Will Spotify Eat the Music Industry?

In one of the videos Spotify put on its investor relations website ahead of its IPO, the company positioned itself as the savior of the music industry. While global music sales fell for 15 straight years, they finally started to turn around in 2015, increasing 3.5%, according to the IFPI's Global Music Report. Sales accelerated in 2016, up 5.9%, reaching $15.9 billion.

Spotify contributed nearly 3 billion euro to that 2016 number, about $3.6 billion. Spotify's sales grew 39% in 2017 to 4.1 billion euro. Investors have historically valued Spotify's shares for growth, which the company has clearly produced. The question for individual investors as Spotify nears its public listing date is whether Spotify can continue its growth as it accounts for a bigger share of the overall music industry.

Image source: Spotify.

Where is Spotify in 5 years?

With 159 million active listeners already, Spotify's growth is slowing. Its listener count increased just 29% year over year in 2017, down from 36% the year before. Premium subscribers grew 46% in 2017 compared to 71% in 2016. Notably, Spotify generated less revenue per premium subscriber in 2017 as it grew through more family plans and promotional pricing.

Those growth numbers are still strong, but they indicate Spotify will likely see a continued slowdown in its revenue growth over the next few years. But even if Spotify's growth slows 5 percentage points each year over the next five years, it'll still produce nearly 12 billion euro ($14.8 billion) in revenue in 2022. That's the same amount as the entire music industry in 2014.

Table source: Author.

The question investors have to ask is does that make sense?

How fast can the overall music industry grow?

There's no way the entire music industry can grow at the same pace as Spotify, even if the streaming service's growth is slowing.

Indeed, many expect physical media to continue its sales decline. Physical sales totaled $5.4 billion in 2016. But physical sales won't go to zero, as many listeners still prefer to own and collect their music, and there's an entire subculture of vinyl lovers.

Digital download sales from services like Apple's (AAPL +2.59%) iTunes are also declining as digital buyers turn into digital subscribers. That's a market that could much more easily go to zero as consumers weigh access versus ownership. Apple, for its part, has done well to turn its iTunes downloaders into Apple Music subscribers.

Overall, the music industry may see growth return to the levels it saw in the early 90s of about 10% per year. That would put total revenue around $27.8 billion by 2022. Spotify would account for just over half of that total based on the above forecast.

Spotify accounted for just under half of digital music sales in 2016. As digital downloads move toward zero and consumers move toward streaming, Spotify stands to capture a larger share of total digital sales. And as digital sales eat into physical sales, it's reasonable that Spotify could account for a majority of music sales within five years.

Image source: Getty Images.

The importance of sanity checks

It's important to perform sanity checks on long-term growth expectations for companies -- especially those growing quickly. If you project a company to produce more revenue five years from now than the entire industry, there better be a good reason.

In the case of Spotify, it's growing quickly, and its growth, along with the growth of other streaming services, is bringing the music industry out of a 15-year downtrend. If the music industry does reach $28 billion in 2022, it'll still be below the all-time high global sales reached in 1999 on an inflation-adjusted basis. So, consumers have shown a willingness to spend that much on music in the past. That said, investors should expect a continued slowdown in Spotify's growth over the next five years as it becomes a bigger and bigger part of the overall industry.

The analysis above also leaves room for competitors, of which there's a growing number. Apple, for example, could see its digital music download empire crumble, but Apple Music still has plenty of room to grow -- even in a world where Spotify takes over 50% of market share.

Importantly, investors should plug in their own expectations for Spotify and the rest of the music industry and see if everything adds up and makes sense. This is just one example using numbers that, quite frankly, I just guessed at.

Moreover, when Spotify stock starts trading, investors should look at what the price says about the market's growth expectations for the company and see if those make any sense.