to over 13% in Japan (a U.K. market monthly compound growth rate at 0.2% was due coming off a high base from Ed Sheeran streaming). Streams are what drive growth in Spotify’s two pipelines to premium subscriber growth (i.e. recurring monthly subscriber fees).
- Free and discounted trial users – Users typically convert from discounted and free trials to paid within a 36-month. Free and discounted trials require entry of credit card information.
- Ad-supported users – Spotify has stated that its ad-supported users (5% gross margin) are a pipeline for future premium subscribers. 60% of premium users were at one point, ad-supported users.
Why Streams Matter?
Streams are the first factor that can be tracked that will determine future premium subscribers. Below is generally the order of how Spotify gains premium subscribers.
Streams -> Monthly Active Users (MAUs)-> Ad-supported users -> Free/Discounted Trial Users -> Higher Content Hours -> Premium Subscribers.
Once content is recorded for greater than zero milliseconds over the last 30 days it is included as an MAU. These are reported on every quarter and would generally be a good starting point to look at future trends.
However, users who sign-up as a US$10/month (country dependent) Spotify premium user consume on average 3x the amount of content as an ad-supported user. As a result, higher content hours we believe is a necessity to predict higher premium subscribers (recurring revenue) as well. The precursor to high content hours are weekly streams.
Recurring Revenue Growth – In addition to short-term indicators, low country penetration, low ad rates, improving churn rates and an established promotional model for increasing MAUs (both free and premium) makes us believe 20%+ sales growth can continue for at least the next five years. We expect sales growth to slow as the market saturates.
How the stock trades – With SPOT only listing on April 3rd, there is not a long trading history to go off on.
Exhibit 1: SPOT vs. NASDAQ Composite Since Direct Listing on the NYSE
Source: Perspectec
Exhibit 2 – SPOT’s Sales Results and Perspectec’s Forecast
Source: Perspectec
25% Gross Margins mean the Business Model is Questionable
Spotify reported gross margins of 20.8% in 2017 after seeing up and down gross margins in the teens the last four years.
Spotify has signed new deals with Universal (April 2017), Merlin (April 2017), Sony (July 2017) and Warner (August 2017) that provided Spotify with roughly a 300 to 700 basis point improvement in pricing according to our estimate. These labels represented over 88% of the U.S. music market share and a large majority of the Global music market share.
However even after these deals, gross margins are tracking to Spotify’s guidance range of 23% to 25%. We forecast gross margin to be $1.26 billion (24.4% GM%) in 2018 versus operating expenses of $1.56 billion.
Longer-term, gross margin improvements are expected to come incrementally from scaling into minimum guarantees to labels, payments made to artists and groups outside the control of major labels, and possibly some form of subscription upsell. However, all of these appear to be a story for 2019 and beyond, and improvements are likely to be gradual.
Exhibit 3 – SPOT’s Price Sensitivity to Gross Margin and Churn
Source: Perspectec
2018 Operating Margins Will Likely Be Closer to the Low End of Their Guidance Range
Whichever way the costs are sliced, operating margins appear unlikely to improve at the rate that Spotify has guided towards at the mid-point of their 2018 guidance.
Exhibit 4: Financials Expectations for Q1, 2018 and 2019
Source: Perspectec
Source: Perspectec
Given the structurally low gross margins due to 50%+ royalty rates and approximately €1.06B in minimum guarantees due to music labels in 2018, we believe the company needs to take a non-traditional approach to its operating model in order remain viable. While -9.2% GAAP EBIT margins do not appear unfixable, in relation to gross margin, they are very material and are not likely to improve anytime soon.
Exhibit 5 – Revenue Dollar Growth Should Accelerate Versus EBIT Losses
Source: Perspectec and Company filings
Exhibit 6 – EBIT Losses Will Remain Material in Relation to Gross Margin Dollars
Source: Perspectec and Company filings
Sales and Marketing costs – They have salaried employees dealing with advertisers and about 1,500 employees Globally in sales and marketing. Costs as a percentage of revenue for S&M costs were 13.9% of revenue in 2017 versus 11% for Netflix. However, embedded in S&M costs are expenses associated with free trial royalty fees. Reducing free trials will lower S&M but will negatively impact the pipeline of new business.
R&D costs – During Spotify’s 2018 Investor Day, CFO Barry McCarthy laid out several long-term goals, one of which was for R&D as a percentage of revenue to rise above 12% from 9.7% in 2017. As a point of reference, Netflix R&D costs were at about 9% of revenue. The last data point is that the CFO stated in March that “you should expect us to continue to invest in growth.”
We are forecasting breakeven net income by 2021, but even if Spotify is able to achieve slight profitability this quickly, we do not believe this will be quick enough for investors. The road to an EPS valuation at this point does not appear achievable.
We view Advertising as a Subsidy on Customer Growth Costs (CGC)
In fiscal 2017, the gross margin produced by the ad-supported business amounted to roughly 5% of overall gross margins and 10% of ad revenue. Spotify has stated that advertising MAUs act as a customer funnel for premium users. As their subscription business is likely the only profitable standalone business over time, we believe Spotify should be valued with advertising gross margin being deducted from sales and marketing expense (and as a result a credit against CGC). Making these adjustments allow the company to be valued in a similar way to larger media peers such as Netflix and Sirius.
Decreasing S&M expense by ad-supported gross margin decreases S&M expense as a percentage of sales from 13.9% to 12.8%. The advertising business increased the number of active users on Spotify by 14 million in 2017. Given the number of conversions to premium subscribers, the ad-supported model has proven to be a very good use of funds in place of spending the same amount of money on marketing and promotions.
Our view appears to differ from the consensus view of Spotify (ads as a separate revenue source). While improvements for advertising gross margins are on the horizon due primarily to low ad load rates (relative to Pandora), Spotify appears aware that excessive loads can damage growth and prevent users from interacting with their best in class content discovery and recommendation engines. In addition, the majority of future growth in content hours will come from international users from developing countries where ad rates are materially lower. We believe a material increase in ad load rates is a signal that Spotify would be taking steps to move from subscriber growth to profitability.
Exhibit 7: SPOT Ad-Supported Business is Not Expected to Contribute Materially to Spotify’s Profitability
Source: Perspectec and Company filings
Using a Relative SaaS Valuation versus Netflix, Sirius and Pandora, We Get to A Valuation For Spotify
Absent visibility to positive EBITDA, we believe Spotify can be valued on a trailing 12-month CLTV added ratio (Price / TTM CLTV Added) acknowledging it is still very much in the early growth stages despite its size. Our forecast model of dilutive market capitalization using a SaaS valuation has an r-squared of 0.992.
We initiate our coverage with a 6-month price target of $86 based on a 120x multiple, in-line with Netflix and SiriusXM and a steep premium to Pandora
Our target is based on the estimated Q2/18 trailing 12-month Customer Lifetime Value (CLTV) added of EUR120 million. This translates to $145.2 million in TTM CLTV added. Multiplying the Q2/18 TTM CLTV by the 120x multiple equals a $17.4 billion market capitalization. Dividing that by an estimated 201.6 million shares outstanding we get to a share price of $86.
Our take on Pandora – A significant premium to Pandora is warranted, in our view, due to Pandora’s presently increased reliance on advertising revenue (78.5% in FY 2017), declining gross margins from content costs, scale issues, and deterioration in engagement metrics.
We believe investors are still treating Pandora as an internet advertising business and note that the company has taken significant steps to change course including the hiring of former SlingTV CEO Roger J. Lynch in 2017. We think Lynch recognizes the necessity of a shift to a subscription service, and was brought on with the intention to accomplish that task.
Exhibit 8: SaaS Retail as of April 27, 2018
Source: Perspectec
Exhibit 9: Spotify is Expensive Relative to Other Retail SaaS Companies on a Price / TTM CLTV Added Basis
Source: Perspectec
Price / TTM CLTV Added Captures the Value of the Business to an Acquirer
While we recognize that this metric does not capture operating expenses. However it does encapsulate the primary valuation metrics that make Spotify an attractive asset:
Revenue and subscriber growth – We do not believe revenue growth is likely to decrease below 20% in the next five years
Gross margin improvement – Recently driven by contract renegotiations and in the future being driven by new product offerings to artists and labels.
Customer loyalty improvements (churn rate) – Spotify programs approximately 31% of all listening on its platform versus less than 20% two years ago. This is being done through both machine learning and editorially-curated playlists. Increases in R&D along with continued promotions are expected to increasingly reduce churn.
These three factors are similar to those driving Netflix – However, Spotify is likely to have a much tougher time solving the content cost problem. Unlike Netflix, in which media producers are typically free to find any form of funding to finance their productions, the music industry is an oligopoly of labels that control the most popular content. This has forced platforms including Spotify to pay labels largely on a per streamed basis or as a percentage of revenue (50%+).
An alternative Price / TTM CLTV valuation method which contemplates the existing value of Spotify’s customer base rather than the growth in customer value does not present a more favorable view on its current attractiveness.
Exhibit 10: Spotify is Expensive Relative to Other Retail SaaS Companies on a Price / TTM CLTV Basis
Source: Perspectec
Why are Gross Margins So Low?
Since 2013, Spotify has stepped up their engagement in fixing this issue (seen in Step 3 of Exhibit 9 below), both intimating its long-term intention to operate in a publishing capacity as well as obtain more favorable deals with existing rights holders.
Exhibit 11: Royalty Payment Structure Described by Spotify in 2013
Source: Spotify, Stereogum
Gross margin expansion in 2017 was primarily attributable to two factors:
Negotiated large fixed payments while royalty rates were lowered – Spotify conceded paying out larger future fixed minimum guarantees for music licensing, amounting to approximately €1.06B in 2018, as part of securing a more favorable percentage cut of revenue with music labels. Typically Spotify pays the larger of the two amounts.
Re-classification of student and family plans – Spotify was able to convince major music labels to treat student and family plan subscriber accounts more favorably than standard premium accounts when determining revenue payout calculations. We estimate greater than 50% of Spotify’s userbase does not fall under a standard premium subscription plan.
Encroaching on the Oligopoly is dangerous – Fundamentally, the issue that remains is major licensing deals have historically not lasted for longer than two years at a time, are still high in variable costs (we estimate greater than 50% of the payments labels receive from Spotify), and each side demands an increasing number of concessions out of the other as contracts expire. Music rights being concentrated in the hands of so few providers makes Spotify’s best chance to escape this problem encroachment into the business model of music labels, an act that could potentially cause friction between them in future negotiations.
Subscribers can receive our Stream analysis by request by emailing general@perspectec.com.
Summary of Risks
Risks to the Stock Moving Higher
Tencent valuation – A successful IPO of Tencent Media Entertainment that places TME’s valuation materially higher than Spotify.
Bundling with a subscription service – A significant bundling deal with a major mobile carrier (example:a free subscription with 2-year Verizon contract) or media company (example a combined Netflix and Spotify subscription for a discounted price). Depending on the terms this could be a positive for the stock price and be used to help beat quarterly expectations.
Bundling with an auto manufacturer similar to Sirius – A hardware product announcement tied to the car similar to Sirius would be a positive to the stock price.
Exhibit 12: Shareholder Voting Interests at Spotify
Source: Perspectec and Company filings
Summary of Sell
The most expensive of its peers – The stock is expensive in terms of its relative valuation to Netflix, Sirius and Pandora using a metric that values all three of them in the most detailed fashion, customer lifetime value added to their dilutive market cap.
Profitability may not ever happen – Recent comments from the CFO at the company’s investor day took us by surprise. While “We will continue to invest in growth at the expense of operating profit” is not the first time we have heard this, He said that the company expects that such growth will ultimately increase the company’s enterprise value. There has been no talk about when the company expects to reach profitability.
No info on upcoming businesses – Few details on timing or specific ways Spotify can take a role in music publishing have come out. Having these undefined new businesses become material to company-wide gross margin appear whimsical at this point.
Losing large lawsuits – Unfavorable outcomes relating to several of Spotify’s large pending legal battles over copyright and past royalty disputes. Spotify is the current target of a $1.6B lawsuit alleging past copyright infringement by Wixen Music Publishing among several others.
The potential for misalignment of goals with shareholders – Founders Daniel Ek and Martin Lorentzon control 37.0% and 43.5% of the voting power in the company respectively (80.5% in the aggregate) through beneficiary certificates which carry voting rights but no economic interest. Spotify’s articles of incorporation provide the additional ability to create 1.4 billion more of these certificates which carry up to a 20-to-1 voting interest in the company. Spotify’s founders are effectively immunized from outside influence and they may choose to disregard the advice of their board of directors on matters that represent the interests of other shareholders.
2018 Q1 Non-Financial Highlights
Exhibit 13: Non-Financial Key Performance Indicator Forecast
Source: Perspectec
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For the purposes of complying with NYSE, NASDAQ and all Self-Regulatory Organizations, Perspectec Inc. has assigned the following rating system BUY, HOLD/NEUTRAL, SELL for the securities which are the views expressed by an analyst, Independent contractor, and or an employee of Perspectec Inc. The information and opinions in these reports were prepared by Perspectec Inc. or an analyst, independent contractor. Though the information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Perspectec Inc. makes no representation as to its accuracy or completeness.
