Spotify Investment Thesis

1. Spotify Investment Thesis
A company which fits into my investment philosophy is Spotify Inc.
Spotify Inc listed on the NYSE on 3 April 2018. Since its inception in April 2006, Spotify has grown to
be an international audio streaming platform, with more than 248 million Monthly Active Users
(MAU) in more than 79 countries. LTM revenue from Spotify was US$6.4 billion, and was growing at
28% YoY. In my opinion, Spotify Inc makes an attractive investment because of the following
reasons: (i) its business model is coherent and is set up to optimize cash flow; in short, the business
is very cash generative, (ii) there are various growth levers for them to reinvest their cash flow to
generate more value for the company, (iii) management are very shrewd and capable to spot
industry trends, and have strong track record in executing strategy.
Spotify is very cash generative
A company’s ability to generate cash is strongly tied to its business model. Spotify Inc has a coherent
business model, which allows it to be very cash generative, despite being a young company.
Figure 01: Value chain for music industry
Source: Author’s work
Figure 02: Functions and roles performed by various players in the music industry
Players Roles / Functions
Artist/ Song Writers Content producer
Record Label Marketing of artists
Spotify Channel for helping artists reach end users
Consumers People who consume music
Source: Author’s work
Spotify is an audio streaming platform, connecting streamers (or users) to artists (or singers). Users
can either (i) sign up and pay a monthly subscription fee to Spotify or (ii) use Spotify’s audio
streaming services for free and are subjected to advertisements. The former group of users will be
referred to ‘premium users’, and the latter group of users will be referred to as ‘ad-supported
users’. Premium users pay Spotify a monthly flat fee before the start of each month before Spotify
provides them the services, and advertising companies pay Spotify the advertising fees, before the
advertisements are broadcasted to the ad-supported users. Therefore, Spotify’s revenue structure is
set up in a way that it receives its cash, before the revenue is earned.
Spotify does not own any record company or artists. Instead, it relies on the “Big Three” music
record labels – Universal Music Group, Sony Music Group and Warner Music Group, who will
manage the relationships with different artists / songwriters / singers. Spotify then pays these music
record labels royalty and distribution costs at the end of the month primarily based on the number
of songs streamed. Royalty cost, which is recorded as cost of revenue, makes up ~75% of Spotify’s
operating cost, with the remaining ~25% operating cost being R&D, sales and marketing, and general

2. and administrative expenses. These are mainly staff wages, which are distributed at the end of the
month. Spotify pays record label companies and its employees only after they have performed their
obligation. Therefore, Spotify’s cost structure is set up in a way that it pays out cash, after the cost is
incurred.
With this, we can see that Spotify’s revenue and cost structure are very cash generative. Instead of
using cash, Spotify relies on its working capital to generate cash. In fact, the more Spotify grows, the
more capital Spotify generates. Spotify then can use the capital raised for investment in marketing
and R&D, which will be explained in the later part of the report.
Figure 03: Spotify’s cash flow statement
Source: Spotify’s prospectus
The music streaming industry is growing and underpenetrated
Music streaming revenue increased by 60% in 2016, reaching $4.6 billion. This growth is occurring
concurrently in many markets.
Figure 04: Market trend favouring music streaming
Source: Spotify’s prospectus
In fact, music streaming is still in its early days and is relatively underpenetrated. Spotify, being the
market leader in music streaming, only has ~250 million MAU. According to Spotify’s prospectus,

3. Spotify’s market share was ~42%. This implies that there are ~600 million users who use streaming
services worldwide. Music streaming, with a global appeal, is very underpenetrated as compared to
Facebook, with an estimated 2.0 billion users and YouTube with an estimated 1.5 billion users.
Furthermore, there are over 3.6 billion Internet users, and this number continues to grow. This
implies that the potential market size can be ~3x to ~6x its current market size.
Spotify is well-positioned to capture this growth in music streaming industry, because of its strong
distribution capability among the music streaming companies which results in the lowest
customer acquisition cost.
The shift from listening to CDs to streaming songs is analogous to the shift from watching TV to
streaming shows online. Netflix and other video streaming companies are replacing TV channels as
customers’ preferred way of access video content. Likewise, if we were to think about the shift to
digital streaming, music streaming companies are replacing the CD shops to become the new go-to
channel for artists to reach end users or consumers. As a distribution channel, music streaming
companies compete based on their distribution capabilities, and Spotify has the strongest
distribution capabilities among its peers because (i) it has the access to largest consumers group as a
result of its independence, and (ii) it has an effective customer acquisition strategy via freemium and
tie-up/ partnerships with other companies to acquire customers.
Unlike many of its peers like Apple Music and Amazon Music, Spotify is truly independent and is not
a subsidiary of any other businesses, and effectively it has the largest Service Addressable Market
(SAM) among the music streaming companies. The second and third largest music streaming
companies, Apple Music and Amazon Music, are not truly independent, as they are linked to Apple
and Amazon respectively. Apple and Amazon’s purpose for going into music streaming is to enhance
their core products. Most people who use Apple Music tend to be iPhone users and not Android
users, while most people who use Amazon Music tend to be Amazon Prime users. Therefore, Apple
Music’s SAM is effectively capped by the number of iPhone users, and Amazon Music’s SAM is
effectively capped by the number of Amazon Prime users. Since Spotify is truly independent, its SAM
is much larger than Apple Music and Amazon Music. In other words, Spotify has access to the largest
group of end users. Since marketing cost is mostly fixed cost and it is spread out among the largest
number of potential customers, Spotify effectively has the lowest customer acquisition cost among
the various music streaming companies.
It is no use if Spotify has the access to reach the largest group of end users, but is unable to convince
these end users to join Spotify’s music streaming platform. Spotify has an effective customer
acquisition strategy (freemium model and partnership with other companies), which allow it to
convince end users to join its platform.
Unlike Apple Music and Amazon Music, Spotify has a freemium model, which reduces friction for
customers to try its product. The freemium model works in three folds. Firstly, Spotify ropes the
customers by allowing users to use its service for free, in return for advertising fees. Secondly,
Spotify then promotes its free trial to users. Thirdly, after Spotify manages to successfully convince
users to join the free trial, it then tries to convert them to paying users. From a customer
perspective, there is little incremental cost incurred on their part to commit to the next stage. This
effectively reduces friction for users to use Spotify’s services, rather than Apple Music and Amazon
Music, which skip the first stage and ask users to try a free trial, before joining as a paying user. This
is congruent with what are disclosed in Spotify’s prospectus. “Our Ad-Supported Service serves as a
funnel, driving more than 60% of our total gross added Premium Subscribers since we began
tracking this data in February 2014.”.

4. From Spotify’s perspective, freemium model provides Spotify another advantage. Besides being able
to reduce friction for customer to try its product and gain new paying customer, freemium model
provides another revenue stream for Spotify, as it is still able to monetize its free users via
advertising. On a Gross Profit Margin level, it was 10% in 2017, and has been increasing to 16.0% in
2019 Q3.
Figure 05: Spotify’s gross margin for premium and ad-supported users in 2017
Source: Spotify’s prospectus
Figure 06: Spotify’s gross margin for premium and ad-supported users in 2019 Q3
Source: 2019 Q3 Press Release
Hence, this freemium strategy not only serve as a customer acquisition strategy, but also a revenue
stream for Spotify, which further reduces its customer acquisition cost. This business model has
allowed us to achieve scale with attractive unit economics and is a critical part of our success.
Furthermore, Spotify has other great customer acquisition strategy. Being independent, Spotify can
have more tie-ups with other companies such as Hulu, which allow it to reach more users. In
addition, Spotify heavily advertises to the youth such as students, and its audience is skewed to
young users. This group of users is the best group of users, as this group of users with highest
Customer Lifetime Value (CLV) as compared to adult users because they will spend more over the
lifetime on Spotify’s product if Spotify keeps them within the ecosystem throughout their lifetime.
Besides having the lowest customer acquisition cost, Spotify has the lowest customer retaining
cost. To retain the customers, Spotify constantly researches on how to improve its product – how to
improve its algorithm such that it can recommend new songs which users like. Therefore, R&D
expenses can be thought of as the maintenance capex. This R&D maintenance capex is fixed cost,
and similarly to marketing expenditure, Spotify can spread out this expenditure among the largest
group of users, which allows Spotify to have the lowest customer retaining cost.

5. From the user’s perspective, the cost of leaving Spotify’s platform increases as the longer the user
stays on the platform because of (i) the playlist feature, and (ii) the song recommendation. The
longer the user stays on Spotify’s platform, the more songs they save to their playlist, the harder it is
to migrate the playlists and their personal song library to another platform. Based on the customers’
usage of the music streaming platform, Spotify is then able to harvest the data to understand
customers’ taste and recommend new songs to suit the users’ taste. The longer the users stay on
the platform, the more data Spotify it collects, the better Spotify is able to customize the data to
understand the users’ taste, the better the song recommendation. (It pays to be first-mover)
Spotify and other music streaming platforms have the ability to raise price once market reaches
maturity, which will benefit and improve its long-term margin.
Spotify and other music streaming platform are underearning to drive users’ adoption, especially in
emerging market. Consumers used to pay 10 dollars for a CD, but now they are getting ~10 dollars a
month to have an entire access to song library. Furthermore, like Netflix, Spotify is promoting
student plan and family plan, which are priced at US$5 per month per user and US$15 per month for
up to six users respectively, which are much cheaper than the regular US$10 per month for its
premium subscribers. ProfitWell, a subscription metrics platform, collected data from 7000 users
and found that Spotify is leaving some money on the table. The study found that consumers are
willing to pay US$19 per month for a family plan, which is $4 or 26.6% more than their current plan.
Therefore, since Spotify and other music streaming platforms are not charging consumers very high
and are under-earning to drive consumers’ adoption, Spotify / music streaming platforms have the
potential to raise price once the market reaches saturation. In fact, Spotify has followed Netflix’s
playbook and raised price in saturated market like Scandinavia countries, which is Spotify’s earliest
market/ its home market and where competition has eased. Other developed markets will most
likely follow this trend. Since Spotify pays artists hugely based on number of songs streamed by
users, an incremental increase in ARPU will go directly to Spotify’s bottom line and improve its
margin. Long term margin should trend around ~30%, which is in-line with what other platforms are
charging. Apple charges a take-rate of ~30% for its platform services.
Additional upside potential from podcasting and marketplace services for artists
Management has big plans for Spotify. Management is trying to further monetize the platform by
pushing out marketplace services for artists to enable artists to market directly to customers.
Furthermore, management is growing its podcasting business, with the acquisition of Gimlet and ….
Though podcasting is relatively small, management believes that it has high margin. Management
mentioned in Spotify’s earning call that both marketplace services for artists and podcasting are high
margin businesses, which can improve Spotify’s margin in the long term, as these businesses require
very little incremental capex, as they are tapped on Spotify’s existing structure and services.
Capable and savvy management
Founders for Spotify, Daniel Ek and Martin Lorentzon, are serial entrepreneurs. Prior to founding
Spotify, Daniel founded Advertigo, which was acquired by TradeDoubler. Trade Doubler was
founded by Martin in 1999.
Management’s past track record have helped them greatly in navigating the past challenges and
survive for 13 years in a competitive tech industry. If the readers can recall, there are various
different companies which were trying to revolutionize the music industry during the same time as
Spotify. Competition came from large corporations, with deep pockets like Apple, Samsung, YouTube

6. and Google, which was trying out different business models. Apple tried to capture a piece of music
industry through its introduction of digital song downloads. iTunes charged users $0.99 per song.
However, it did not take off and ended up introducing its streaming platform, Apple Music in 2015.
Google introduced its version, Google Music, in 2011, and had various deals with “Big Three” record
labels with 13 million tracks available to download. However, it did not take off, and Google Music
was rebranded as “Google Play Music”, which provides streaming services. Some call it luck.
However, there is an element of skill involved in keeping competitors with much more resource,
more cash, more connections, and platform advantages like owning the iOS and Android system at
bay for close to a decade.
Valuation
Spotify should be trading at the same multiple as Netflix. Both of these are platform company. The
valuation gap between Spotify and Netflix exists because of Netflix’s cost structure. Netflix managed
to negotiate for a favourable agreement with the content producers, such that Netflix pays them a
flat fee for its content, rather than based on viewership (i.e., usage). This effectively enables Netflix
to “source” its resources at a cheaper rate. Netflix’s Gross Profit Margin is ~35%, and its COGS as a %
of sales is ~65%. Spotify’s Gross Profit Margin is ~25%, and its COGS as a % of sales is ~75%.
However, as content producers realize that their licensing agreement has been hurting themselves,
most of them decided to pull their catalogue away from Netflix platform. Now, Netflix has to create
their own content, and Netflix does not an advantage in creating their content. Therefore, its COGS
(as a % of sales) should go up to ~70%, and its GPM should be ~30%, which is similar to the margins
which most platforms have. Similarly, Spotify’s GPM has been trending up and should reach ~30%.
Valuation gap between Spotify and Netflix should narrow. A suitable multiple will be the average of
Netflix’s multiple (EV/forward Sales = 7) and Spotify’s multiple (EV/forward Sales = 3.5). Taking the
average multiple of EV/forward Sales of 4.75, Spotify’s share price will be $203, which implies an
upside of ~35.7%.
Figure 07: Historical multiple of Spotify and Netflix
A great pair trade will be to short Netflix, and long Spotify.

7. Conclusion
In conclusion, Spotify has a world-class management, coherent business model and is in the industry
that is growing. Most companies are either established, low growth and very cash generative or high
growth and uses a lot of cash. Spotify has the best of both worlds. It is able to grow at +28% YoY,
while generating a lot of cash because of how its business model is set up. It did not even need to
raise funds when it went public. It is then able to use this cash to invest in marketing its brand and
R&D, or other growth areas like podcast and marketing services for artists. It even announced a
US$ 1 billion share buyback programme (~3.5% of their market cap). Furthermore, it is trading at a
discount as compared to its peers.
Porters’ 5 Forces
Bargaining power of customer: medium and getting weaker. Customers / users are very fragmented.
The switching cost for customers to leave Spotify’s platform increases as they stay on the platform
for longer – they have a longer list of song catalogues stored on various playlists, which is hard to
move to another platform. As users stream more songs on Spotify’s platform, Spotify uses the data
to customize better song recommendations for the users. This is supported by decreasing premium
churn.
Threat of new entrant: low. A new music streaming company requires to invest huge amount of
fixed cost in advertising and marketing. New entrant must be backed up very strong backers or VCs,
who can give them a lot of cash to sustain. With the current market conditions, most VCs are
unwilling to burn more cash to gain customers. Most of them are prioritizing profit, before growth at
any cost. It is hard for start up to gain traction. Even if they have access to capital, it takes time to
build a brand and gain customer awareness. Spotify had done that over the past 13 years, and have
significant lead over any new entrance.
Industry rivalry: medium. The music streaming industry is relatively mature (13 years) in developed
market. Competition is more rational. While various players are giving out free trials (1-3 months),
they are still pricing their full services at US$9.99 per month. Furthermore, music streaming industry
is a relatively niche industry. It is hard to move the needle for Apple and Amazon’s P&L statement.
Apple’s revenue was US$260 billion, while Amazon’s revenue was US$230 billion. Spotify’s revenue
was US$5 billion. Management for Amazon and Apple have other areas which need their focus.
Bargaining power of suppliers: medium and getting weaker. As music streaming gains traction,
Spotify will contribute more to the “Big Three” labels’ revenue and EBITD, which weakens the “Big
Three” bargaining power.
Threat of substitute: low, but getting stronger. The greatest threat to music streaming is podcasting.
Instead of listening to music, users can listen to podcasts. Spotify is mitigating the threat well by
investing in podcasting, with the recent acquisitions.
Disclaimer: This write-up is to showcase and highlight the candidate’s writing ability and financial
analysis, and it does not serve as investment advice.