A Foolish Take on Spotify: Don't Rush In

In this segment from the Rule Breaker Investing podcast, Motley Fool co-founder David Gardner sifts through his listeners' questions and comments to pick subjects to dive into for your elucidation and entertainment. He brings back frequent Foolish guest Aaron Bush to weigh in on the direct listing of Spotify (SPOT -4.24%). The music-streaming leader may have a large and growing base of users and subscribers, but whether its business model will ever make it profitable, let alone seriously profitable, is still unknown. So here's how they suggest you might finesse the investment.

A full transcript follows the video.

This video was recorded on March 28, 2018.

David Gardner: Listen, Aaron, as long as you're here, I'm going to do Mailbag Item No. 4 and I want you to weigh in here.

Aaron Bush: Looks good.

Gardner: You probably have a better opinion than I do. Here we go. This one's coming out of the blue. You don't know what's coming. I do. You'll be ready, though. It's from Chris Gimmer.

"Hey, David. Absolutely love your podcast. It's one of the few that I tune into each and every week." Well, thank you, Chris!

"I'm curious to hear your thoughts on Spotify's upcoming direct listing. As a music fan, Spotify is one of my favorite companies, and it's a product I use on a daily basis. As a long-term investor..."

Mnm, a tautology, Chris. You need to go back to Rule Breaker Investing 101. We don't use the phrase "long-term investor" on this podcast because by definition investing is long term. I'm having some fun, there. Don't take it personally, but you learned a great lesson, there. We don't say long-term investor. Maybe people use that phrase elsewhere at The Motley Fool, or even in the world at large, but not here, my friend! OK, so I'll just patch that up.

"As an investor, I think they have the clear lead in music streaming and I believe they'll figure out a way to make the business more profitable. However, I'm cautious about the direct listing. Not sure what to expect. I'm expecting some serious volatility during the first week or two of trading. As a Rule Breaker, what are your thoughts? Thanks, Chris." Well, thank you Chris! Aaron, what are your thoughts?

Bush: For one, I like the idea of doing a direct listing if they don't need to raise money from it but still want to go public and be open about their business. I think that's actually a great thing. Probably more businesses should do that. What do you think about that, David?

Gardner: What I think about it is do I want to own the stock or not? That's primarily where I am. We've had a bad experience with Pandora.

Bush: It's been rough.

Gardner: Pandora, to me, was such a good idea at the time. It was an out-front leader in the space. But what we've seen with Pandora's severe underperformance over the years as things like Apple Music showed up, and Amazon had Prime Music, and Spotify got bigger and bigger is that it's such a competitive field out there.

Typically, when I think about any listing, if it's going to be a new company -- an IPO, an initial public offering -- which is when a company is born on the public markets, you can buy that bouncing baby for the first time as a public market investor. In general, we've been well-rewarded for waiting and seeing how things shake out, usually three to six months later. I think studies show six months later most IPOs are below where they were when they came out as a listed company for the first time. That's how I'm feeling about Spotify.

Bush: I think Spotify is probably running laps around Pandora to be fair. They're growing subscriptions, growing users pretty aggressively, and that's really impressive. The main thing to look out for with Spotify is that the music business, by itself, is really tough. When you scale a streaming business, it's hard to scale the profitability of that business because every song you play, every new person coming in and listening to music, you have to pay for that music, and it's tough to get over that hump.

That said, I think something that could be worth looking at is, they can get so many users compared to everybody else and they become a dominant platform, maybe they can become more competitive in negotiating some of those rates down, in which case they could have a better and more profitable business.

Gardner: You know, the dream of every Rule Breaker is, in time, if it could, if it would, it certainly should become a Rule Maker. And the real question that I think about, living backwards from 25 years from now, is will there be a Rule Maker of streaming music, or will it remain a utility feature of the big dogs like Apple and Amazon? And where will Spotify or Pandora wind up?

One thing that's fun about this is that it's a business we can all watch. A lot of us are using these products or services, and so it's very consuming-facing and there's lots of lessons to be learned, especially if you're a new investor. Take a look at how Spotify does. Let's watch together.

Chris, in closing, I want to congratulate you for paying attention. Seeing that Spotify is planning on coming public and thinking that that might be a stock you'd like to buy. We're certainly fans. As long as you're not putting a lot into it, we're certainly fans of getting some skin in the game right away. That's what we've always talked about here at The Motley Fool.

We sometimes talk about buying in thirds. Let's say that you want $3,000 in that investment overall. You could buy $1,000 in the first week or so. After the stock settles a little bit, and you've just got one-third of your investment and you're buying in thirds, then let's say a month later, wherever the stock is, with your eyes closed you go ahead and add that second third, that second $1,000. And then maybe a month after that another $1,000. Taking that incremental approach often, for a lot of people, unleashes their willingness to buy into things when otherwise they would have been gun-shy thinking, "I either have to invest all $3,000 or not." That feels like a much bigger leap.