Is There Still A Bullish Case For Spotify? Time Is Running Out.

Let me start by saying that I love Spotify and have been using it for over seven years. Everything about the platform is great and like many others, I have no plans of switching. The algorithm is unlike anything I’ve experienced on a music streaming app and has helped me discover countless new artists and genres. I’m sure you have felt a similar experience. Unfortunately, none of these amazing features should allow an investor to turn a blind eye to an obscene valuation. As history has shown, Wall Street will eventually make you pay the price. People quickly forget that Pandora Media was one of the world’s leading internet radio providers before collapsing due to more competition, and eventually was bought by Sirius XM.

Growing Sales Doesn’t Justify its High Valuation. Spotify is currently valued as a high-margin, wide-moat business. Investors are willing to pay a premium now for profits that aren’t expected for at least four to five years. Bulls love to only focus on the impressive revenue and MAU growth, huge podcast signings, and overall great product. The question I always follow up and ask is, “How much more room is there to grow?”. Spotify has already absorbed close to 35% of the music streaming market as of 2019 and with a number of new platforms emerging each year, it’s only going to get more competitive. Some reports are claiming that Spotify’s share has declined closer to 30% as of 2020 but these are difficult to verify.

If Spotify can’t generate a profit now, when will they? Their explosive growth and exclusive content signings are costly and while it looks good in the near term, it doesn’t imply a sustainable business model. On top of that, Spotify’s high EV/EBITDA (can’t use profit margins since negative) imply it’s trading well above fair value vs. similar names such as Netflix, Sirius XM, or Apple.

Some may argue that it is unfair comparing a low/negative EBITDA with companies that have stronger multiples, but to me, that is the point I’m trying to make. Spotify doesn’t deserve this valuation given its low-margin business. If management can prove to investors that it can scale AND improve operating margins, then it will deserve the valuations of Netflix and Apple who already have 18-25% net income margins.

Royalty Fees Remain a Major Concern. One of the biggest things I feel Wall Street fails to effectively understand with Spotify is its painful royalty fee structure. 73-80% of the company’s revenue is subject to this in a given year, and it isn’t going anywhere. There are no economies of scale or optimization strategies that will fix this; it’s a constant payment to recording owners such as Universal Music or Sony that eat up the vast majority of Spotify’s revenue. Figure 3 shows Spotify’s unchanged gross margins for the last three years despite impressive top-line growth.

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It’s even more surprising when you find out that Spotify is one of the worst paying streaming services out there. There isn’t much more room for management to decrease payouts or else they risk losing more market share.

Why is that important you might ask? Well, one of the hottest topics in music streaming right now (has been for years) revolves around artists, who are demanding to be paid more and rightfully so. This does not bode well for Spotify’s low payout coupled with more streamers entering the market who will try to gain exclusive access from artists by paying them more. If Spotify decides to increase payouts to retain artists, it’s only going to hurt their bottom line.

Competition From Apple Music Will continue to be an issue for Spotify. Earlier this year, Apple unveiled its lossless streaming and spatial audio which is essentially a new enhanced way to listen to your favorite artists. It’s a relatively new feature that launched in June and I believe as more people become aware of its better high-resolution stream offering, there is potential for them to take more market share from Spotify. I’m not claiming to be a music expert, but many blogs/articles are out there touting Apple’s achievement and we have yet to hear from Spotify on their next move. They may match what Apple has released, but until then, it has become a new near-term risk for Spotify.

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Don’t Sleep on Spotify’s Debt. Although Spotify currently generates a healthy operating cash flow, it’s important to recognize the $1.8 billion in debt on its balance sheet. In early 2021, Spotify raised $1.3 billion in unsecured notes. For what exactly? Many are speculating on the uses. An acquisition? General corporate purposes? Paying out more to artists? That remains to be said, but regardless this adds a new risk factor to Spotify if it cannot execute on a plan to pay off these notes due in 2026. The company does have a history of getting out of a high debt situation. Prior to going public in 2018, Spotify had raised approximately $1 billion of convertible debt at a roughly $10 billion valuation with private investors before selling it off to Tencent for the direct listing. Kind of weird when you’re competitor owns a piece of your company after going public.

Spotify is a tricky business to evaluate. There aren’t any fair comparables (I’ve seen research analysts use Netflix and Amazon for multiples) to accurately value it. So, what is a fair value for a company that can generate massive revenues, has a superior product, but can’t make a profit? I’m a firm believer that investors eventually lose patience with a company that doesn’t improve bottom-line margins. Does it take five years? Ten? After going public in mid-2018, Spotify traded range-bound between $105-200 per share and appeared to be fairly valued until April 2020 when it began to take off. In my opinion, this more than 100% increase to $350 per share was not justified given the company’s inability to improve profit margins while management gave no indication that things were drastically changing. Some will argue that higher sales and improving MAU’s played a role but that was already factored into the share price prior to the run-up. Even though Spotify’s share price is down 28% from its February high, there is still room to fall. Don’t catch a falling knife as this name heads back to the low-$100’s where it belongs.

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