Spotify (NYSE:SPOT) looks like another richly valued tech stock, but it's a lot cheaper than you think. Here's why: It has an enormous addressable opportunity ahead, it is by far the most well-positioned company to capture that opportunity, and it is expanding into more profitable revenue streams. None of that appears widely accepted by the market, but I think it is only a matter of time.
Huge addressable market
Spotify has 271 million monthly average users (MAUs), including 124 paying Premium subscribers. That is a huge number already, but Spotify is still only scratching the surface. The number of internet-enabled smartphones is a relative proxy for Spotify's addressable opportunity, and there are over 3 billion of them in territories where Spotify operates or intends to operate over time. And that figure should only grow as smartphone penetration continues.
Spotify founder and CEO Daniel Ek recently discussed the company's long-term opportunity on the Invest Like The Best podcast. He said:
We believe our market that we're going after is audio. And that's going to be at least a billion, probably two or three billion people around the world that would want to consume some form of content like that on a daily or weekly basis. And if we're going to win that market I think we'd have to be at least a third of that market. So we're talking -- we probably have somewhere between 10x-15x from where [we] are now of opportunity left. So we are still very early days in our journey.
Leading the global audio streaming market
In the battle for this big long-term opportunity, Spotify has plenty of competition from Apple Music, Amazon Music, Alphabet's YouTube Music, and Sirius XM's Pandora, as well as local players like India's Gaana.
But Spotify is benefiting from having a superior product, which is evident by its enormous and widening lead versus its competitors. No. 2 music streaming service Apple Music had 60 million paid subscribers in June of last year, the last time Apple was willing to disclose the figure. If Apple had impressive numbers to share that compared favorably to Spotify's torrid growth, it surely would have shared them.
Spotify not only has far more users and subscribers than its direct competitors, but its users use the service much more. (Peer Tencent Music technically has a larger user base but doesn't directly compete with Spotify in any geographic markets.) Ek estimates Spotify's user engagement is twice that of Apple Music and three times that of Amazon Music. That is another sign of Spotify's product superiority.
What makes that possible is a corporate strategy that is focused exclusively on audio streaming. None of Spotify's direct competitors are as focused on this single opportunity because no other company will live or die by it. Apple Music, Amazon Music, and YouTube Music are side projects, among many, for their parent companies. Just look at the research and development (R&D) intensity at Spotify. It has almost 2,100 research and development employees, which is almost 50% of its entire workforce.
Mix shift toward higher-profit areas
Spotify's core business of streaming music that's controlled by the major music labels is a relatively low profit margin business because it is believed to pay more than 65% of revenue to the music rights holders as royalty payments. After other costs of revenue, the company's gross profit margin of about 26% gets eaten up by plenty of additional costs and overhead expenses, leaving operating income slightly negative. That's why two of the company's newer initiatives are so interesting -- original podcasting content and marketplace services.
Spotify is investing hundreds of millions in acquiring podcasting content and development assets. It acquired Gimlet, Anchor, and Parcast last year for a total of 357 million euros (equivalent to about $387 million at current exchange rates). And just last week, Spotify announced plans to acquire sports website and podcasting platform The Ringer. While the exact purchase price was not disclosed, it's been reported to have cost an estimated $250 million. Original podcast content that Spotify owns allows the company to make money via advertising while also boosting conversion rates of free users to paid subscribers. And the advertising technology that the company is creating to radically improve podcast ad targeting and measurement is designed to significantly increase the value of podcast ads. This should be a far more profitable venture than streaming of label-controlled music.
Spotify's "two-sided marketplace" strategy essentially sells advertising and promotional services to artists and music labels. Sponsored recommendations, where artists and labels promote a certain album or song to users who Spotify thinks will like it, is the latest example. Management has said this should have "software-type" profit margins, which are far higher than Spotify's existing business today.
The market doesn't seem to to care about these initiatives at the moment, but investors should think about how big and profitable Spotify should be in the future when considering how cheap it is today. After all, value is the present value of all future cash flows.