Shares of streaming music service Spotify have rallied by close to 32% since the company went public in early April, driven by demand for high-growth tech stocks and some positive research reports from sell-side firms. While Spotify is projecting high levels of revenue growth (as much as 35% per year in the coming years), driven by strong subscriber adds and a higher mix of paying users, there are multiple risks to the company’s business as well.
We have a $179 price estimate for Spotify, which is roughly in line with its current market price. We have created an interactive dashboard on Spotify’s valuation, which you can use to arrive at your own estimates for Spotify.
Aggressive Growth Targets
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Spotify remains the single largest streaming music service, with a user base of about 170 million users as of Q1, out of which about 75 million users are paying subscribers. In comparison, the second largest player, Apple Music, has 50 million subscribers (including free trials). Spotify is targeting a long-term revenue growth rate of 25% to 35%, as it increases its user base while bolstering its mix of paying users. As of Q1 2018, about 44% of its users were paying for the service, up from 31% in 2015. These subscribers are generally much more lucrative in terms of revenues as well as margins. However, the company indicated that its 2018 revenues are only expected to grow between 20% and 30%, as it is likely to be under-monetizing the advertising on its app, as it looks to improve customer experience and engagement. This could, in turn, drive more subscriptions to its premium service. In April, the company began offering ad-supported users a new experience, by providing greater control and an increased focus on curation and personalization. As the company’s user base rises, its margins should also expand. Spotify’s gross margins rose from around 21% last year to nearly 25% during Q1 2018. The company is targeting 30% to 35% gross margins in the long term.
Spotify Lacks A Compelling Economic Moat
Streaming music services operate on the same basic premise of providing an extensive catalog of mostly the same music at similar prices. For instance, Apple Music, Spotify, and Tidal all offer libraries of upwards of 30 million songs, with basic ad-free packages starting at about $10 per month. The relatively weak differentiation could hinder pricing power in the market, making streaming into something of a commodity. In contrast, streaming video services such as Netflix offer a significant amount of exclusive and original content, allowing them better pricing power while enabling them to co-exist with other video providers (a household is more likely to subscribe to multiple video services than multiple music services). Spotify could face pressures on the cost side as well, as a group of four record companies (Sony, Universal, Warner, and Merlin) control a bulk of its music catalog. Separately, Spotify also has to compete against deep-pocketed U.S. rivals, including Amazon (Prime Music), Apple, and Google (YouTube Music). These companies are much more diverse and profitable compared to Spotify, and their user bases could be more sticky, considering the scale of their respective platforms. Although Spotify may score in terms of content curation and user interface, the larger players could easily play the pricing card, hampering Spotify’s growth.
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