Episode 32 | Spotify’s Business Mix: Growth, Competition, and Margins

In Episode 32 of “Market News with Rodney Lake,” Rodney Lake, Director of the GW Investment Institute, explores Spotify's business model, which revolves around two main revenue streams: premium subscriptions and ad-supported services. The company operates in a competitive streaming market dominated by players like Apple and Amazon, but is praised for performing well in its niche. Spotify’s revenue reached $15 billion in 2024, growing at 18%, though its margins are relatively modest, with a 30% gross margin and 7.5% net margin. Co-founder and CEO Daniel Ek remains as a key factor in the company's success, with a high alignment between management and shareholders. Despite Spotify's solid business fundamentals and impressive leadership, Lake discusses concerns over Spotify’s valuation, with a high forward PE ratio of 60 times, given its modest growth projections and net margins.

Transcript

Thank you for joining “Market News with Rodney Lake.” This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to “Market News with Rodney Lake.” I'm your host, Rodney Lake. Today's episode is going to be on a company called Spotify.

And again, we're coming to you from the George Washington University School of Business, Duquès Hall. All right. So if you've been following this is the GW Investment Institute framework that we're going to use to evaluate companies. Of course we have guest now and again as well. But today we're talking about Spotify. It is a portfolio company for the GW Investment Institute.

It's not a large position. It's grown thankfully, but it's not a large position. But because you know, lately it's been doing well and it's been in focus. We wanted to take some time to evaluate how is it doing. And as you know, we use the GW Investment Institute investment framework: business management, price valuation and balance sheet. So let's jump into it.

You've probably heard of Spotify. You probably even maybe even have Spotify. Maybe you're listening to this podcast on Spotify. And welcome to everybody on Spotify, Apple, Amazon and YouTube if you're watching video as well. So let's get into it. So what is their business? What is Spotify actually do? Most people know it. It's a streaming business and they make money two ways.

They have a premium service and they have ad supported services. The vast majority is on the premium service. That's the bulk of their revenue. Then they have some revenue now coming on the ad supported. Now they have a high cost because they have to pay artists, you know, for, you know, for their music, for their podcast, whatever it happens to be.

Where is the revenue split? You know, and it's, you know, in many countries, the US is the bulk of the revenue, almost 20%. And then UK is another almost 15%. Luxembourg actually is a big number for some reason, about 18%. That's the growth, excuse me, for those countries. So these are these are significant markets.

These are these dominate sort of, you know, most of their business. And so this is a, you know, a company that, you know, is in a very, challenging business, let's say, has a lot of competition. If you think about who are the competitors? It's Apple, as you can probably guess, is a huge competitor. Now Amazon, you know, Amazon Prime people use Amazon Music.

And so this is not an easy business to be in. And yet it's carved out its niche. It's carved out a place in the market. And it's it's been doing well. So let's now look at what okay what's the overall number. So you know this is how they make money right. Mostly from premium service, some from ad supported.

But what's the what's the revenue look like. Well, and let's tackle the market cap here as well. 100 and, $22 billion market cap. So this is not a small company, right? It hit a 52 week high. We're in, you know, mid-February here. Just recently hit a 52 week high. And so, you know, this company is doing well.

Market cap 128 billion right now. So it has been doing well. This is not a small company by any stretch of the imagination. So when we talk about it, you're talking about a sizable company, but it does operate within its own realm, its own niche, in the streaming services area. So now let's let's tackle the revenue.

What's the revenue look like? Well, when you talk about 2024, 12/31, you're talking about, you know, 15 billion in revenue, it's grown at 18%. That's pretty good. That's not bad at all for where the revenue is. And so when you look at the gross profit margin now, so we're talking again about the B here the business part of the equation.

You're at a 30% gross margin. You're like well that's not you know it's not Visa type at 70 plus percent. But that's not terrible. But then you start thinking about, okay, let's look down at the net margins. The net margins here are 7.5%. So these are not terrific. These are even if you said like maybe ten is an average number for the S&P 500 for a net margin.

This is below average. And and even if you said, okay, we're going to lower that average to about seven and a half. Okay. Then it's an average net income business here, so, margin business. So that's not fabulous. But, you know, they are growing the business. They are, you know, carving out their own niche.

They have been doing a good job, certainly been leading, in, in the world of podcasting as one example, where they, they've done very well and people, like, tend to like this service and certainly are paying for it. Most of their revenue comes from the premium service. So when you look at the revenue, it's grown, you know, 20 some percent, 20%, 13% over the last, you know, few years, 18%.

And it's projected to grow about 16%, for next year. So not a huge growth number. But when you're talking 15 billion in revenue, a sizable revenue number. And again, when you look at the the gross margins, 30%, the projected to go up a little bit, and then net net income margin seven and a half projected to go up to just over 11.

So again these are not fabulous margins that would make it maybe if you said 10% is average business, this makes it slightly better than the average business. And so when we talk about the business of Spotify again, how do they make money? They're making money from premium subscriptions and ad supported subscriptions. You know the business very likely. But they have to pay a lot of money out to artists, people to produce this content.

So it can be very expensive. And you look at the net margins and yeah, this is not a fabulous, high margin business. You're not talking about aVisa or an Nvidia or a Microsoft. You do not have those type of margins in this business, even though you would say, well, this is a consumer facing tech business.

And you would think, well, maybe the margin should be higher. But when you really think about, okay, well where the costs? Well, the content right is the cost. And so they have to pay a lot of money for that content. Some people say content is king. Distribution is obviously a huge part of, of any business. They are the distribution.

They gotta pay for that content. So we talked about the business. Now let's get into now the management of this business. And so if you've been following at all this business is based in Stockholm and its founder, Daniel Ek, still runs this business. And so he is the chairman, CEO and co-founder of this business currently. And when you look at businesses that have done well over time recently we talked about Oracle, still a founder involved in that business.

You talk about Apple, Steve Jobs involved in that business up until he passed away. When you really talk about business that are founder led, Nvidia, we've talked about that as well. You know, they tend to have a passion about this business at this point in the business. They probably made a bunch of money. So they're not really driven okay.

How am I going to get fabulously wealthy? They're already wealthy, but they're really trying to grow this business. This is their enterprise. This is their baby. However you want to describe it, you know, this is something that is important to them, beyond, you know, sort of material wealth set up. So that's important when you think about, okay, is this management team incentivized?

Is this management team motivated? Does this management team have a sense of urgency that they need to drive this business forward? You would think a founder generally speaking, not always, but generally speaking of a founder still involved at this point, the business that goes from startup into a, you know, $100 billion plus company, market cap company, okay, they have a drive associated with them.

They have something they have a vision about what they want to do, and they can get people on board for that vision. And you need that for a fantastic management team. You need a leader that's going to push people, that's going to get people to stay motivated even after they've had success. And a founder many times, not all the time, many times can have that impact.

Can have that effect. And so generally speaking of the Institute, we like founder-led businesses because we think that they have these attributes that are associated with, you know, keeping people motivated. A sense of urgency around that business. Now, they can still check out and that happens from time to time. However, now we like this.

So, you know, big mark for Daniel Ek, we go back to the business. So the business, I think we would give them, you know, when we're doing 1 to 10, ten being the best, we'd probably give the business to 6 or 7 right now with that sort of gross margins, of 30 and net margins of seven and a half.

And even if you look forward for next year, slightly better there, but still kind of an average. So maybe you give them a six and a half, seven, because they're going to, you know, they're still growing 15%. But you would also now you would give the management  very high marks. And so you could give the management an 8 or 9 right here and say that Daniel Ek and company are doing a good job.

Are their incentives aligned? It seems that way. Daniel Ek still owns something like 15% right around there of the business right now. So still very much aligned with shareholders. You know, when, you know, if you talk about just the wealth, you know, his wealth will be directly tied to the growth of the business, right? A huge chunk of his net worth is probably tied up, specifically in that 15% of the company that he owns.

And so we're very likely aligned there. Founder’s still running the business. So that's exciting for us. And so you can give the management team at 8 or 9, led by Daniel Ek when we talk about the management side. Now, some of the things that we can talk about, we talk about capital allocation for management and really where they're making decisions, they have been quite disciplined about what they've been up to and they have been very focused.

And they really just have these two revenue streams. And so you can also give management credit. And now this is probably not, considering everything, but certainly considering most things, they have been fairly focused on what they've been good at, which is the streaming business getting people to pay for that premium business, making sure that they get content on that platform, making sure they get access to artists, making sure that, you know, when they were really trying to drive the podcasting forward.

And you had Joe Rogan as an example, to, to move on to that platform. And they did a deal with him a few years ago. And so you have to give them credit. The management team are thinking about what's the future of the business. What's this going to look like? How do we distinguish ourselves? How do we carve out this niche?

It's a crowded field at the top. You're not. It's not crowded as in there's 100 players, but there are big players with deep pockets. When you talk about Apple, when you talk about Amazon, these people have a lot of money, right. So they can put resources at things and they have distribution. When you talk about Apple, they have their phones and Amazon has Amazon Prime.

So these are important factors to consider. And so the management team you again you have to give high marks on the capital allocation keeping the company focused side of the business. And so they have not tried to veer off into 8 million different things. They've been, you know, working on the business that they're good at, working at the business that I think people appreciate.

And I think that has paid dividends for them. Now. They don't actually pay dividends as a company. Excuse me, but, it's paid dividends as far as the growth of the company, staying focused, all those things I think are relevant, to consider. And it's something that they should get credit for. And so, again, the management team: founder-led, alignment of interest good.

15% of the company still owned by Daniel Ek, still leading the business seems still very super charged. Sense of urgency to make this business better. Still leading the troops. I think this is a good management team. And you talk about capital allocation, keeping the business focused, doing deals that matter. You know, the Joe Rogan a few years ago certainly helps on the podcasting side of the business.

And so I think those things are all good signs for the management team. And you can give them credit for that again in 8 or 9 for the management team too. So far we're talking maybe 6 or 7 for the business, 8 or 9 for the management team. Now let's jump into the price versus valuation.

Now lots of people get super excited about this part of Spotify because when you look at this, the PE forward, which is the one we care about, we care about the forward PE, not the trailing because we, you know, we're if we own the company today or we're buying shares or selling shares today, tomorrow, in the future, but we don't care about the rearview mirror. 60 times.

That's where we are right now. Again, we're mid-February, so 60 times. That's not a cheap business. And when you square that with, okay, we got 7.5% net margins, 30% gross margins. We're you're paying up, you know, however you want to cut it. You know, not even being old school value oriented. You're still paying up for this.

When you talk about a 7.5%, net margin even grown to, let's say, even if they can get to 12, right, you're still maybe slightly better than an average net margin business, and you're paying 60 times for that. So you better have the growth. But when you look at the growth, well the growth is okay. But the growth in revenue even next year you're projecting, you know, 16%.

These are not, this over this next, 2025, you know, 16%. And the year after that, 15%. The consensus numbers, these are not enormous numbers. And certainly when you talk about paying 60 times for that, that's not easy. So here not that it's not a good business. Right. We've already established that it's a good business and maybe not a great business in the current setup.

Excellent management team. But the the price versus the valuation right now you're really talking about, you know, maybe it's a six because you have to pay 60 times for those earnings. Now again, maybe that's going to work out. Maybe they're going to grow faster. Maybe they're going to get into a different line of business.

Maybe they're going to figure out a way to increase those margins so they get a better, even a better multiple, but even 60. They need to grow into a little bit. So probably give them a six here on the valuation. And you know not bad. And again last year the full first year of profitability that they had.

So the business is good. I think the forward multiple is appropriate to use for them. Right now you can use a PE for this company. But again, a six here. Not fantastic. But let's say, slightly better than average here. And, and you could probably argue that either way. All right.

And we're going to review everything again here, as we go back through it. So but now let's move on to the balance sheet. How is the balance sheet doing for this company? So again we mentioned market cap 122 billion revenue of 15 billion. What does the balance sheet look like? So they have about 2 billion in debt.

Is that an issue? Well they have 7 billion, almost 7.5 billion of cash and cash equivalents. So you got you got net cash on the balance sheet. You know, $5 billion. You're really not worried about this business. And they're generating 2.2 billion in free cash flow. So they're generating more in free cash flow than they have the debt.

And they're, you know, net cash, on the balance sheet of, let's say, $5 billion plus. So you're not really worried, right? So net cash of 5 billion plus 2 billion of free cash flow so that debt piece you're not really worried about they have a low interest coverage ratio, but not to be too concerned about that.

They got net cash. They're generating, you know, 2 billion of free cash flow. And they have basically 2 billion and if you look at how they have managed the balance sheet over time, it's something also as an analyst that we asked our analyst at the Investment Institute to look at, you know, how how has it changed over time? Because if it's dramatic, you know, you might want to look into it. If it's gone from 0 to 2 billion, you know, in the last year, you might say like, okay, well what's going on?

Did they do an acquisition? You know, you want to look into that. But the balance sheet 18 17 17 2 over, you know, 21 22 23 24 respectively. So you're not really thinking like, okay, we're alarmed about this balance sheet. It's been pretty consistent over time. And they've had all that way. They have it, they've had net cash, and now they even have a higher net cash position than they've had over the last three years.

And so not worried, they're generating 2 billion in free cash flow as well. So when you look at the interest coverage ratios it seems a little bit low. But you might not want to be too focused on the interest coverage ratio, just because it's not something that, you know, you want to get yourself too worked up about if you, you know, even right now, though, it looks pretty good at it 38 times.

And so, so but you look at the stats for the balance sheet, these are all good metrics. You can probably give the balance sheet a nine or even a ten. Right. This is not something that you're going to be concerned about. And if you look at how they manage the balance sheet over time, and again the balance sheet is a reflection of management.

So these two components are obviously very connected. But you're you're given management high scores and you're giving the balance sheet a very high score here, a 9 or 10. So now let's go back through. Right. So the balance sheet, to wrap up that part before we pull everything together. 9 or 10. Not an issue. So let now let's go through everything.

Right. The business of Spotify as we talked about, is the premium, and this and the ad supported. Right. So most people are paying for the premium. Their business is a is a global business. The US is a huge chunk of it. Europe is a big chunk of it. The rest of the world is a big chunk. So you know, you have to, you know, be mindful of of how sort of those economies that are doing around the world, they don't seem to be that cyclical.

Now we, you know, we have to watch that over time. You know, this is something that is a service that people pay for. So it is a subscription. So if there is a significant downturn in the market, you have to think, well, if people are looking to cut things, maybe they would cut their Spotify subscription and maybe not.

Right. Maybe this is just one of those small luxuries that people they want to keep. And so maybe it's a little more resilient than we might think. It's not necessarily a consumer staple. It is consumer discretionary. But maybe it gets a little closer to consumer staple iIf people really feel like this is something that they use every day, that this is where they get news, this is where they get music, this is how they get information from podcasts.

And so maybe they're less likely to cut their Spotify subscription versus, you know, that third cup of coffee or something like that. So overall, business good. But you know, those, net margins of 7.5%. Not great. So we're talking, you know, again, in the realm of 6 or 7 there. But when we move on to the management, Daniel Ek and company doing a fantastic job have done a fantastic job.

The founder of the company, co-founded the company, currently the CEO and chairman, doing a great job, has been very responsive about growing the business. $122 billion market cap right now, $120 billion market cap right now. Fabulous execution here. And so you get you have to give the management team credit, led by Daniel Ek aligned with shareholders again, 15% of the business still owned by Daniel Ek, co-founder of the business.

So alignment there. Capital allocation good. They've been steady. They've been disciplined about the growth of the business and been very focused on the categories that matter for them. Next up is the price valuation. Here you talk at 60 times forward. You're giving a little lower score there. Again 8 or 9 on the management the the valuation. You're probably talking even 5 or 6.

We talked about six the first time through it. And then when you look in and again that's because you're, you're paying up for it, right? 7.5% net margins paying 60 times forward. That's can be tough. They have to grow and they're growing. You know, 18%. That's good. But that's not 60%. That's not, you know, 100% growth.

So 60 times you are definitely paying up. But then you look at the balance sheet again connected to the management team. That's who's deciding how to manage that balance sheet. And net cash 5 billion, been responsible over the last three years. Net cash position. You can sleep at night. We're not worried about that high interest coverage ratio 38 times.

So this this business has, overall good marks, right. So when you pull all those together, depending on how you score each one, 25 percent weighting for each, you're probably coming out in the seven and a half range or something like that. Right. So not something you're like, okay, let's pound the table, and buy this company right now because we're so convinced.

But also we own shares of the Investment Institute. Should we be buying more? Should we be holding our positions? Should we be, you know, watching it closely. It's something that we have to think about. That's what we're asking our analysts to do. The business has grown. They've recently hit a 52 week high, first year, full profitability. So it's a company to watch.

It's a company that is executing. It's a company that's well-led well-managed. So I'd say good business. Fantastic management team. You know a little bit rich on the valuation rate as of right now and maybe not, you know, who knows. But certainly up there on the valuation. Strong solid balance sheet overall 6 or 7 on the you know, maybe seven let's say, on the business 7.25 overall for Spotify.

We’ll ask our analysts, they keep looking at this company. Well obviously keep hopefully benefiting from their growth and their good management. Until the next time, until the next episode. That's a wrap for market news with Rodney Lake. See you next time. Thank you.

Disclaimer the content shared in the GW Investment Institute Podcast is for informational and educational purposes only, and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest, and do not necessarily reflect the views of the GW Investment Institute or the George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor. Investing involves risks including the loss of principal. The GW Investment Institute, the George Washington University, and the podcast hosts do not assume any responsibility for any investment decisions made based on the content of this podcast. Always conduct your own research and consult with a financial advisor before making any investment decisions.