Sergi Alexander
The following segment was excerpted from this fund letter.
Spotify (NYSE:SPOT)
Spotify (SPOT) is currently selling for about $15 billion. Does this make any sense?
We have written a few times (Q2 ‘20 Letter, Q2 ‘21 Letter, Q2 ‘22 Letter) about Spotify and it still remains our favorite idea that is currently extremely mispriced by the market, in our view.
Spotify is estimated to end 2022 with 479 million monthly subscribers. Management thinks that their subscribers can get 1 billion over the next 4-5 years. The paid subscribers are estimated to end 2022 at 202 million. Therefore, based on today’s price, we are paying only $74 per paid subscriber. Now, let’s assume that Spotify can get to only 5 euros in ARPU (they are at 4.63 euros currently), then they would be collecting 60 euros per paid subscriber over a 12 months period, which makes our current payback period of only 1.2 years.
This may not be an ideal comparison, but just for some context, Netflix (NFLX) is currently selling for $590 per user and traded as high as $1,400 per user in 2021. According to the “Netflixed: the epic battle for America’s eyeballs” book by Gina Keating, the founder/CEO of Netflix Reed Hastings offered $200 per subscriber to Blockbuster back in 2007. Blockbuster’s management was insulted by such a low-ball figure and rejected his acquisition offer — the rest was history.
This sounds like a once in a lifetime kind of deal for a very high quality brand and a unique audio platform that is still early in its growth stages. But that calculation does not even take into account their rapidly growing podcasting and advertising business, which had revenues of 1.4 billion euros over the past 12 months. When Spotify went public in 2018, their ad-supported revenues were only 542 million euros and podcasting was not even in the picture.
We estimate that revenues from this business could double (we’re being very conservative) over the next 4-5 years and gross margins could grow significantly as they gain scale and pass through their very heavy investment cycle. In 4-5 years, this business alone could be worth the current market cap of $15 billion. We estimate that the premium revenues could top 20 billion euros over the next 4-5 years (assuming they can grow premium subs to 338 million and increase ARPU to 5.5 euros).
If we placed just a 2x sales multiple on this business earning close to 30% gross margins, which we believe it deserves, then the entire company should be worth close to 60 billion euros in 4-5 years time, and we believe this number could prove to be very conservative. That is a 4X return from the current price over the next 4-5 years (30%+ IRR).
While virtually no one paid attention to profits and free cash flows over the past several years, in 2022 most investors have quickly reverted back to the ‘old school’ ways of evaluating the attractiveness of a business model and long term viability of a business.
Overall, we think it’s a very healthy transition from being focused purely on revenue growth while being completely ignorant of the economic realities of the business. However, just like with everything else in life, there is a healthy balance between making sure that a business you own generates healthy profits and cash flows, and whether a company reinvests sufficiently and profitably in order to grow and expand its competitive moat over time, making sure that their profits and cash flows are sustainable.
In the case of a digital platform business like Spotify, they reinvest into their future growth through Research & Development (R&D) and Sales & Marketing (S&M) expenses. R&D runs at about 10% of Sales and S&M expense runs at about 12% of Sales. When you have a business that earns about 26% gross margins (management’s long term goal is 30-40%), these expenses can make you appear as they do not have a profitable business model — which is exactly how Mr. Market currently views Spotify. Here is what Deniel Ek (CEO) said on their most recent earnings call:
“So if you recall, at our Investor Day in June, I said that I suspect many of you think Spotify is a great product, yet at the same time, you may also think that we’re a bad business or at least a business with bad margins for the foreseeable future. And our Q3 results clearly show that our investments in the product and experience have resulted in strong user growth, retention and increased engagement, but they’ve also been a drag on near-term margins.
Just to remind everyone, this is all consistent with the strategic decisions we communicated in early 2021 and again at Investor Day. So as we’ve said, we expect this drag on margins to start to reverse in 2023. As I also shared at Investor Day, LTV (the lifetime value of a user) is the primary tool we use to inform our business decisions and judge whether our strategy and investments are working and achieving better outcomes. And the beauty of LTV is that it factors in the longevity, quality and value of the relationship we have with the user.
It is a critical metric to all teams at Spotify. And we’re constantly experimenting with what leads our users to stay longer, engage more deeply and ultimately convert to our paid offerings. And what we’ve seen time and time again is how sticky our users are because of the product and experience that we’ve created.”
Consistent with these words from Spotify’s CEO, it’s important to realize that the health and viability of a business model for digital platforms, especially ones still early in their growth stages, need to be evaluated by a different measuring stick than we typically use for mature physical businesses like Starbucks or Costcos of the world, which grow by opening new stores and investing into capital expenditures. The primary long term value driver of Spotify’s business is the lifetime value of a user (LTV) and how much they need to spend in order to acquire and keep that user engaged.
Simply put, this is how Spotify derives its long term value:
(Amount of users) X (LTV of a user — cost of user acquisition)
Thus, in order to grow its value, Spotify needs to heavily invest into (1) growing the amount of users through investments in Sales & Marketing; (2) making sure that the user experience is industry-leading and that users are engaged and stay with Sporify for a long time, which is done through investments in Research & Development. We believe that on these key metrics Spotify’s management has done a good job.
Below is a great example of how management approaches their investment decisions:
“We will make new investments with two criteria in mind. First, it must be accretive to margin over the investment period given this new hurdle rate. And second, over the long term, that investment must strengthen our value proposition to users and creators alike. This said, new opportunities will likely emerge in downturns. As an example, we may find that our customer acquisition cost goes down as the cost of advertising typically declines in a softer market.
This would then offer us a clear opportunity to grow our market share even in a challenging economy because we can acquire users at lower cost relative to LTV. We saw this dynamic play out in the beginning of the pandemic, and we benefited from it. And we expect we would do so this time around should the opportunity present itself as well. And this philosophy is not new for those that have followed us for a while, but I realize that this may frustrate some of you who would prefer we manage to the quarter.
Some companies do just that, and I get that’s what some investors look for, especially now in this show-me market. But simply put, I don’t think that’s a winning strategy long term nor is it the right one for Spotify.”
Since Spotify went public in 2018, it has invested over 4 billion euros into R&D and over 5 billion euros into S&M. These investments helped Spotify become the number one audio platform in the world and grow their MAU from 207 million to 479 million. Spotify’s premium business gross margins are currently close to 30%, however they are willing to sacrifice these margins in the short run in order to invest into their podcasting business, which is pulling those margins towards mid-20s (another factor that Wall Street is not a fan of at the moment).
We believe these investments will prove to be lucrative over time and Spotify could see a boost in its gross margins to 30-40% over the next 4-5 years (advertising business is much more profitable than the music business, where Spotify has to pay out 70 cents on the dollar to music labels).
If that plays out and Spotify continues reinvesting at the same rate they have been in the past, they could be earning ~10% operating margins by 2025, which would translate to 1.3 billion euros in operating profits on our projected 24.5 billion euros in revenues (in comparison, their GAAP operating profit was just 94 million euros on 9.7 billion euros in revenues in 2021). If we were to adjust for their heavy R&D investments, which we project to be ~2.3 billion euros by 2025, their adjusted (steady-state) operating profits would amount to ~3.7 billion euros (or 15% adjusted operating margins).
Let’s apply a very conservative multiple of 18x (for the quality of the business and its growth potential) — this would amount to ~67 billion euros valuation by 2025. This translates to ~45% annualized return or IRR. Even if they fall short on the future growth projections or on their gross margin expansion, we believe that this type of expected IRR compensates us more than sufficiently for the business and macroeconomic risks.
In other words, we think that the risk/reward on this investment at today’s price is incredible, especially if we were to compare it to the “safe” Proctor & Gambles and Coca-Colas of the world that barely get us to the mid-single digits IRRs.
DISCLOSURESThe information contained in this letter is provided for informational purposes only, is not complete, and does not contain certain material information about our Fund, including important disclosures relating to the risks, fees, expenses, liquidity restrictions and other terms of investing, and is subject to change without notice. The information contained herein does not take into account the particular investment objective or financial or other circumstances of any individual investor. An investment in our fund is suitable only for qualified investors that fully understand the risks of such an investment. An investor should review thoroughly with his or her adviser the funds definitive private placement memorandum before making an investment determination. Rowan Street is not acting as an investment adviser or otherwise making any recommendation as to an investor’s decision to invest in our funds. This document does not constitute an offer of investment advisory services by Rowan Street, nor an offering of limited partnership interests our fund; any such offering will be made solely pursuant to the fund’s private placement memorandum. An investment in our fund will be subject to a variety of risks (which are described in the fund’s definitive private placement memorandum), and there can be no assurance that the fund’s investment objective will be met or that the fund will achieve results comparable to those described in this letter, or that the fund will make any profit or will be able to avoid incurring losses. As with any investment vehicle, past performance cannot assure any level of future results. If applicable, fund performance information gives effect to any investments made by the fund in certain public offerings, participation in which may be restricted with respect to certain investors. As a result, performance for the specified periods with respect to any such restricted investors may differ materially from the performance of the fund. All performance information for the fund is stated net of all fees and expenses, reinvestment of interest and dividends and include allocation for incentive interest and have not been audited (except for certain year end numbers). S&P 500 performance information is included as relative market performance for the periods indicated and not as a standard of comparison, as it depicts a basket of securities and is an unmanaged, broadly based index which differs in numerous respects from the portfolio composition of the fund. It is not a performance benchmark, but is being used to illustrate the concept of “absolute” performance during periods of weakness in the equity markets. Index performance numbers reflected in this letter reflect reinvestment of dividends and interest (as applicable). Index information was compiled from sources that we believe to be reliable; however, we make no representations or guarantees with respect to the accuracy or completeness of such data. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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