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Edited by Brian Birnbaum and an update of my original Spotify thesis.
Spotify is a world-class implementation of the Costco Algorithm.
Spotify is now a $100B+ business. In the graph below you can see how Spotify’s market cap has evolved over the past few years, trending down to a low of $14B in late 2022 before surging to the current levels. At that time the consensus held that Spotify was a mediocre business, but a first principles understanding of the fundamentals would have revealed otherwise. Much like the Netflix case, Spotify teaches us that the path to wealth is focusing on fundamentals over price action.
In businesses with network effects, scale precedes profits in the list of strategic priorities. Understanding this axiom, coupled with a few other important abstractions, is what enabled me to make a big bet on Spotify at $97.50. I term the mental model behind this investment the Costco Algorithm, which I teach in myTech Stock Goldmine course. In essence, I have found Costco’s operational blueprint replicated across industries to extraordinary success in the most brilliant instances.
The Costco algorithm is best understood via the slide below, taken from my course. Costco is unreasonably obsessed with lowering real prices for end customers to ultimately deliver more value per dollar spent and reinvesting the profits to lower prices further. Nick Sleep coined this operational blueprint as economies of scale shared. Over the long term, the strategy produces vast goodwill with end customers.
The algorithm is harder to replicate with every turn of the flywheel, as the company continues operating profitably, reinvesting, and lowering prices. Scaling begins to cut off their competitors’ oxygen and fortifies their moat to the point where customers have little reason to go elsewhere because they know they will get the best deal with the company running the Costco algorithm.
In the market’s defense, Spotify’s free cash flow per share trended down considerably in 2022, as you can see in the graph below. But the same occurred with Amazon and Meta, whose stocks also fell to unreasonably cheap levels, because investors tend to extrapolate the evolution of free cash flow per share rather than perform deep fundamental analysis. I have therefore insisted on countless occasions that financials be the scaffolding on which you build your qualitative thesis, rather than the other way around. Without a qualitative understanding of a business, there’s very little understanding at all.
As I predicted, following the decline in 2022, free cash flow per share grew exponentially. So what happened? Spotify’s world-class implementation of the Costco Algorithm suddenly exploded on the income and, to an even greater extent, cash flow statements.
In late 2022 Spotify was compounding goodwill faster than ever, with MAUs (monthly active subscribers) growing at record pace. Since its foundation Spotify has been focused on iterating the user experience faster than competitors, much to the delight of its customers. Spotify’s top operational priority is enhancing user lifetime value; every update to the app must promote this metric.
Economically, this means delivering more value to end customers per dollar spent on their behalf. As Spotify achieves more scale, greater investment delivers greater value at lower prices, making it harder for others to compete. To me, the clearest evidence of Spotify’s extraordinary ability to run the Costco playbook is beating Apple and Amazon simultaneously, with much fewer resources.
Although Spotify may look to the untrained eye like just another audio player, perhaps not so different from Apple and Amazon music, for those well acquainted–and in a rather subliminal manner–the user experience is palpably superior. Such superiority is the result of their exclusive focus on improving user value, while Apple’s and Amazon’s focus is divided between many other businesses.
After decades of being exclusively focused on compounding customer goodwill, Spotify has shifted some of its attention to becoming an extraordinary business. The work they’ve done over the past two decades has created a strong moat that has put them in a position to make a lot of money. The exponential rise of free cash flow per share has been the result of some minor price increases and additional focus on cost efficiencies, as you can see in the graph below.
Costco only increases prices after verifying that they’ve added sufficient additional value to end customers–and never more than 15% above cost. And cost efficiency has been a major focus for them since the outset, driving much of the additional value that they’ve delivered to customers over the decades. However, Spotify is a network-defined variant of the Costco algorithm. For them, the most important scale is their path to delivering maximum value.
This is generally true of all other businesses with network effects; the moment a larger platform comes along, your earning power starts to wither considerably, which is why, when it comes to businesses that rely on network effects, scale precedes profits on the list of strategic priorities. Another great example of this axiom is Amazon: they focused on scale over profits for decades, as you can see in the graph below.
Amazon’s extraordinary earning power, the result of focusing on compounding customer goodwill for over three decades now, only started to show up in the financials towards the end of that last decade. Amazon is also a world-class implementation of the Costco Algorithm and also wields significant network effects. The Spotify case shows that, with regard to companies that reinvest heavily and build upon network effects, the market hasn’t quite learned to identify value until quite late in the game. In fact, my recent Wise deep dive is looking like another example.
Since the economy is evolving ever more rapidly into a collection of networks, I have created a specific section in my course to teach folks how to spot network-defined variants of the Costco Algorithm. For shorthand, I now call them the Amazon/Spotify algorithm.
One of the most important aspects of the Amazon/Spotify Algorithm is understanding that it’s much more useful to focus on cash flow than the income statement. In 2022, much of the market’s focus was on Spotify’s lack of GAAP profitability, when the company was producing ample cash from operations, as seen below. Excellent growth companies engineer their income statements to minimize profits, and therefore taxes, in order to optimally reinvest capital.
The cash flow statement is a much more accurate representation of a growth company’s earning power. Much of the Spotify thesis’s asymmetry back in 2022 stemmed from its positive cash from operations. The business was much more viable than the market believed, even before consideration of future upside.
While Spotify’s more-than-five-fold increase in value from $97.50 per share seems ready for a break, whether or not we see a price retracement, the company has much more upside from here. Spotify has been adding new audio verticals to the platform, which boast far better unit economics than does music. Historically, Spotify has had to pay 75% revenue to music labels in exchange for rights. But this is changing as Spotify users come to spend more time listening to podcasts, audiobooks, and the subsequent audio verticals that Spotify will deploy.
Some time ago I said that Spotify was the Google of audio in the making, highlighting the fact that Spotify is becoming a search engine. I believe that five years from now Spotify will have solved a vast volume of problems for both creators and consumers across a broad range of media verticals, greatly increasing margins and free cash flow per share from here. By then, the platform will look and feel like a search engine that I believe will pose Youtube and other search engines serious challenges.
Spotify’s earnings are coming up on the 4th of February. Stay tuned for my update.
Until next time!
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Thanks for your article. Honestly, i don't see Costco algo at work at all:
- https://www.reddit.com/r/spotify/comments/1d72opc/spotify_hikes_prices_of_premium_plans_again_as/
- https://www.reddit.com/r/indieheads/comments/187msq9/spotify_made_56m_profit_but_has_decided_not_to/
- https://support.spotify.com/us/article/price-updates/
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My plan’s price increased already recently, why are you increasing it again?
We are committed to delivering the best audio content around the world, and we are always working to bring our subscribers a highly personalized experience and powerful discovery tools. This update will help us continue delivering value to fans.
"""
- https://www.reddit.com/r/spotify/comments/1d72opc/spotify_hikes_prices_of_premium_plans_again_as/:
"""
I can switch over to YouTube Music real quick. I'm already paying for YouTube Premium. I literally don't use YT Music because I like Spotify better. That can change incredibly fast.
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It has a relatively low gross profit margin trending up consistently
How is this sharing economics of scaling with customers exactly? Where's the actual moat, if they use its focus to release irrelevant features?
how do you measure the value delivered per dollar in this situation?
how is this different than farming and squeezing users?
Ty