Spotify: A Free Cash Flow Machine.
Q2 2024 ER Update
No time to read the update? Watch/listen for free:
Edited by Brian Birnbaum and an update of my original Spotify deep dive.
1.0 The Anatomy of a 3X Investment
The case for investment ideas that are not immediately justified by the numbers.
As I have been anticipating for years, Spotify’s free cash flow levels are rising exponentially. The graph below depicts soaring cumulative free cash flow production over the last twelve months. Spotify is a blueprint success story–a prime example of the type of company that I teach students to spot in my 2 Hour Deep Diver course.
Note that in the graph below, each bar represents the last twelve months.
I was delighted to bet the ranch on Spotify at $97.50 because few companies on Earth are as focused on maximizing customer LTV (lifetime value). Management’s laser-focus on customer LTV increases Spotify’s ability to capture value over the long term while simultaneously compounding goodwill with its customer base. Such improvements tend to translate into accelerating financials.
Despite the lip service given by so many management teams, constant improvement is a rare quality that underpins some of the biggest successes in modern business history, such as Amazon, Walmart, and Costco. Spotify is a prime modern example of true constant iteration.
Every additional dollar a company earns incentivizes competition and disruption. The only way to produce durable profits is to create increasingly insurmountable barriers to entry, capturing profits in lumpy increments as investments are made to fortify one’s moat. While this may sound simple on paper, only extraordinary managers are capable of forgoing current profits and Wall Street’s adoration in favor of long-term fortification–managers such as Daniel Ek.
Further, the market still does not widely acknowledge that in the network-defined, scaled economy increasingly precedes profits. Spotify has been compounding scale and customer goodwill for nearly two decades now, which has put the company in a position to proliferate free cash flow. So long as Spotify remains focused on LTV, recent leaps in FCF merely mark the beginning of their journey in offering immense shareholder value.
The above graph is inexplicable to the untrained eye. But when it comes to networks, value manifests in the financials only after years of laying groundwork. Network effects do not show up in the income statement until the focus shifts towards monetization. However, companies with immense network effects are likely to also excel at capturing value.
This is because both are simply the result of iterating the user experience better and faster than competitors.
Over its lifetime, a company operating a network needs to oscillate between focusing on scale and profits to sustainably increase shareholder value. This requires timely modifications in the company’s culture, an extraordinarily difficult task producing considerable short-term financial turbulence and stock price volatility. Yet herein also lies the opportunity for savvy investors to buy when investment cycles, which precede greater profits, cause stock price dips due to myopic investors’ negative sentiment.
Identifying a Spotify early in its development is a highly qualitative exercise that transcends generally accepted financial knowledge. It requires understanding businesses deeply and on a first principles’ basis.
2.0 The Next Frontier
Spotify continues its journey towards becoming a super app, as it continues to deploy new audio verticals with improved unit economics and solve problems for marketplace participants.
Spotify’s financial progress over the last year is merely the result of some price increases together with decreased investments in the podcasting business and leaner operating expenses. Going forward Spotify can continue increasing free cash flow levels by solving big problems for both creators and fans, thus increasing LTV disproportionately.
Since inception, I have seen the above as Spotify’s path to a considerably higher market capitalization. However, this is the first quarter I see Daniel Ek making emphasis on Spotify’s journey towards becoming a super app. When asked during the Q2 call how Spotify could go from 30% to 40% gross margins, he said the following:
Overall, the most impacting thing I can probably state around where we’re focused on is we’re focused on solving problems in the intersection between creators and consumers.
Spotify’s move into concerts exemplifies the above and addresses a problem for both creators and fans. For the former, concerts are a primary source of revenue and for the latter, a primary source of enjoyment. By focusing its iterative efforts on making concerts more accessible for both parties Spotify is likely to eventually yield a considerable source of additional revenue at a marginal cost.
I believe Spotify will address many such consumer pain points over the coming years, with an increasing proportion of the resulting revenue accruing to the bottom line. The odds of an AWS-equivalent emerging from this activity are high, rapidly increasing free cash flow levels over the coming decade, with the stock price following suit.
Further, Spotify is growing its user base fastest in developing nations, where monetization is most difficult. The above path opens up a path to monetization that relies on commerce instead of on subscriptions and advertising. Together with Spotify’s ability to optimize LTV, such activity increases the odds of long term success in these (for now) less affluent parts of the world.
I see a clear path towards a much higher valuation from here for Spotify over the long term and I thus remain long.
Until next time!
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Great work, as always.