A case is made for the streaming service.
October 4, 2021
Spotify (NYSE: SPOT) has been a leader in the streaming space for a number of years. The problem, and it’s a big one for investors, is that the company’s core business operates with low margins because it’s selling against rivals like Apple, which are selling essentially the same thing.
That has not stopped Spotify from growing while trying to find ways to expand its business beyond its core offering. To make that happen the company has moved aggressively into the podcasting space making deals with Joe Rogan and buying Bill Simmons’s “The Ringer,” which owns a very successful podcast network.
Spotify has a huge audience but it has struggled to make money. The challenge — and really the big question for investors is whether it can find other ways to monetize its audience. That’s something it has had some early success with but it clearly still has a long way to go.
It’s possible that podcasting becomes a bigger part of the company’s business and it has tested some promising ideas when it comes to advertising revenue. In addition, it’s also possible that Spotify could find ways to make its product stand out compared to its rivals, though that’s a challenge when the core offering is unlimited music which works pretty much the same no matter where a consumer buys it.
Ryan Henderson and Brett Schaeffer from Chit Chat Money joined Dan Kline on the Oct. 1 “7investing Now” to make a case for Spotify. They made a compelling argument (even if Dan remains a skeptic).
A full transcript follows the video.
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At this point I want to bring up we are going to go to a really interesting interview I did with the guys from Chit Chat money, friends of the family. We’ve had them on the show before. I will point out that we did this interview in late August, right when Spotify reported we had technical difficulties, we finally have the video working I think. So sit back. It’s about 22 minutes long. I will join you at the end. If you have any questions please ask but thank you JT. If you want hit the video.
Welcome back to 7Investing Now as we discussed, Spotify just reported Q2 earnings. And its share price fell after it missed on subscriber totals. Basically, they gave a guidance. They didn’t hit that guidance. I don’t put very much stock into any sort of stock movement right now. Because I feel like with a lot of stocks, people are either looking to pick out one positive thing like wow, hey, this company, like everything’s bad, but they didn’t burn anything down like you know, and then the stock will go up. Or if they’ll cherry pick one bad number. I do think this is a cherry pick of one bad number. But the company did fall right after earnings. It’s recovered some of that, but I wanted to invite our friends from Chit Chat money Ryan Henderson and Brett Schaffer to talk about their long term belief in the streaming music company. Gentlemen, it’s been a while. Welcome back to 7Investing Now.
Brett Schafer 22:38 Yeah, thanks for having us. Thanks, Dan.
Dan Kline 22:41 It is so we are recording this. on a Thursday I’m doing it with a relatively limited amount of sleep. So apologies if I’m not as sharp as usual. But let me just lay out the core case of why I don’t own Spotify (NASDAQ: SPOT). Their basic product is music streaming. Music streaming has a a set price.
You cannot cost more than Apple. You cannot charge more than Amazon. And then there’s dueling people who want money, the labels want their share. And artists are increasingly speaking up and saying, Hey, this is not fair. Now there’s some room in cutting out the label. If you’re Taylor Swift, maybe you could do that. If you’re nobody, you don’t have a label. But everybody in the middle has this pressure. So that’s what I don’t like about Spotify. They don’t have a lot of pricing control. There’s not a lot of margin there. I love the podcast business and they could spin off the podcast business though I think Joe Rogan’s can end up biting them in the in the foot. But if they could spin up the Ringer, and all the other stuff they own. I think that would be a great investable business. But guys, you believe in this company way more than I do? Tell me why I’m wrong.
Brett Schafer 23:43 All right, I’ll hit it first. And yeah, I think you’re right, initially on the music stuff. And that is the majority of their business right now, I guess I’ll probably go through some of the numbers, just forgiving a reference for anyone. So if you look at the financials, and these are going to be in Euros, which is pretty close to the dollar, but their total revenue in Q2. Premium was 2 billion euros and then ad support is 275 million euros.
So the majority of their business right now is from the premium music subscription. And I think you’re right that the the pricing power or excuse me on the pricing power. I think we do disagree on the pricing power part. But the margin side on the premium music subscriptions are not going to expand that much. Although I will say that it has incrementally gone up last quarter, it was at 28.4%. And that is up historically. What is it Ryan down closer to 25%, something like that? And there are it is a bit lumpy. But there is some room there. And yeah, you know, there there’s some troubles with the labels and the artists and stuff like that.
But one reason we really like Spotify is some of the numbers they give out on the music side with the engagement that their users have with the product. So they have two to three times the engagement of say they call it their competitors. When they say that I believe they are meaning Apple Music, YouTube Music, or Amazon Music. And when you hear that, that means they have two to three times the engagement. And then that means though, that when they’re paying out the stream per, you know, paying out the artists, the number that they payout per stream is going to be less, and that looks bad and a headline number. But that number really doesn’t matter because it’s all just based on subscriber pools. And Spotify pays out an increasing amount to the publishing labels. If you look at some of the numbers, they give out, over 870 artists generated $1 million or more from streaming royalties in 2020. And that is up 90% from 2017. Or is a lot of that go into the labels? Yes, but Spotify is increasingly providing value and they’re being what streaming now 62%, I think of all music revenue,
Ryan Henderson 25:58 Yeah, they’ve kind of so I would, I would credit Spotify, to almost all that, but the music revenue in the music industry has returned to growth for like the first time it was declining for what, like 10 years?
Brett Schafer 26:11 Yeah, 10, 15 years because of the pirating and stuff like that, and Spotify was the one that saved them. And we see all that stuff and that might not mean much financially. But two things that may mean, you know, could help financially is one, the discovery marketplace.
They’re doing this thing, where labels basically get gross margin, gross profit kickbacks, for promoting their artists on either the homepage, or by notifications that get popped up or from insertions into Spotify playlists. And a lot of these playlists have really, really, you know, I mean, they’re used everyday by a lot of people you have discover weekly, you got daily drive, rap caviar. I think they give out numbers about I think discover weekly hit like 12 billion listens, or something like that. I could be getting the name of that one wrong. But that is a great way for them to get margins back. Dan yeah sorry,
Dan Kline 27:05 Let me jump in. Because this is a lot like paying for end cap space in a grocery store or paying to be to be on the new and noteworthy table at Barnes and Noble. I’ve talked about what my book was on that table. It’s sold 1000s of copies. And when it wasn’t, it didn’t. But that being said, it still has to be good, right? Because if I’m listening to, you know, whatever, the you know, middle-aged dad-rock playlist on, on Spotify, and all of a sudden, it’s a bunch of stuff I don’t want to listen to, well, they’re gonna lose that pricing power. So there’s a really tough, a really tough negotiation there of taking the money, and making sure the songs would actually be playable on that playlist.
Brett Schafer 27:45 Yeah, one thing I maybe get pushed back on that is that Spotify has been really, really good. And one of the ways we believe they differentiated from the competition is the way they’ve curated listening, and curated artists, for their consumers. And that is the reason you know, I think the proof is there that people use it two to three times more than the competition, so they’re able to find songs for you. Again, discover weekly was the big clear one here. I’ll give one stat here.
So from the discover week, or sorry, excuse me from the two-sided marketplace, they gave out last quarter, the discovery mode, if you use it, they have found over 40% more listeners on average, compared to being on pre discovering more load. And then additionally, 44% of those listeners have never listened to the artists before. So one of the big important, you know, streaming for an artist. It’s not where they make the most of the money, most of the money is made and live shows or other ancillary products like that. So streaming is really for artists discovery, and it can boost, you know, the people that have found you by 40%. That indicates to us that the value is there, and that the two-sided marketplace can be strong. And then there’s one other thing I have, but Ryan, did you have anything else?
Ryan Henderson 28:57 I’d also add that there is it is sort of a commoditized service wrapped in a much better app and a much better experience and more personalization, because they’re getting, and I think the numbers kind of proved that out. I think that 365 million total monthly active users. And I think the second closest was Apple with 70 million of the last.
Brett Schafer 29:18 Yeah, this report. Yeah, it’s hard to compare, because they do not update every quarter. But.
Ryan Henderson 29:22 Yeah, so it’s just I think there is But to your point, there’s always going to be a cap because you have to pay out the rights holders. And so there might be a little wiggle room in there in terms of growing their slice of the pie. But overall, what they’re doing is growing the pie entirely in music, and then am I missing anything on the music side?
Brett Schafer 29:43 No, I mean, the margins aren’t going to be super high, but probably about 30% over the long term. That’s not a terrible business, especially as a subscription. So they can make money on that are they going to have 30% operating margins like some of these other software businesses? No way is that going to happen. But the other thing I’d add is, so a lot of people think that Spotify does not have pricing power.
But they have actually been raising prices in a few markets and churn did not go down overall. Now, they only raised it in a few markets, and they’re testing out some things. So while churn is still falling, and they’re at, they have the ability to raise prices, that indicates to us that they may have more pricing power than you assume. Because at first you think, you know, it is a commodity product, but the customer lock in with these things. You have all your playlists on there, you have all your downloaded songs, they know what type of players they want, they’re feeding you the songs that you want, that we believe in, we could be wrong, and we might, they might not have as much pricing power as we think. But we believe because of that they’re gonna have more, it’s less of a commodity than people assume.
And the ability to raise prices is a lot stronger. Will it be incremental will be not as much as maybe a Netflix? We think that’s the case. But then interestingly, if they raise prices, that is more being paid out to the artists, that is something that can really help improve their relationships with the artists with the labels versus someone like Apple Music if they’re trying to sell it for a cheaper and cheaper price. I hope that makes sense.
Dan Kline 31:15 Yeah. So the optics with the artists are never going to work because Apple can always target the 500 most important artists and throw them throw a concert, pay them to do documentaries. There’s other ways they’re making good. Spotify could do that to a very small point, but they don’t have the they don’t need Apple doesn’t need to make any money on music. It’s just a value add for everything else.
So that to me is tough to compete with. The challenge with Spotify for me, because I think you’re right, I think they have $1 or two of pricing ability where if I’m paying 10.99 for Apple Music versus 12.99 for Spotify, I don’t think I care if I’m a meshed in one or the other. Now for me. I don’t see any differences.
Let me ask you guys the question. So here’s how I discover music. I’m a 47-year-old man, most of my musical tastes developed in college. And now here’s how I discover new musicians. It’s almost always Saturday Night Live. Like, generally whoever the artist is. And there’s usually one or two a year and I’ll give a weird example. Never heard of Olivia Rodrigo until Saturday Night Live because why would I as a 47-yea- old man. And while it’s not my music, you can hear the Taylor Swift in influence. I like the recent Taylor Swift albums. And I get it like I understand it.
But the one I really like – Machine Gun Kelly was on SNL this year, never heard of him until he appeared, went to listen to his back catalog. It’s all terrible. But his current album is really really good. And its an incredible step forward. I can’t, I’m not listening to discovery whatever, hearing 100 songs hoping I’m going to hear him too. I’m curious at your age, are you guys just like putting on music and, you know, and hearing things? Like even in colleg I just generally just listen to the music my friends told me, you know, that they liked and I liked a lot?
Brett Schafer 33:01 Well, I do. I mean, you do get that, you know, anecdotal people tossing stuff back and forth. But
Ryan Henderson 33:05 I think you’re right, that a lot of the listening habits actually are formed in college. And I think that’s why they discount the college scription. And then, I mean, I guess our habits are probably different. So like my parents, they used to, like, know everything by the album, whereas we just kind of know him by the song. And it usually it’s because it’s lumped in to a playlist that we’re subscribed to.
And then you’re like, Oh, you like that song or you download it and you add it to your own playlist. But as far as the with the pricing power back to that it’s, they give a churn number and if they really usually discount early on, so they can start to slowly incrementally increase prices, as you’ve been with them longer. They’re obviously not going to do that in there, like a brand new market, because that’s probably a bad luck. But I would say we are kind of belaboring the music point. And I think the part of the business that we like the best and it sounds like he liked the best, but maybe it’s because we’re talking our book is the podcast.
Brett Schafer 34:08 Yeah, we are. I wish to be clear that we use one of the assets. Spotify has his Megaphone, we use their marketplace for the advertising. So I guess we have a lot of anecdotal evidence with that as well.
Ryan Henderson 34:20 Yeah, I’ll unless you have any more questions.
Dan Kline 34:23 No, I think this so here’s the thing. I love the podcast business. I thought 400 million or whatever they paid for the Ringer was brilliant. Bill Simmons on his own is probably paying for that deal. And they basically have an endless ability to launch new podcast. Bill Simmons, if you’re listening. There is no finance or stock market podcast on the Ringer or on Spotify of any note, give me a call. But that being said, I think there’s a lot of ability to grow there.
But I do think there’s a cap for that as well where there’s so much competition. Someone like Joe Rogan or what is it called Call Me Daddy, which they just signed up. There’s, again, there’s only so many of those out there. And any of those, like super controversial ones, you’re walking a tightrope, like if you told me tomorrow Joe Rogan said something that Spotify had to cut ties, it wouldn’t shock me. So I wonder a lot about that’s a great business, and they’re the leader in it. I wonder how big that business can be? Give me your thoughts. And we’ll we’ll close out with this.
Ryan Henderson 35:22 Yeah. And so that is part of the, that’s part of the worries there with the podcasting side is sort of what’s the addressable market look like. And it’s worth noting that the Yeah, they own, like the podcast themselves, that’s part of their podcasting strategy, where they have the Ringer, Joe Rogan, Call Her Daddy. And that’s sort of their originals and exclusives, but another part that we like is they own the distribution. So even if Apple podcast grows, its listeners, the amount of users on Apple podcast, they’re making money off that because if, if they’re, if whatever the podcast is, is being distributed on Megaphone or Anchor.
So I don’t know what you guys distribute yours on, but we use Megaphone and they have basically the best and maybe the only ad targeted marketplace that’s automated. And the way to think about that is it’s a bit like a YouTube where we submit where the ad inventory would be, and then advertisers can automatically bid on it. And it just gets inserted. So we don’t have to record that advertisement or anything like that. And so that part is growing right now it’s at about just north of a billion-dollar revenue run rate.
Brett Schafer 36:31 And that is including music.
Ryan Henderson 36:32 That’s Yeah, but it’s, I would say, I’m guessing, mostly podcasts. And so it’s actually growing. So they categorize that as ad-supported revenue. And that’s actually growing 200%, more than 200% organically and 600% for them in organically at north of a billion-dollar revenue run rate. And while it’s hard to put you kind of have to ballpark numbers on it. I think we compare it a bit to linear TV versus smart TVs and the advertisers shifting over where it’s like linear radio versus on-demand audio, we think that’s early in the shift from radio advertisers to on demand audio advertisers. And I think –
Brett Schafer 37:16 While the audience is already over there, so for example, when Rogan pleased to have all his listeners, but they were struggling to get advertisers in 2016, 2017, you’re like, well, how many advertisers are actually on streaming TV? It takes a few years. Now the majority of people in western markets are listening to podcasts now, but the advertising inventory has struggled to get over there. One of the reasons for that is that Apple has been the big winner.
Overall, they basically embedded podcast because it’s iPod podcast, that’s kind of how it started. But they don’t care at all. They just have it through the RSS feed, they give you no data on your shows, well, they give you minimal data. And they also have it download only so it’s really hard to track how well the advertisers are doing. So the reason saying is that advertisers had no incentive to go on to some sort of inventory thing. Apple was not helping them out at all. But Spotify is trying to do that. It might just take a few years.
Ryan Henderson 38:08 And I know I know I gotta go pretty quickly, I guess. But it is a small portion of their business right now. But even in the last conference call, the CEO Daniel Eck said, this is going to be a substantial part of our revenue mix moving forward, the days of it being less than 10% are gone. We see that continuing to grow. We can see advertisers continuing to ship over for podcasts because it’s a better value proposition for them. They can target people based on data, location, listening habits, age, whatever, they’re the data they provide us. So that is probably the crux of our bullishness is the outside of music audio.
Brett Schafer 38:49 Yeah, and I’ll get I’ll add on to more things. Maybe this is something that Megaphone gave us, they have a monthly newsletter. And it’s one of the reasons why we are happy as a Spotify / Megaphone customers. So when we put those when we put those advertising slots in, right now what would you say it’s probably half get filled at best, it’s not nearly as good of a fill rate as YouTube. But last quarter, they said they gave us an update that fill rates had increased 10% CPMs, which is the advertising per 1000, listens, increased 40%. So what people are paying for advertising slot was up 40%. And that is because of Spotify targeting capabilities. And then the number of unique advertisers nearly doubled for some publishers. That’s a bit bad, but still everything’s heading in the right direction.
So even if, say podcasting, advertising doesn’t grow, or sorry, excuse me, podcast listenership doesn’t grow from its existing inventory. Even if they just get the fill rates, basically, from half to full. They get double revenue in that. And there’s also what two or three other strong tailwinds just from overall listenership going up podcast is growing in podcasting itself listenership around the world is growing at a double-digit rate. And then Gosh, what’s the other one?
Oh, listenership on Spotify is growing at like a double-digit rate they’re taking market share from Apple at an impressive rate. And yes, Anchor and Megaphone can get advertisements out to Apple and other places. But the concern is with Apple, you don’t get the data because it’s just downloaded and stuff like that. So the more that’s on Spotify, the more it’s vertically integrated, the higher and higher the CPM rates will go and that means more money for Spotify. It means more money for creators and it means better targeting hopefully for the listeners which and that’s not like a benefit for them or anything like that, but it’s really helping.
Dan Kline 40:41 No absolutely, it’s a benefit. So if you remember the old days of podcasts and you heard me on many podcasts where you know Chris Hill would be touting me undies or whatever the generic you know food service or whatever it was. If I’m listening to something and it targets an ad to me that’s well-targeted it’s something I’m looking for which is not usually the case that ad becomes content I think that’s something Facebook has done really well. Just a couple of notes as we close out here. There is more advertising moving to digital television, but it’s not moving from linear television.
It’s important to note that advertising rates post-pandemic are actually up on linear television and they’re very up in sports. So there’s just more effectiveness to it so there’s more dollars where we’re losing dollars is a local radio market there’s very little actual local radio if you don’t live in a major city so companies that used to be obvious – when I used to run a toy store we advertise on our local radio station that old guys who build models you know like to listen to. And then when that stopped being a live thing and started being a syndicated programming well we ran cable ads on the History Channel because that’s what old guys who build models are watching sorry people who I’m stereotyping but that’s how we that’s how we targeted our ads. So I do think this is all going to get bigger but guys explained to me all of these seem like relatively tight margins with growth but not massive growth. So why Spotify and not Disney or Apple and I and I’m gonna guess you probably both own both of those also. So that’s a terrible example.
Brett Schafer 42:17 But I get no I get I get what you mean there the so the podcast advertising margins are very, very high. You don’t see that on the income statement right now. But Spotify itself, they’re guiding for 20 to 40% of, excuse me revenue to be coming from advertising over time, and if and there guy for gross margins to get up to 40%, which isn’t crazy high. But that’s with the premium subscriptions at 30% margins max. So well with the gross margins and that’s not true profitability are a lot higher on podcasting. And I think people see right now because ad supported –
Ryan Henderson 42:57 So content costs, all content costs, like podcasts related content cost gets lumped into the cost of revenue under ad supported. So it’s not really representative of the profitability of their podcast side. You run a podcast. Costs are basically a microphone and maybe a Zoom subscription. It’s very high margin just naturally that’s just the type of business that it is. And then so the podcast they own the originals an exclusive or high margin and then the the ad platform that they own has a 50% take rate and it doesn’t there’s very little variable costs. They are essentially just garnering money every time an advertiser bids on ad inventory. So it really is I think it’s masqueraded by the content costs but I think underneath it’s a really profitable business
Brett Schafer 43:47 And then add some risk because you have to not look at what Spotify is doing right now and you have to kind of put on some rosy colored glasses and say Alright, this is what it can look three to five years from now and I will caveat that that does add some risk. But if you believe in that and we believe that you can see it from you know what they’re doing and how they’re really eating market share from Apple and no one else is focusing on audio this heavily with that that’s the that’s the bet we’re willing to make.
Ryan Henderson 44:17 But again, we’re biased because we have a podcast Yeah, that’s
Dan Kline 44:20 Yeah, that colors my thinking as well. Ryan Henderson, Brett Shaffer. Thank you for doing this I have so many more questions but we’ll ask them off here after we stop this so we don’t go on too long. I will now throw it back to myself. I don’t know where I am because I’m not I think this is gonna air Monday so I think I’m going to be in in Orlando but I can’t 100% promise that.
I was only off by roughly 35 days about when I would air that I appreciate all of you watching the Chit Chat money guys go check out their programming, they do a wonderful job. We will have them back on the program.
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