From Bull to Bear: Devil’s Advocate on Spotify

I’m a massive Spotify bull. It’s by far my favorite investment. I plan to keep buying more of this company, but to be your best bull self you need to understand the bear cases better than the bears themselves. This technique is called steel manning (i.e the opposite of straw manning). You build up the best bear case, then you dismantle it. I’ve built the bear case below, but will let my previous blog post work to dismantle these arguments. I believe everything below to be true, but it doesn’t change my bullishness on Spotify.

Power of the Labels

Spotify receives a significant portion of it’s music from three music labels (Sony, Universal and Warner). These labels receive a significant portion of their revenue from Spotify. Spotify and the labels are mutually dependent on each other. Given the low gross margins Spotify has, how do they raise their margins if they are dependent on the labels?

The bears say they don’t and the artists say they don’t pay enough.

The Artists Strike Back

Spotify’s relationship with some artists has always been strained. Pieces like THIS come out regularly. While these pieces contain some misconceptions, they do portray how many artists feel toward Spotify. Music is emotion. If many popular artists came together and told their fans to boycott Spotify, it could change how the company is viewed. Spotify released Loud & Clear to address these issues and improve relationship with artists, but how much does that really change?

Perception is everything.

Poor Pricing Power

How much pricing power Spotify has is a great unknown. It is clear they have some pricing power, as they charge more than their competition. Yet price increases have been irregular at best. Recently Spotify increased prices in many markets, however it’s still too early to tell how effective these increases were.

A huge part of the Netflix bull case is how consistently they’ve been able to raise prices, without impacting churn. Clearly, users still see value in Netflix. Is that true for Spotify?

Audio or Music

A major part of the bull case for Spotify is driven by continued optionality. For many reasons, direct revenue from streaming will always be limited. A huge portion of the bull case for Spotify revolves around making money from sources beyond streaming.

From podcasts to playlist placement, Spotify has a lot of options for monetization. But, options for monetization doesn’t necessarily mean monetization. Spotify was built as a streaming company, and maybe that’s all they’ll ever be.

Maybe Spotify continues to gain market share in podcasts, live audio, etc… but these all turn out to be small prizes. The audio space is old and young at the same time, which makes gauging the market size difficult.

Censored Sound

Censorship is always a hot topic in which you never win. Someone will always be upset with you. Some will say you don’t censor enough, others say no censorship is the way.

As Spotify continues to merge into owning and developing more content, this topic will inevitably come up.

From Sound to Soccer

The most obvious risk to Spotify is founder, CEO and Chairman of the Board, Daniel Ek moving on to other endeavors. Most recently he’s been rumored to be interested in purchasing Arsenal. Whether you are a bull or bear, all would surely agree that Ek spending less time on Spotify would be bad.

Strong Competition

Google, Amazon, Microsoft and Apple (GAMA) all want a piece of Spotify. They all have the audience and capital to make it happen. All have tried in the audio space to varying success. If the market continues to grow, GAMA will pay more and more attention. Could any of GAMA acquire a label to gain an upper hand? Seems crazy, but when you are a trillion dollar company anything is possible.

Spotify relies on GAMA much more than GAMA relies on Spotify.

App Store Dependence

The app store giveth and taketh away. Without really clear rules, Spotify currently doesn’t pay app store fees on the overwhelming majority of their customers. But what if that changed? A low margin business would turn negative.

Spotify has built their streaming business on the back of the app store, without paying the cost. But with podcasts, Spotify is starting to run into more trouble. Both Apple and Spotify have announced paid podcast subscriptions. The major difference is that Apple allows subscription within the app, while Spotify doesn’t. Spotify doesn’t want to pay the Apple tax and as a result is making it more difficult for customers to subscribe.

Spotify is picking a fight with Apple. First they’ve sued Apple and more recently they have supported Epic’s lawsuit against Apple. From building on the backs of Apple, while still being extremely dependent on Apple, Spotify is poking the bear. Will Apple ever strike back?

Crypto

Any and all middle men are under the threat of the blockchain. Spotify is a middle man, primarily connecting artists to listeners. Could the blockchain do this more efficiently? Audius is an example of potential competition for Spotify. Any crypto alternative is still way out and doesn’t make logistical sense (given back catalogs controlled by labels), but if you expand your time horizon long enough, this is a threat.

NFTs could also be a threat to Spotify. Artists are already making millions off selling NFTs directly to customer. The bull case for Spotify is driven by them controlling the relationship with the customer. Could crypto cut out the middle man?

“I would be really scared if I were an incumbent player, because they have no idea what’s coming.”

Anjos

Show Me the Money!

Spotify has been around for 15 years and has yet to turn a profit consistently. What will it take for Spotify to be profitable? When will that happen? Spotify is trading at a price to sales ratio of 5, which implies margin expansion and continued sales growth.

Combine this with consistent share dilution and you have a questionable financial picture.

Back on my Bull Shit

None of the above scares me from investing in Spotify, but they are all points we should keep track of. To be the best bull, you need to understand the bear cases better than the best bears.

I believe Spotify is a once-in-a-generation opportunity. Yet, the best investments often have obvious problems. Great management can overcome these. Spotify has so much going for it, but it’s not like other investments. The margins, etc… terrify away investors. But when you look past the low margins (and consider everything else), holy shit is Spotify a great company. Understanding the bears helps you avoid the noise. I’ll chase signal, bears make noise. Listen for the difference to find the returns.