Spotify has been a subject of interest of late, especially among many investors I work with. I try to be relatively optimistic when it comes to the tech industry, but there are times where it becomes harder when patterns align that you have seen so many times before. When it comes to Spotify, it seems as though we have seen this movie before and it doesn’t end well.
Generally before an IPO, particularly around companies that are in the realm of what I study, I get a lot of questions from investors who are looking to make an investment decision around the IPO. While I provide quite a bit of analysis and data to these investors, I also get a look at their thinking and whether they are leaning long or short on the stock. The sentiment I’m getting from investors, and they are not always 100% correct mind you, is most are leaning toward the short view on Spotify. In fact, the sentiment I’m getting from these conversations reminds me quite a bit of similar conversations I had with them around Fitbit and GoPro.
In many of these conversations, we explore both sides of the debate. The case of short Spotify and the case to go long on Spotify. Even though many of them seem to lean short, I appreciate they are willing to game theory the reasons to be optimistic. In the short view, Spotify is more like Pandora. In the long view, Spotify is more like Netflix. These are the two angles we can explore in this analysis.
Spotify = Pandora
The bear case for Spotify, is that it is more like Pandora than any other comperable service out there. Now, these two aren’t exact 1:1 comparisons because Pandora is not available outside the US and Spotify is thus giving Spotify a larger user base and total addressible market. But, just looking at the US market, you can see from this data via a research partner of ours, that Pandora’s decline in users has been Spotify’s gain.
This chart is looking at total active users, but is not breaking out paid vs. free accounts which was tracked seperately. I’ve seen from a range of data points similar to this chart that the dynamic of Pandora’s decline due to users leaving and going to others services with Spotify among the top gainer for now.
Spotify stated their user numbers as follows:
Spotify had 71 million paying users at the end of 2017, up from 48 million in 2016. Overall monthly active users, which includes paid and free users, totaled 159 million compared with 123 a year earlier. Churn, a measure of users leaving the service, continues to fall, hitting 5.5% in 2017.
Two key observations with that data is their overall growth has slowed but they are converting free accounts to paid accounts at a faster rate. The US is Spotify’s largest paying subscriber base with roughly ~10 of their US user base paying for the service. Overall, when I looked at most countries in Europe and the America’s like Brazil, Spain, Portugal, Netherlands, Ireland, Mexico, Brazil, Germany, and a few others, on average, Spotify had 25-30% of consumers in those markets using the service. Most were using the free service, but as I looked through the country data of users saying they were paying it varied between 5-15% depening on country with most countries trending under 10% of consumers paying.
Understanding this free vs. paid account dynamic is central to the Spotify growth story so it is a reason I’m tracking that so closely.
Spotify = Netflix
The bull case for Spotify is it is more like Netflix. In this scenario, Spotify succeeds in not just growing the service but convert the vast majority of their users to their free account. For this to happen, I have no doubt Spotify needs to create original content, meaning have artist exclusives or originals, and for this to work the public market is going to have to be confident in this strategy and support them in this funding.
This angle, I think, will be very tricky for Spotify becauuse the music industry is not a fan of exclusivity since the music business model depends on reach. Artists make a fraction of whatever the agreed compensation is per song/album so if they cut off a portion of the market by only making music for Spotify subscribers, they are limiting their reach and how much money they can make. This scenario for Spotify only works if they have a monopoly on music, which they don’t, and never will.
Furtermore, I don’t think the public market will support or like this move. Should Spotify come out and say they are going to invest in exclusives, or become a label, etc., I am not sure the pubilc market would react very well to this strategy.
The Bottom Line
Thinking all this through, there are a few key things that stand out to me which are big roadblocks for Spotify.
First, consumers think about music different than video. This is the main reason I have a problem using Netflix as a comperable for Spotify. Having done a lot of work with the music industry in particular, I know they know this as well. Music execs have told me time and time again, consumers will not pay as much for music as they do for video content. That’s just the simple reality and there is a mountain of historical data to justify this position.
Maybe it is because of radio, or some other dynamics where the expectation of free, or very low costs, associated with music is the norm. Signles always sold better than albums, sometimes it was cost, sometimes it was something else but the economics of music have always been different than video. Quality high-produced video is almost never free but often music can be accessed for free at any time, via an ad supported business model. This is just what consumers are use to and reversing that is very challenging.
Second, Spotify will likely be out-integrated by Apple, Google, and or Amazon. If Spotify’s most profitable market is the US, as the data suggests, it is worth noting the US is a stronghold for both Apple and Amazon. Two companies who already are good at extracting value (commerce, money, subscriptions, etc.) from their US userbase. It is highly likely both Apple and Amazon make it easier for their consumers to use their music services than choose spotify. Integration removes friction, a main reason integrators have the advantage, and Spotify as a outside service is likely to be out-integrated when it comes to the Apple and Amazon ecosystem. In the European market, where Spotify also has a good chunk of users, is also a Google/Android stronghold. You can argue, Google will keep integrating their music subscription services more deeply into Android and can push Spotify out of those markets as well.
Given the uphill battle I think Spotify has, it is this lack of control of any deeper ecosystem where they run the risk of being out integrated, that I think is the biggest reason to be bearish on Spotifies outlook.
I can track users of competing services, so the next year it will be interesting to see how this dynamic changes.