Spotify: A 5X Investment (And Counting).

Q3 2024 ER Digest

Edited by Brian Birnbaum and an update of my original Spotify thesis.

My Spotify investment is up nearly 5-fold and has entered the two comma club. Here’s the mental framework that led to this investment, when the market thought Spotify was just a music app:

For decades Spotify has been focused on growing its subscriber base and increasing engagement, by relentlessly increasing the value delivered to customers. In turn, Spotify only increases prices sparsely, when the gap between value delivered to the customers and price is wide enough for price increases to have no negative impact on customer lifetime value. You may notice that this modus operandi is an instance of the Costco algorithm, minus the obsessive cost reductions. Now that Spotify has embedded cost efficiency into its algorithm, the sky is the limit in terms of financial performance.

Spotify is now on its way to becoming one of the strongest businesses on Earth. As you can see in the graph below, quarterly free cash flow yield is now growing exponentially, coming in at a record 12% in Q3. However, this enhanced ability to produce cash is merely the result of a few price increases, decreased investments in the podcast vertical and some newly acquired cost efficiencies–leaving all the time in the world for Spotify to solve any number of acute pains both for creators and consumers while growing its subscriber base. This endeavor will greatly magnify Spotify’s cash flows going forward.

I can’t predict the future, but I can spot vehicles that are more likely than not to successfully overcome obstacles along the way and, ultimately, profitably solve problems for customers in a way that’s increasingly harder to imitate. As such, I couldn’t possibly predict that gross margin was going to come in at a record 31.1% this quarter. But I did understand that once Spotify incorporated cost efficiency into its algorithm, financial performance was a natural byproduct. 

Spotify is now a machine that delivers more value, monetization, and cost-reduction each passing day. Over a long period of time, these daily actions will likely compound into a business one or two orders of magnitude bigger than today. With my investment up nearly five-fold at present, I believe this will evolve into a historic trade.

At this stage Spotify is still in the process of deploying new verticals, including audiobooks. In the Q&A section of the earnings call, it was interesting to learn that subscribers that engage with audiobooks consume content on Spotify for five more hours, on average. This is further evidence of Spotify’s ability to identify new verticals that can increase ARPU (average revenue per user) and capitalize on the opportunity. While Spotify has only publicly talked about the music, podcast and audiobook verticals, Ek mentioned in the call that Spotify doesn’t plan on stopping there:

So as you think about Spotify in 2025 and beyond, picture a company that operates with the same disciplined management you've seen this year, but one that also has the ambition to seize the opportunities presented by what's happening in technology. 

In the near term, I see potential for transformative shifts in music discovery and new innovative ways to connect artists and fans like never before. 

All great stuff for the music industry, which will drive further growth across our core business. And just as we successfully entered the audiobook space, we're committed to making the targeted investment that also expands Spotify into new areas, enhance the platform and deepen the value we bring to users. 

A lot of the spectacular MAU growth in the past few years has come from Spotify giving customers more options. The range of subscription plans is now broader than ever. For example, Spotify has plans to introduce a super premium subscription tier. Allegedly, this tier will offer subscribers increased proximity to their favorite artists and improve sound quality, among other features. However, it would be futile to speculate obsessively over the new tier. My view is that so long as the Spotify algorithm continues improving, all sorts of new things will emerge that will simply deliver more value to customers and thus increase LTV (lifetime value) across the board.

Spotify saw a bit of a slowdown of MAU (monthly active user) growth last quarter. YoY growth slowed down further this quarter, coming in at 11.4% in Q3 versus 13.6% in Q2 and 19.4% in Q1. We are yet to see MAU growth reaccelerate to prior levels. This is not something that concerns me. Historically the company has alternated between focusing on growth and focusing on financial performance. There’s now ample evidence that Spotify can simultaneously grow and be profitable. In the Q3 earnings call Ek said they are back to MAU growth, having missed guidance given in Q2, and that the re-acceleration is due to–you guessed it–product iterations:

I think it's early days, but I do believe we turn a corner and are back to growth again on the MAU side. And I'm happy about that because I wasn't happy about us missing the prior forecast. So it feels like we've got a good grip of it now. 

Now, as it relates to what do we do to make that happen, the reality is it's a bunch of different things, but the chief among them is really product improvements. 

So, lots of small tweaks that have been driving good results. Things in the past that's probably weren't smart, we've reversed. We've added new things as well. All that's created the backdrop of stronger engagement, which then translates to more MAU.

According to Ek, AI DJ has turned out to be one of the few features that moves the needle. In the Q&A section he explained how most progress on the platform is due to many iterations, that amount over time to yield tangible improvements. He also explained how rarely does one feature “move things” in the aggregate. This feature is testament of the Spotify algorithm and how trying to model or predict their progress over the years is a nonsensical exercise. Ek said the following about AI DJ during the Q3 call:

AI DJ, we're seeing amazing results, not just on quantitative metrics, but also on quality metrics, how people feel about Spotify, what they say they love about Spotify. 

Both music videos and AI DJ are showing up in pretty great ways. And I think this showcases the strength of Spotify. We are at our best when we can bring great innovation to our consumers.

Many of you have correctly pointed out in the past that Youtube and Spotify are set to collide in the future, with both starting to compete for eye-share in the video-podcast business. A widely under-appreciated fact is that Spotify has been going against much larger competitors repeatedly since inception. It’s borderline miraculous that they’ve managed to offset both Amazon and Apple in the music business, with the former leveraging its operating-system-level advantage to compete - and still failing to do so. In the call Ek explained how they’ve managed to this repeatedly and how he believes they will succeed again, going head to head with Youtube:

Well, I mean, if you look at the history of the company, we've always been up against much bigger companies and platforms. 

And I feel like this is the story of Spotify. And we don't really as we're entering spaces, we don't think too much about competition is the honest answer. What we do think about is, what are the needs of the consumer, what are the needs of creators.

[…]

I hope you'll follow along in what I'm sure people will live tweet and all that from the event where you can see really our philosophy at play, where we are solving real creator needs, where we're solving real consumer needs that we're seeing. And it's really how we're pursuing this. I think that there's not so much -- people make it out to be this sort of a winner-takes-all dynamic in that there's only one player that can solve all of it.

Spotify ended Q3 with €6.1B in cash, just €1.3B in debt, and rising cash flow. The company’s financial health is getting better. Over the next year or two, I believe the market is set to discover that Spotify is a world class business. Looking out further into the future, there’s no limit to Spotify’s potential to continue increasing free cash flow. And so long as the Spotify algorithm continues to improve over time, I believe shareholders will be handsomely rewarded.

Until next time!

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