Spotify’s stock is risky because the music industry is not changing fast enough. – Barron’s

Spotify’s stock is risky because the music industry is not changing fast enough. – Barron’s

Spotify saved the music industry. Some thanks it is getting: Artists skewer the streaming giant, a record label has sued it, and

calls it a freeloader.

Fans on Wall Street, however, see a more harmonious future when
Spotify Technology

(ticker: SPOT) dominates not just the music industry, but all of audio.

CEO Daniel Ek “has been saying to us for years that audio is far too small relative to seeing (10% of the value, at most) and doesn’t reflect either time spent or the troubles of internet privacy and discontent,” says James Anderson, head of global equities for Baillie Gifford. “The next generation listens more than it looks.” Baillie Gifford is the biggest institutional investor in Spotify, with a 10.4% stake.

Illustration by Justin Metz

Investors love Spotify because it checks so many boxes: a fast-growing, youth-focused, cloud-operated, subscription-based music streaming service with a visionary founder. And Spotify is now investing heavily in podcasting, a nascent business whose U.S. revenues are expected to more than double, to about $659 million from 2017 to 2020.

That potential is why investors value the company at $25 billion, more than the annual revenue of the entire global recorded-music industry. Bullish analysts such as RBC Capital Markets’ Mark Mahaney think that Spotify can be the next

(NFLX), an underdog that outmaneuvers all the tech giants.

A year after Spotify first listed its shares on the New York Stock Exchange at $165.90, investors are debating whether it is indeed the next Netflix or a jukebox that doesn’t get to keep most of its quarters. Spotify’s stock has climbed and plunged more than Mariah Carey’s voice on her hit “Emotions”—from a high of $198.99 to a low of $103.29. It’s now at $140.

Wall Street was surprised in February when the company projected that its gross profit margins would fall to 22%-25% in 2019 from 26.7% in the fourth quarter of 2018. Analysts have more than doubled their estimated loss for Spotify this year, to negative $1.48 per share, and their timeline for its projected profitability keeps fading into the distance. A year ago, Wall Street was convinced that Spotify would be reporting annual profits by 2020. Since then, analysts have pushed expectations back to 2021. Estimates range widely, from a gain of $3.66 to a loss of 95 cents.

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Without earnings, Spotify is difficult to value. Its price-to-sales multiple of 3.4 times isn’t outrageous for a growing tech company. It’s less than

(GRUB), for instance, but Grubhub is profitable.

Spotify might well end up being as indispensable to an investor’s portfolio as it is to a teenager’s phone. But for that to happen, investors need to believe that the music industry’s underlying structure will change radically in the coming decade, and that the tech giants that are competing more aggressively with Spotify will lose interest. Don’t bet on it. At current prices, the stock’s potential reward isn’t worth the risk.

Spotify’s revenue is rising, and it has more listeners—96 million paid subscribers and 207 million monthly active users—than any other music service. The problem is that its costs to license that music are high, with almost 70% of its revenue going toward content costs. There is little evidence it can reduce those costs anytime soon.

Money Changes Everything

How a $10 monthly music subscription fee would be shared with the label, artist, songwriter, and publisher.


This amount of the monthly

fee goes to the record label,

with $1-2 of that going to the



This is the amount of money

a streaming service takes

from the total based on a $10

monthly fee.


This is the amount the

publisher takes, with 0.50

cents to a $1 going to the



This amount of the monthly fee goes

to the record label, with $1-$2 of that

going to the artist.


This is the amount of money a streaming

service takes from the total based on

a $10 monthly fee.


This is the amount the publisher takes,

with 0.50 cents to a $1 going to the


“Spotify’s business model at this stage is really tough because the bulk of the revenue they’re generating goes to the labels and the artists,” says David Marcus, CEO of Evermore Global Advisors. “While [the company] has a humongous valuation, they now have to figure out how to get a bigger piece of the pie.”

The largest slice of the pie goes to the three largest music labels:
(VIV.France) Universal Music Group division,
(SNE) Sony Music division, and privately held Warner Music Group.

“The place to be at this stage is with the content,” Marcus says. His firm owns a stake in Vivendi, but not in Spotify.

The labels’ music libraries get more valuable as more people pay to access them. While Spotify is the one hustling to persuade millions around the world to pay for streaming music, the labels are the ones hearing ever louder “cha-chings”—whether you’re streaming “Money” by Pink Floyd (Universal), “Money” by Cardi B (Warner), or “Mo Money Mo Problems” by Notorious B.I.G. (Sony).

The music industry was singing a sadder song in 2006, when co-founder Ek formed the company in Stockholm at age 23. Napster’s music file-sharing system had destroyed the old business model. Young people downloaded gigabytes’ worth of music for free, and revenues from recorded music tumbled to $19.6 billion in 2006 from $25.2 billion in 1999. Sweden, thanks to its lax copyright laws, was on the frontline of that download revolution when Ek came of age. He briefly ran a company called uTorrent that enabled file-sharing.

At the time that Spotify started, iTunes was ascendant. By 2009, digital purchases had passed physical sales as the top way of buying music. With iTunes, people could buy individual songs for 99 cents—no more shelling out $15 for an album. During the late 2000s and early 2010s, people spent nearly twice as much on singles as they did on full albums, according to the Recording Industry Association of America. The new economics were even worse than the old ones, and music industry revenue kept falling until bottoming at $14.3 billion in 2014.

The labels had an incentive to encourage competition among music distributors. So even though Spotify was a tiny start-up housed above a coffee shop in Stockholm, Ek was able to get meetings with them. As an added sweetener, Spotify sold the labels 18% of the company’s equity at attractive prices. The deal was a huge boon for the service because its most important suppliers now had a literal stake in its success.

Artists were not as sold. One recent survey by Digital Music News put Spotify’s payout rate at 0.4 cents per stream. That paltry rate translated into just $12,231 for cellist Zoë Keating, even though her songs had been played 2.25 million times by 241,000 people in 2018.

Prince compared selling music over the internet to “carjacking.” Taylor Swift pulled her music from Spotify in 2014, and in an op-ed article in The Wall Street Journal lumped streaming with piracy.

Ek met with musicians to try to convince them he wasn’t the enemy. Often, it worked. Swift returned to Spotify in 2017 and even released a music video exclusively on the service.

Patrick Carney, drummer for the Black Keys, initially fought the trend, criticizing Spotify and holding his album off the service. But after meeting with Ek, Carney was assured that Spotify isn’t the biggest problem in an industry “designed to confuse the living crap out of everybody,” he says, employing a more colorful word.

“Ultimately, streaming is the way of the future,” Carney tells Barron’s. “We’re never going to go back. Every artist would agree with that.”

Still, some songwriters are also upset that Spotify is appealing a ruling that would increase their royalties.

Spotify, whose executives declined to comment for this article, entered the U.S. market in 2011 after signing rights deals with the labels. That gave it a head start on Apple’s streaming service, which launched in 2015. Today, the two services are thought to have similar market shares in the U.S.

The international market is a different story.
Tencent Music Entertainment Group

(TME) dominates China. (Spotify has taken a minority stake in the company.) Outside of China, Spotify is the clear global market leader, with an estimated 31% market share, ahead of Apple (AAPL), at 17%;

(AMZN), at 12%; and
Sirius XM Holdings

(SIRI), which now owns Pandora, at 11%, according to
Credit Suisse
YouTube’s paid music services are still relatively small, but one survey found that free YouTube videos accounted for nearly half of the time that people in 18 countries spent listening to music.

Unlike other industries such as online travel, where competition was eventually whittled down to two dominant players, music streaming is likely to remain a battlefield. “I’ve had conversations with every label, and they understand very clearly that it is in their best interest to maintain as much competition of the distributors of their content as possible,” says Brian Russo of Credit Suisse, who rates Spotify at Underperform with a $120 price target.

Competition among the current streaming players is fierce. Spotify filed a complaint last month with European antitrust regulators claiming that Apple is unfairly charging Spotify to use its App Store. Apple countered that Spotify wants to get free access to services that other companies pay for.

Most of the world doesn’t pay for streaming music, choosing to listen on the radio or to pirate content, which still accounts for 38% of the market, Credit Suisse says. The bullish case for Spotify implies that many of those people can be persuaded to pay up. Even bearish analysts expect the company to more than double its global paid subscriptions over the next five years.

Yet there are sharp disagreements on Wall Street over where Spotify will be able to add subscribers and how profitable those subscribers will be. (The ads that run on Spotify’s free service account for less than 20% of revenue.) As the company has expanded, its average revenue per user has fallen, because it’s growing faster in less lucrative markets and more people are choosing student and family plans.

In February, Spotify projected a slowdown in the growth of monthly active users and paid subscribers for the coming year.

Before Spotify went public, the labels signed deals that allowed the company to increase its gross margin from 13.4% to 25.5% from 2016 to 2018. Their equity stakes—and interest in seeing Spotify succeed to compete with Apple—gave them substantial incentives to do so.

But there’s little evidence that the central players will give the next inch quite so easily.

Sony, which had initially taken the largest stake in Spotify, sold half of it last year, and Warner sold everything. Universal, the largest of the three and the home of 2018’s best-selling artist Drake, hasn’t announced any Spotify stock sales, but it is now going through its own transition. Vivendi plans to sell as much as half of Universal, and the company has been pitching itself to investors as a more valuable part of the music industry than Spotify.

Last year, Sony also bought EMI Music Publishing, which could further bolster its leverage. Spotify is girding for the next round of negotiations. “There was an economic self-interest of the record-label partners to allow the margin to increase, because, after all, streaming has been the single source of renewed revenue growth to labels,” Spotify Chief Financial Officer Barry McCarthy told investors in February. “So what was good for Spotify was good for the labels, and that’s why the margin increased. Now, on a go-forward basis, is that going to happen again? No, that’s not going to happen again.”

The labels are fighting Spotify in other ways, too, with Warner recently suing Spotify to try to limit its expansion in India.

How does Spotify fight back against these forces, and widen its slice of the pie? The company has clearly gained power as it has added subscribers. And Spotify could compete directly with the labels; it even has a small business helping independent artists stream their music directly. But Ek has repeatedly said he doesn’t want to replace the labels.

McCarthy, who was previously CFO at Netflix, outlined two paths to greater profitability. The first is to sell labels and artists new services like data about streaming habits.

The other strategy is to create new kinds of content. That’s where podcasts come in. Spotify announced this year that it will spend $400 million to $500 million on podcast-related acquisitions. It announced the first two deals in February, buying podcast producer Gimlet Media and podcast software company Anchor for $340 million. Ek has said that he sees nonmusic content eventually accounting for over 20% of Spotify listening, and that it is valuable largely as a draw for subscribers. Already, Spotify has shows that you can get only on its platform.

Industry insiders said the price tag—particularly for the Gimlet portion—was remarkably high, perhaps as much as 10 times revenue. And while the appeal of podcasting is growing, its financial impact is modest.

Podcasting may not scale as well as other digital media. A growing share of ads are read by the hosts, and they pay off for advertisers because they blend more easily into the content. Targeted programmatic ads—the kind that have made billions of dollars for
Google (GOOGL) and

(FB)—haven’t taken off on podcasts. The industry’s trajectory looks more linear than exponential.

There’s a third way for Spotify to become a chart-topping investment, but it’s a wild card that won’t play out for a while, if at all. The music industry is rarely static, and the pending sale of a stake in Universal Music is one sign that the players could change.

If the labels break apart, or a more tech-focused company buys into the content, Spotify is well placed to take advantage. Anyone with a garage full of 8-tracks knows change happens fast in the music industry.

Anderson of Baillie Gifford believes that Spotify’s CEO has the necessary skills. “Ek will probably be the most important European business leader of the next 30 years,” he says.

Write to Avi Salzman at [email protected]


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