[00:02:56] Shawn O’Malley: iTunes helped bring some stability to the business, as did radio, live concerts, and CD sales. But the writing was on the wall, and despite Steve Jobs vision for us all wanting to own our own music, that is not really the direction that things were moving in. In 2002, Jobs had already grown frustrated with this new status quo in music.

[00:03:16] Shawn O’Malley: Downloading music was easy, but only if you didn’t mind breaking the law. And music labels were more concerned with suing websites, facilitating music piracy, than they were focused on crafting their own response to the digital revolution. After a call with executives at Warner Music Group, Jobs outlined an early vision for what would become the iTunes Music Store.

[00:03:34] Shawn O’Malley: Over the next 8 years, Apple would sell over 300 million iPods and 10 billion tracks via the iTunes Store to become the world’s biggest music retailer. Where others had failed to convince music labels to license their music for online use, Steve Jobs succeeded. With music piracy holding them hostage, music label executives agreed to push the industry away from high profit CD sales to the lower margin business of selling individual tracks in the iTunes Store.

[00:04:01] Shawn O’Malley: It was a lifeline, but the real winner was Apple, at least for a period of time, and not the music industry. While Apple’s stock moved up 10x, music companies plummeted. By 2009, Apple had a whopping 69 percent market share in the digital music sales market. Yet, Jobs vision was never bound to last, because he hadn’t actually imagined a new music business model for the 21st century.

[00:04:25] Shawn O’Malley: He had just created a nice digital interface to bridge the 1990s and 2000s. Libraries of music, shuffling through songs at will, and custom playlists were all big steps toward how we would consume music today, but the iTunes Store was still premised around the idea of people owning their own music, buying songs one by one.

[00:04:43] Shawn O’Malley: This offered more discretion in choosing music than CDs. But it wasn’t something fundamentally different. It didn’t truly capture how our relationship with music would change because of the internet. Tension remained between the ease with which one could illegally download music and law abiding citizens who cringed at taking out their credit cards every time they wanted to download a single song.

[00:05:04] Shawn O’Malley: Across the pond is where the real next generation of music was being developed. In 2006, Daniel Ek and Martin Lorentzon founded a small startup in Stockholm, Sweden called Spotify. They saw a music industry that was still reeling from a battle with piracy and that wasn’t satisfied with the cut it was getting from deals with iTunes.

[00:05:23] Shawn O’Malley: Over the next two years, they built a new model where they’d offer music fans a free service supported by advertising while hoping they’d upgrade to a 10 year old per month ad free subscription. As Daniel said in 2010, quote, I realized that you can never legislate away from piracy. The only way to solve the problem was to create a service that was better than piracy.

[00:05:42] Shawn O’Malley: And at the same time, compensate the music industry rather than owning music. This was more like renting it. For a small recurring monthly fee, you could functionally own an infinite catalog of music. Launching in the US in July 2011, Spotify flipped the music industry on its head again. While iTunes was still dominating as a digital music retailer selling songs in 2011, Spotify’s surge in popularity would force the company to 180 in just 4 years and launch its own streaming service that would ultimately make iTunes defunct.

[00:06:12] Shawn O’Malley: Apple Music joined the scene in 2015, and ever since, music streaming took off, and the music industry more broadly caught a second wind. By 2020, recorded music revenues saw their fifth consecutive year of growth, after more than a decade of piracy induced decline, for major music labels like Universal, streaming now represents 70 percent of their revenues from recorded music.

[00:06:34] Shawn O’Malley: It’s probably not an understatement to say that Spotify, or at least streaming generally, saved the recorded music business. Streaming music was so easy that Spotify convinced a new generation to pay for music again, flipping the paradigm and making music piracy uncool. A 2019 study of online piracy by the American University International Law Review found that online piracy is declining because of, quote, the increasing availability of affordable legal content rather than enforcement measures.

[00:07:02] Shawn O’Malley: So Spotify’s co-founder Daniel Ek was right, lawsuits wouldn’t reduce piracy, only a superior paid product would. There are other ways streaming has boosted music consumption beyond just lessening piracy though. Music sampling used to be an expensive luxury. If you wanted to dive into a new genre, you might pay 20 for an album you ended up disliking.

[00:07:22] Shawn O’Malley: Streaming removes that dynamic entirely and actually encourages people to be more adventurous with their music tastes. Much of Spotify’s business today is built around using AI and algorithms to help people discover new music they like that will keep them engaged with the app. Spotify also has a free subscription tier, which further blurs the line between owning and renting music.

[00:07:42] Shawn O’Malley: The margins on it are thin, but even the free product with ads is a superior product to most of the alternatives. And from Spotify’s perspective, if they can add enough value for users and get them hooked on streaming, there’s a pretty good chance that free users will eventually convert to paid. With that, let’s look at where Spotify is today.

[00:08:00] Shawn O’Malley: Today, Spotify is central to pop culture and people’s music consumption habits. But how much of that cultural relevance and importance to the music industry translates into intrinsic value for Spotify shareholders? It’s a question I’m going to try and answer later in the episode, but let’s go through how things look for Spotify in 2024.

[00:08:18] Shawn O’Malley: I’m biased, but as a Spotify user for almost a decade, it’s hard for me to imagine subscribing to music somewhere else. That doesn’t necessarily mean Spotify is a great investment at today’s prices, but it is telling of their earnings power. They could probably double monthly prices, and I don’t think I would leave.

[00:08:34] Shawn O’Malley: That’s not true for everyone, but I think there are a lot of people who can relate to that sentiment, at least in the US and Europe, where Spotify has deeper market penetration and where subscribers have more discretionary income to absorb price hikes. I’ve been making new and refining old playlists for years, so my entire account is one big work in progress that gives little snapshots of different moments in my life.

[00:08:55] Shawn O’Malley: And obviously, Spotify has played into that with their yearly Spotify wrapped summaries, which have become something of a recurring viral phenomenon. Everyone wants to see the songs they listened to most in the past year, their top artists, all that stuff, and share it with their friends and family. That creates a pretty potent network effect as non-Spotify users see millions of people posting about their custom music listening profiles and feel left out.

[00:09:18] Shawn O’Malley: It’s a really good viral marketing strategy that a bunch of other companies have tried to copy with less success. And that advantage for Spotify is because they have years of user data on my habits, preferences, and archives of all my playlists. On top of that, Spotify famously dove into the podcasting world by acquiring the rights to Joe Rogan’s podcast and now hosts 4 million other shows on its platform.

[00:09:39] Shawn O’Malley: So that has only added another dimension for Spotify to better understand its users via the content they consume. Some quick stats, Spotify has over 600 million total users with around 60 percent of those being free subscribers who use the ad supported tier and the remaining 230 million or so being premium subscribers who pay monthly to be able to download music for offline listening.

[00:10:03] Shawn O’Malley: And for no ads on that music and the US those premium subscribers might be on a solo plan for 1199 a month, a duo plan for 1699, a family plan for 1999 or a student plan for 599. Spotify’s prices vary around the world, adjusting for the cost of living and different countries and median incomes and developing countries like Nigeria, Egypt, and India.

[00:10:27] Shawn O’Malley: Monthly costs for premium subscriptions are much lower, closer to 1 or 2, and the rest of the world falls somewhere in between for the most part. Japanese users, for example, pay around 6. 50 per month. One of the core questions for Spotify is whether you believe that, over time, monthly subscription costs will converge on the higher rates that people across the US and Europe pay.

[00:10:49] Shawn O’Malley: Since most of Spotify’s future growth will come from emerging markets, that’s going to be a key value driver for the stock. It makes sense that as emerging market countries become richer and median incomes rise. People in these countries would, over time, be able to pay rates closer to what users in developed countries pay today.

[00:11:07] Shawn O’Malley: But there’s a lot of uncertainty around that timeline, and whether cultural or lifestyle differences in other parts of the world might affect their music consumption habits and willingness to absorb higher prices. I think it’s pretty safe to say that subscription rates globally will continue to rise, even in countries like the U.

[00:11:22] Shawn O’Malley: S., just because Spotify’s service is so ingrained into many people’s lives and creates so much value for them. The extent to which Spotify can raise prices reflects its earnings power. While Spotify isn’t very profitable today, investing in the company now is sort of a bet that they can continue raising prices globally and earn more revenue per user thanks to users becoming more and more dependent on the service over time.

[00:11:46] Shawn O’Malley: Spotify’s average monthly revenue per user, also known as ARPU, has actually been in decline though, from around 6.70 in 2016 to 4. 72 at the end of last year. Much of that has been due to growth in emerging markets, where prices are lower in dollar terms, and because of offerings like cheaper student plans and family plans, which technically expand the number of premium users, but might divide that subscription revenue across five or six family members.

[00:12:14] Shawn O’Malley: Increasing ARPU while also growing subscribers is key to any bullish outlook on the company long term. Over the past four years, Spotify has made progress in reversing the downtrend in ARPU. It actually seemed to bottom in 2021. So, Spotify will almost certainly raise prices more aggressively going forward than they have previously as a way to increase ARPU.

[00:12:36] Shawn O’Malley: Netflix did something similar, entrenching itself into households worldwide, getting people addicted to binging shows, and then later raising prices and cracking down on password sharing as growth has slowed down to increase revenues. Netflix might be several years ahead of Spotify on that journey, but the idea is similar.

[00:12:53] Shawn O’Malley: Become a pillar of people’s entertainment habits at break even or unprofitable prices and ramp up pricing. The similar strategy is no accident either. Netflix’s is actually on Spotify’s board, as is Barry McCarthy, who is Netflix’s former CFO. Part of the reason you can ramp up pricing or crack down on password sharing is that these services become more valuable to people over time.

[00:13:18] Shawn O’Malley: If I were to sign up for Spotify today, it would be worth much less to me because its algorithm wouldn’t know anything about me yet in terms of suggesting relevant music or podcasts for me to listen to. So I might not be willing to pay much, if anything, to stream music from Spotify because music streaming by itself is more of a commodity.

[00:13:35] Shawn O’Malley: I could go somewhere else and basically get the same thing. But that commodity business evolves over time. Now, I rely on Spotify to help me find a lot of the new music I listen to, and I listen to Spotify exclusive podcasts, and I’ve got years of custom playlists there. Spotify’s algorithm is also quite good, too.

[00:13:53] Shawn O’Malley: They’ve mastered a technique called collaborative filtering, where the company almost has a map with data points for popular songs and based on whether users have placed songs together in the same playlist, Spotify can map those songs closer or farther together from each other. So if you choose a specific song to listen to, after it finishes, Spotify will automatically recommend more songs based on balancing your own listening habits with what other listeners tend to enjoy after listening to that song or artist.

[00:14:19] Shawn O’Malley: On a deeper level, it does a meta-analysis to further ensure that its recommendations are appropriate. Looking at when a song was published, and even analyzing the audio file itself for things like loudness and danceability. That way, even if a pop song like All I Want for Christmas Is You by Mariah Carey is close to a Christmas carol like Silent Night, through collaborative filtering, Spotify avoids the whiplash of going from a party song to a more religious song.

[00:14:45] Shawn O’Malley: It even goes as far as trying to determine a song’s cultural context by scraping the web for reviews of the song and looking at adjectives used to describe it to determine its relevancy as a recommendation. None of that is technology that is necessarily exclusive to Spotify. By having the most users, they also have the most raw data to feed their algorithms.

[00:15:05] Shawn O’Malley: I’m also just used to the app. It’s familiar to me, so I wouldn’t be that excited about switching to Apple or Amazon music and I’m sure there are a lot of people out there like me who feel the same way. Because of all that, the amount I’d be willing to pay for a Spotify subscription has risen over time, and I think much of Spotify’s strategy today is banking on continuing to create more and more value for people such that they would happily pay higher prices in the future.

[00:15:29] Shawn O’Malley: For over 10 years, Spotify kept prices fixed at 9. 99 per month, but recently Spotify began putting its pricing power to the test. The hope is to raise subscription costs enough to more than offset any subscriber churn. In July of 2023, Spotify hiked prices in the US, UK, Spain, France, New Zealand, Hong Kong, and Peru.

[00:15:50] Shawn O’Malley: For US users, prices rose by a dollar a month. If there was any negative impact from the hike, it was quite minimal. Premium and free subscriber growth has largely remained intact since. With 239 million premium subscribers in Q1 of this year, that’s up from 205 million at the end of 2022 and 124 million in 2019.

[00:16:10] Shawn O’Malley: Spotify is priced at a modest premium to its biggest competitors, but analysts who follow the company tend to think it can be more aggressive in raising prices than the others. Apple Music is a bit cheaper for individuals and families at 10.99 and 16.99 per month, respectively. YouTube Music carries the same cost for its plans as Apple, but offers YouTube Premium for 13.99 per month, which also includes YouTube Music. And Amazon Music is the other big rival out there, which is included for free in Prime memberships that run for 14.99 a month. The unlimited music plan, though, is an additional 9. 99 a month at Amazon. Meanwhile, Spotify has pushed forward again this year with further hikes in the US.

[00:16:50] Shawn O’Malley: It raised prices for plans ranging from $1 to $3 a month. Spotify also recently announced a new ultra-premium plan for an additional $5 per month that provides access to better audio and new tools for creating playlists and managing song libraries. So after years of providing all premium subscribers with the same core service, Spotify is experimenting with multiple plan types beyond just the difference between free and premium.

[00:17:15] Shawn O’Malley: Do you notice any similarities between Spotify’s main streaming rivals? They’re all big tech companies, and that makes them pretty formidable competition. At the same time, Spotify is the only one that’s solely focused on doing one thing really well, audio streaming. Apple and Amazon Music are both rounding errors for those companies broader businesses.

[00:17:32] Shawn O’Malley: Music streaming is a complement to their other offerings, but it’s not the core focus. Same with YouTube. YouTube has its hands full with its core video business, while also adventuring into areas like live sports. There’s something to be said about doing one thing and doing it really well. These big rivals are not going anywhere, but it’s unclear if there’ll be significant hindrances to Spotify’s growth plans either.

[00:17:55] Shawn O’Malley: Again, that isn’t to say that music streaming isn’t a serious priority for the competition, but I think it’s telling that none of these companies have squashed Spotify yet. Spotify is by far the biggest of them all, and despite Apple giving away Apple Music Trials when people buy new phones, or Amazon and YouTube trying to lump music streaming into bigger packages like YouTube Premium or Amazon Prime, Spotify continues to grow and grow.

[00:18:20] Shawn O’Malley: On the one hand, what may be an advantage for these companies in one sense is a disadvantage in other ways. For example, Apple and Amazon streaming apps are both ways to make their hardware products stickier. Apple hopes to make money off streaming, but it really wants to ensure that you keep buying their phones, watches, iPads, and computers, and your use of Apple Music is one more thing pressuring you to keep coming back.

[00:18:41] Shawn O’Malley: And their app is really well designed to fit into Apple products, but the focus is mostly on Apple products. Same for Amazon. Amazon Music is meant to make Amazon Prime more valuable, as well as Alexa devices. But I don’t think their ambitions extend too far beyond that. Even more telling, despite Spotify being a competitor, Amazon still enables Spotify to integrate into their Alexa devices.

[00:19:03] Shawn O’Malley: If they didn’t, they’d probably have far fewer Alexa sales, because so many people have Spotify and want to use it across all of their devices. This leads into the bigger point that Spotify doesn’t sell hardware. It’s hardware agnostic. Actually. Spotify wants to be the universal audio streaming app. As of 2022, Spotify had more than 2000 partners that it was integrated with from smartwatches to cars and kitchen appliances.

[00:19:28] Shawn O’Malley: Spotify’s broader focus is meant to ensure that its user experience is frictionless almost anywhere versus competitors who may be more focused on keeping music streaming integrated within their own product ecosystem. But the story for Spotify is also much bigger than music. I want to just read a quote from Spotify’s investor day two years ago with CEO Daniel Ack.

[00:19:49] Shawn O’Malley: He says, in reference to some of Spotify’s competitors, quote, looking back at the best companies you’re all very familiar with. They are vastly different companies today than when they started. And they might’ve made their initial mark in one specific category, think books, search desktop computers, and they then redefine the way we think about those categories by expanding their potential through innovation.

[00:20:10] Shawn O’Malley: And these companies didn’t stop there. They’ve continued to expand and build on those strong foundations, applying their learnings and leveraging their customer base to move into new categories, ultimately broadening their value proposition. And as a result, they built more resilient businesses. And this is the exact same journey we’re on as a testament to his belief in this journey.

[00:20:30] Shawn O’Malley: One thing I really love is that Daniel Ek hasn’t taken a base salary since 2017. He’s also Spotify’s biggest shareholder. What does this journey look like for Spotify? Well, I think it’s partly through it already. Podcasts are now just as much a core part of Spotify. In some ways, as music. In 2018, less than 7% of its users listen to podcasts on Spotify on a monthly basis.

[00:20:52] Shawn O’Malley: Now that figure is over 30%. The company has also had a lot of success producing original podcasts or licensing podcasts, despite only licensing or producing 1000 of more than 4 million podcasts on the platform. 15 of the top 100 most listened to podcasts on the app belong to Spotify itself. This just adds value and makes the platform stickier for most existing users.

[00:21:15] Shawn O’Malley: Some will and have jumped ship to music streaming apps that are just music and nothing else like Apple music because they’re not interested in podcasts. But the general trend is that more people are routinely listening to podcasts on Spotify. Which makes the service more than just a place to stream music for them.

[00:21:31] Shawn O’Malley: That helps differentiate Spotify. In that same vein, Spotify has more recently made a move into audiobooks, further increasing Spotify’s total addressable market, which includes the music streaming market and the podcast space. The global book market does around 140 billion in sales each year, and audiobooks capture around 6 or 7 percent of that.

[00:21:50] Shawn O’Malley: But that’s global. In the most penetrated audio markets, as Spotify put it to investors, The market share of audio books to total book sales is closer to 50%. So the audio book market could be worth as much as 70 billion a year. And Spotify is hoping to capture a chunk of that. The plan has so far included giving premium users up to 15 hours of included audio book streaming beginning last October with the option to purchase more hours beyond that.

[00:22:16] Shawn O’Malley: In April, Bloomberg reported that one quarter of users based in the U. S., U. K., and Australia had started an audiobook as part of their subscriptions. Purchases of audiobook hours doubled in the first quarter of 2024 versus the end of 2023. As audiobook usage picks up on Spotify, it should increasingly support higher ARPUs over time, while also increasing how much people use the Spotify app more generally.

[00:22:39] Shawn O’Malley: This plays into Spotify’s idea that similar to how a stock’s value represents all the expected future cash flows to shareholders discounted to a present value today, the lifetime value of subscribers is the future value a Spotify user will get from the app across their lifetime discounted to the present.

[00:22:56] Shawn O’Malley: So the goal that management has expressed to investors is to maximize the lifetime value received by users of Spotify. That means becoming the world’s largest audio streaming platform, which they’ve done, and continuing to build on top of that platform from educational courses to promoting live events, like concerts for musical artists and helping drive their merch sales by sharing audience data with them.

[00:23:17] Shawn O’Malley: You can imagine a number of different overlapping business models that Spotify can continue to expand into based on its massive audio platform. So there’s a flywheel effect here that builds Spotify’s free ad tier brings people to the top of the funnel, which helps propel the company into new markets, bringing in more new users.

[00:23:35] Shawn O’Malley: Meanwhile, the company eventually converts many of those free users to paid subscribers. As Spotify’s user base gets bigger, it attracts more artists and podcasts and authors of audio books and other creators to distribute their content on Spotify. With more audio content creators, that attracts even more people, and with more users and more data on existing users over time from their habits, that attracts more and more advertising dollars because advertisers want to be where everyone is and want to have data about all those people.

[00:24:02] Shawn O’Malley: And as the company adds more to its premium services, like audiobooks, it can convert more of those free users into paid subscribers. So if you buy into this more positive outlook for Spotify, the company has a pretty incredible opportunity to keep compounding the benefits of scale and treasure chests of user data that it has to its advantage.

[00:24:21] Shawn O’Malley: Layered into this are other business models that help support margins, like Marketplace and the Spotify Audience Network. Marketplace enables artists or labels to pay Spotify to promote their music to new listeners or new releases to existing listeners. This is another advantage of Spotify’s scale and algorithm.

[00:24:39] Shawn O’Malley: Music labels can get a positive return on their promotional spending, thanks to Spotify’s deep insights into user preferences. Even more important is that this goes a long way toward boosting Spotify’s gross profit margins. Rather than showing up as revenue, the roughly 500 million marketplace business supports margins by reducing the royalty rates that Spotify owes to artists.

[00:24:58] Shawn O’Malley: So if an artist wants to reach a larger audience, Spotify will promote them to more people in exchange for paying them a lower royalty rate on those additional streams, which ultimately helps Spotify’s margins. The company’s biggest expense are these royalty contracts with music labels, because these are set at negotiated rates that scale up with more users listening to music and more revenue for Spotify.

[00:25:19] Shawn O’Malley: So, if Spotify gets a dollar of revenue, around 70 cents will essentially be handed over immediately to pay out royalties. That makes it really hard to garner any kind of operating leverage. Normally, you’d hope to achieve some economies of scale by spreading fixed costs over a wider revenue base, but Spotify’s challenge is that royalty costs scale proportionately with revenue.

[00:25:38] Shawn O’Malley: Sponsored album or song recommendations flow those dollars back to Spotify. Spotify helps artists get more eyeballs on their music, which earns them more royalty money or helps them sell out concerts, and Spotify earns extra revenue that can help its gross profit margin. As of 2022, Marketplace had contributed around 160 million to Spotify’s gross profit margin.

[00:25:59] Shawn O’Malley: Up eight times since 2018. And then on the podcast side of things, the company launched its Spotify audience network in 2021, which is an advertising marketplace for podcasts. It’s basically a way for advertisers to tap into sponsoring Spotify’s original and exclusive content, as well as third party podcast publishers who opt into the Spotify audience network or span as it’s called.

[00:26:20] Shawn O’Malley: What a lot of people might not realize is that there are many thousands of great podcasts out there with decent sized followings that are run only by a very small team or a single person. And for those podcast publishers, it’s really hard to secure advertising deals to monetize your show. These people might edit their own podcasts, manage their website, post on social media and do everything that goes into building a brand while also working a day job.

[00:26:43] Shawn O’Malley: In some cases. So, these smaller podcasts don’t have the time to cold email advertisers, nor do they have the resources to hire a sales team. Oftentimes, these publishers either under monetize their content, or pay large fees to advertising agencies. Span is really helpful for these types of publishers, or even large publishers who generally source their own advertising deals but like to fall back on Spotify’s audience network from time to time.

[00:27:07] Shawn O’Malley: And Spotify takes a 50 percent cut of those podcast advertising dollars, which leads to much better margins than in the music business. From advertisers perspective, rather than going through the effort of securing sponsorship arrangements with a bunch of different podcasts one by one, they can just go to Span and tap into Spotify’s broad network of podcasts to sponsor.

[00:27:26] Shawn O’Malley: So rather than sponsoring one or two shows, you might sponsor two dozen. All the while Spotify is using its data to help you tailor your campaign to the exact audience you want to reach. As a result of all this, Spotify is expecting its advertising business to grow quickly in the coming years and become a much bigger part of the company’s revenues.

[00:27:44] Shawn O’Malley: Ad supported revenues grew 22 percent in 2022 and almost 14 percent last year. Let’s take a step back a bit and examine Spotify’s royalty costs more closely, since this is such a big part of the story for them. As Spotify waded into the music world in 2011, it had to make deals with major labels to license that content.

[00:28:03] Shawn O’Malley: Music labels are notoriously protective of their music rights. And you can imagine that they had a good bit of skepticism toward this new model that Spotify was trying to introduce. In fact, it was a two year start stop negotiation process that quite literally came down to the last minute. 48 hours ahead of Spotify’s US launch, it still needed to reach a deal with Universal.

[00:28:23] Shawn O’Malley: What has ultimately helped Spotify disrupt the music industry is that the music industry owns a chunk of Spotify, or at least it did. Early on, the biggest labels received an 18 percent stake in Spotify virtually for free. So, beyond having their businesses tied together, music labels were rooting for Spotify’s success as shareholders.

[00:28:42] Shawn O’Malley: And the labels have since cashed in on that. Warner Music Group sold its entire stake worth 500 million after Spotify’s IPO. And Sony and Universal both sold hundreds of millions of dollars’ worth of shares but retained a piece of their ownership. Spotify has obviously done much more than just share royalties to create value for these music labels, which builds goodwill between them.

[00:29:03] Shawn O’Malley: According to Spotify, as part of royalty arrangements, two thirds of its revenue from both advertising and premium subscriptions goes toward compensating music rights holders. Once the dollars flow out from Spotify to the rights holders, it’s out of their hands for how the money is divvied up. How much an artist makes then through Spotify is tied to the contracts they have with their labels and publishers.

[00:29:25] Shawn O’Malley: From song collaborators to agents, managers, lawyers. Songwriters, musicians, and so many more. There are a lot of different people and intermediaries taking slices out of that pie of money. What’s left over for artists is typically less than a penny for each stream, meaning they must get hundreds of thousands or millions of streams to earn decent money.

[00:29:45] Shawn O’Malley: As of 2020, out of the millions of recording artists on Spotify, about 13, 000 made 50, 000 or more in a year from music streams, and only around 2 percent of artists earn more than 1, 000 per year. How royalty payouts are determined can range from where the listener is located in the world to Spotify’s total revenue that month, its total streams that month, and the nuances of a specific music rights holder’s deal with Spotify.

[00:30:11] Shawn O’Malley: A source of ongoing pressure for Spotify has been that it’s royalty payouts per thousand streams tend to be much lower than those of Amazon, Apple, and title. Spotify, however, is by far the biggest. So artists on Spotify, to some extent, make a trade-off for larger audience exposure at lower royalty rates.

[00:30:28] Shawn O’Malley: To further help me understand how royalties work in the music business, I turned to an investor who goes by Sleep well Capital on Twitter, who has covered Spotify well for a few years now and has some great insights on the industry more broadly. He explains that songs are essentially made up of two separate individual copyrights.

[00:30:46] Shawn O’Malley: The composition, which includes the notes, melody, and lyrics, sort of like the script for a movie. And the second copyright is the actual sound recording, or to continue the metaphor, what would be the actual movie itself that you watch in theaters or on Netflix. The composition belongs to the publishing industry, while the recording belongs to music labels.

[00:31:06] Shawn O’Malley: That’s This is why they’re considered two different and separate businesses, known as publishing and recorded music. As an example, a concert pays a publishing royalty, but not a recorded music royalty, since the artist is interpreting a version of the song by using the composition, but not literally using the sound recording that came out of the studio.

[00:31:26] Shawn O’Malley: So music publishers are companies that work with songwriters to pitch songs to artists to do the performance and recording. The earnings, then, are split evenly between the publisher and the songwriter. But recorded music is typically associated with music labels. Labels oversee the production of an album, promote it, distribute it, and own the monetization rights of the master recording since they take the risk of financing its production.

[00:31:50] Shawn O’Malley: Publishers tend to take a much smaller cut of the total pool of royalty money coming from streamers like Spotify, and the rates they can earn are actually overseen by the government, whereas there’s more of a free market for the royalty rates that labels can negotiate. So most of the variability in royalties over time for Spotify will stem from negotiations with music labels in particular.

[00:32:10] Shawn O’Malley: And There are many more layers of complexity, but this breakdown is what’s most relevant for Spotify. Publishers, labels, and artists are sort of the big three, but again, there are countless others involved here. You can also see why royalty costs are structurally so high for Spotify. There are dozens of intermediaries between a song being written and you streaming it on your phone, and Spotify has to reimburse them all indirectly.

[00:32:34] Shawn O’Malley: From booking time in a recording studio to producers and legal fees, there’s no shortage of costs along the way that music rights holders want to be compensated for. In terms of what Spotify’s future looks like, CEO Daniel Ek has outlined some bold plans. Even though the music streaming market is expected to reach around 80 10 years, He expects Spotify to earn a hundred billion dollars in revenue by 2032.

[00:33:01] Shawn O’Malley: That’s not an official company projection by any means. It’s much more of a moonshot ambition, but if it were to happen, it would be thanks to Spotify’s expansion into podcasts, audio books, and soon courses, as well as other potential verticals that haven’t yet been announced. What might those other revenue streams look like?

[00:33:19] Shawn O’Malley: Well, imagine your favorite artist is releasing a new album that you’ve waited months to listen to. How much would you pay for an early screening of it? Would you pay 5 or 10 to listen to it a week early? Some people certainly would, and that’s just one illustration of how, once you’ve built a platform as big as Spotify’s, there are so many different ways to extract new revenues.

[00:33:39] Shawn O’Malley: Meanwhile, Daniel Ek expects gross margins to rise by 10 percentage points to 40%, while its operating margin hits 20 percent off revenues generated by over 1 billion users worldwide. Those are some really ambitious numbers. But growing from over 600 million users today to 1 billion plus isn’t actually as crazy as it sounds over the next few years.

[00:34:01] Shawn O’Malley: The less plausible part is the increase in operating margins. Cost cuts this year surprised analysts by bumping operating margins up to around 5 percent of revenue, but going from there to 20 percent is where the bigger leap occurs. As the podcast and audio books, businesses with higher margins grow, that’ll improve the company’s overall margins.

[00:34:22] Shawn O’Malley: Even if it’s music business margins remain steady, and there’s a chance that the music business margins improve too, because of marketplace, which I mentioned earlier. As artists bid for Spotify’s algorithm to drive additional promotions for them in front of new audiences, they accept reduced royalty rates.

[00:34:38] Shawn O’Malley: This should also, over time, help Spotify get closer to 40 percent gross margins or higher, in line with Daniel Ek’s target. What remains harder to believe is the 100 billion in revenue, and the 20 percent operating margin, as I mentioned, but for a moment, let’s just imagine that those numbers are realistic.

[00:34:55] Shawn O’Malley: With a 20 percent operating margin, that’s 20 billion a year in operating profits if they can actually hit 100 billion in revenue. Today’s biggest tech platform companies like Meta, Netflix, Amazon, and Apple all have enterprise values that trade at roughly between 20x and 40x operating income, which as measured by EBIT, which stands for Earnings Before Interest and Taxes.

[00:35:16] Shawn O’Malley: Assuming Spotify follows a similar trajectory with a 20x multiple of operating income in 2032, then that would suggest that Spotify’s enterprise value in 2032 will be roughly 400 billion. Using a 10 percent discount rate to bring that value into current dollars, the present value of 400 billion today is 127 billion.

[00:35:38] Shawn O’Malley: This gives us an estimate of enterprise value, which is different than market capitalization because it includes debt, but Spotify doesn’t carry a ton of debt and actually has net cash. So the difference isn’t that far off. And this is sort of just a back of a napkin way to calculate what the company would be worth today.

[00:35:54] Shawn O’Malley: If it succeeds in hitting its most ambitious goals, if you want to keep doing very, very rough math, I would discount that number by the odds that you think it can reach these goals. With that logic, Spotify is trading around 60 billion today, as of the time of recording, and you might say that investors are discounting a 50 percent probability that this vision will come true.

[00:36:15] Shawn O’Malley: A more realistic valuation with the same back of the napkin math would be that they hit, say, 65 billion in revenue by 2032, with a 15 percent margin for operating profits. That’s about $10 billion and with a 15 times multiple discounted back to today, as we did previously, the present value for Spotify is around $66 billion, which doesn’t leave much upside at today’s prices without really buying into Daniel Ek’s projections.

[00:36:41] Shawn O’Malley: You can manipulate that big picture math, however you like to think about the range of reasonable valuations for Spotify here, but those are the two ways that seemed appropriate to me to think it through. As I tried to put together a more rigorous financial model valuing Spotify, I used Daniel Ek’s vision for 100 billion in revenue off a billion subscribers by 2032 as a best case scenario to reference.

[00:37:04] Shawn O’Malley: I tried to dig in to see just how realistic these projections are because for better or worse, investors are probably going to anchor their expectations to Daniel Ek’s prediction here. At a billion subscribers, assuming Spotify maintains its ratio of roughly 40 percent of total subs being premium. That would be 400 million paid subscribers, up from over 230 million today.

[00:37:24] Shawn O’Malley: Spotify’s average monthly revenue per user is just shy of 5 today. So on 400 million paid subs, that would be around 24 billion in annualized revenue. That’s pretty well short of the 100 billion that Daniel Ek had targeted. Given that 90 percent of Spotify’s revenue today comes from premium subs, either its advertising business would have to grow massively or more likely, It’s going to have to increase its average revenue per user dramatically to get to a hundred billion dollars for Spotify to realistically hit a hundred billion dollars in revenue by 2032, as its CEO hopes, it would, by my math, have to more than triple its average revenue per user, while also growing its advertising business.

[00:38:04] Shawn O’Malley: For context, Spotify’s ARPU has basically been flat for several years and has actually declined over the last decade. From price hikes to planned upgrades and purchases of courses or audiobooks, you could imagine they may be able to raise ARPU from the 5 it’s at today. You just have to be very optimistic about Spotify’s pricing power for them to reach an ARPU of 15.

[00:38:25] Shawn O’Malley: The challenge is that while Spotify will certainly raise prices across the world, as it grows more in emerging markets, subscribers with lower ARPUs will become a higher composition of the paid subscriber base, which would at least partially nullify price increases on average. Through that lens, it becomes much harder to see how the company triples its average revenue per user, the key word there being average.

[00:38:47] Shawn O’Malley: Even if the ARPU is 20 or 25 per US and European subscriber, the average ARPU across the board will decline as more of the subscriber base is made up of people in India and China and South America. Who, even after price increases, might generate a fraction of the revenue of users in more developed economies.

[00:39:07] Shawn O’Malley: I wouldn’t want to bet against Spotify, but I also think compounding its ARPU at 10 20 percent a year until 2032, after years of flat and declining ARPUs, is no easy feat either. My model for Spotify basically attempts to find the present value of Spotify’s existing paid subscribers over their lifetimes.

[00:39:24] Shawn O’Malley: Plus the present value of future new subs net of marketing and acquisition costs, plus the value of Spotify’s advertising business. Then I subtract out debt and the present value of things like future R and D expenses to try and value the company. The approach is inspired by the method used by NYU professor of finance, Aswath Damodaran, who tried to value Spotify back in 2018 when the company first went public.

[00:39:48] Shawn O’Malley: When I entered in my own assumptions into the model, even with some pretty aggressive growth inputs around the advertising business and increases in ARPU for premium subs, I had a difficult time justifying a current market valuation of much more than 30 or 40 billion for the company. For context, that’s a 30 to 50 percent discount from where the stock has traded through much of 2024.

[00:40:09] Shawn O’Malley: My valuation is actually not too far off from the valuation where Spotify itself has been a buyer of its stock. In 2021, Spotify authorized up to 1 billion for repurchasing its shares. As of the end of 2023, the company has bought back less than 100 million of stock at an average price of roughly 208 per share, which gives you some idea of the price level at which the company thought shares were attractively priced.

[00:40:33] Shawn O’Malley: At 208, Spotify’s market capitalization would be just over 40 billion. With all that said, it’s important not to miss the forest from the trees. Spotify is ultimately a growth story, a bet based in optimism about the company’s specific advantages and the broader growth of music streaming worldwide. As we’ve talked about, having a platform with a billion loyal users invites a ton of different opportunities to launch new business initiatives that can quickly improve the company’s overall economics.

[00:41:01] Shawn O’Malley: If you buy into that and the value that Spotify is creating for users with its range of services and algorithms, then modestly overpaying today would ultimately not be a big deal given its huge future runway. It’s sort of like Amazon in 2012. You could have sat around debating the company’s gross margins, but ultimately, you’d be missing the bigger picture.

[00:41:20] Shawn O’Malley: And you could have bought in at the highest price in 2012 and still earned a 24. 5 percent compounded annual return since then, so the price at that time really wasn’t that consequential. Not buying Amazon at the split adjusted price of 12 in 2012 because you thought it was only worth 10 would have meant missing out on Amazon’s rise to over 180 per share in 2024.

[00:41:43] Shawn O’Malley: Spotify is not Amazon, but they are both tech companies with low margins for their industries that make up for it by creating a ton of value for users and winning their loyalty. A Spotify subscription is as valuable to many people as Amazon Prime. The point being, if you see Spotify as being on a similar journey, but just being a decade earlier along, then you can really justify almost any valuation at today’s prices.

[00:42:06] Shawn O’Malley: So, there are a few different ways to think about what Spotify is worth today. My feeling is that Spotify is a really exciting company for a few reasons. Reason one is that for me, at least as an avid Spotify user, I really appreciate the value proposition they offer and how it has grown over time.

[00:42:22] Shawn O’Malley: Beyond that, the company has a huge user base with really rich data on users that it can use to further improve people’s experience when using the app. And that can also be monetized through advertising. We’ve all seen how other big tech companies have leveraged those advantages from network effects to big data to build companies that are worth hundreds of billions and even trillions of dollars.

[00:42:43] Shawn O’Malley: Thanks. The opportunity for Spotify is substantial, but at the same time, the unit economics for Spotify are really hindered by royalty costs. The big tech names all have much, much higher gross profit margins. Meta, for example, has a gross profit margin of over 80 percent and Apple and Netflix have gross margins, roughly between 40 and 45%.

[00:43:04] Shawn O’Malley: Alphabet and Microsoft’s gross margins are closer to 60 and 70 percent respectively. At those levels of gross profit, companies have a lot more room for error. You can just spend hugely on research and development and throw money at a lot of different things and still have a nice net income margin. And much of that is because there isn’t much marginal cost of software.

[00:43:24] Shawn O’Malley: Microsoft has no real marginal cost when it sells another copy of software packages like Word and Excel, which gives it a ton of operating leverage. As we’ve talked about, Spotify is also a software company, but its cost scales when its business grows. If more people stream music on Spotify, Spotify has to pay more royalties at fixed rates.

[00:43:43] Shawn O’Malley: Because Spotify has valuable data insights that it can share with music labels about people’s listening habits, it’s reasonable to think that Spotify is negotiating power will increase over time and that royalty costs as a percentage of revenue could decline a bit, but they’re always going to be a big chunk of its business, which explains why Spotify has pushed into other areas like podcasts and audio books where it thinks it can get better.

[00:44:05] Shawn O’Malley: Down at 26 percent though, Spotify just has much lower gross profit margins, and therefore a lot less room for error. After accounting for research and development costs, marketing and promotional costs for attracting new users, financing expenses for debt, and general corporate overhead costs, there’s really not too much left over for shareholders in Spotify.

[00:44:25] Shawn O’Malley: Obviously any bullish bet on Spotify is a bet that, that dynamic will change, which I think it will, but Spotify’s profitability is capped in a way that it isn’t for some of the best performing tech companies. Personally, I’m not excited about Spotify at over 300 per share, which is around where it’s trading today at the time of recording, but it’s a company I’ll be tracking closely.

[00:44:45] Shawn O’Malley: And on the next sell off where the company falls 28 or 30 percent or more, I expect to take a position. And that’s all for today. But next week we’ll be diving into the other side and the music industry to explore Universal Music Group as one of the largest music labels and trying to figure out what their intrinsic value is and whether they’re worth owning as a company.

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