Chit Chat Stocks - Fundamental Analysis: Spotify (SPOT)

Episode Date: May 24, 2020

On this show we discuss Spotify. Brett gave them a rating of 8.6 and Ryan 8.5.  --- Support this podcast: https://anchor.fm/chit-chat-money/support Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Hello and welcome. This is the Fundamental Analysis Show on Chit Chat Money, and we are talking one of our favorite companies, one that we probably talk about too much, one of the few, and it is Spotify. This was actually the first show we ever did, and it was me solo. Really bad, but it was kind of the trial run, and trial by fire, trial and error, and we're going to try to improve on it with this show. It's been over a year since the last time. And there's been a lot of news on Spotify. The financials have changed a bit. The management's still there, but they've done the big podcast initiatives. So I'll let Ryan get into Spotify, what they do. A lot of people know the company and then the history of the stock.

Yeah. And before I get into what they do, full disclosure, this is my second or third largest holding. And I believe it's one of your, either your first or second as well. Yes. Yep. Yep. Well, it could be the largest now since the stock's done pretty well the last a week or so but yeah it's up there so full disclosure you'll definitely hear a little hint of bias in there but uh yes don't know what they do spotify is a digital music podcast and video streaming service that offers access to a massive library of content from all around the world so there's two revenue drivers for the business there's the ad free subscription service or their premium service which is and there's different pricing plans which i'll get into

for that and then there's the ad supported free version um and the way i kind of think about that is it's like an intro period it's okay if you're religious at all the ad free the or the ad supported version is like purgatory you're just waiting to go to heaven with the premium subscription that's a good analogy yeah and for reference they get 46 conversion from the free to the premium so it's like the customer acquisition tool right and so 92 of the revenue comes from the subscription So it's basically all from the subscriptions, and like I said, that ad support is basically that purgatory or that introduction period. They are the leader in terms of paying users across the world. I think they have double the second most, if I'm not mistaken.

And then as an individual in the U.S., I'm not sure if it's the same for everywhere. They have three plans that I can choose from, and so each offers the first three months for free. So for $9.99 a month, there's the individual plan. For $14.99 a month, there's the family plan, which is up to six accounts. And for $4.99 a month, there's the student version, which also comes with Hulu and Showtime. And then it just varies for the prices across the world in different currencies. And then in a few markets, they're introducing a couples one, which is two. And I think it's a little more than the single.

So it's like $12 a month, or depending on what currency you have, it could be more or less. And then like in India, it costs a lot less in dollars just because that market, it's a lot less, you know, people have less money, I guess, is the most blunt way to put it over there. And when you're entering a market, especially a new market, you definitely don't have as much pricing power. So you're going to start at sort of a low price point, which is contributing to the lower ARPU number, which we'll talk about. But I'll get into the history. The idea first came to Daniel Ek in 2002 when the file sharing services like Napster and Kaza were enabling pirated music. And Daniel Ek said, you can never legislate away from piracy. Laws can help, but it doesn't take away the problem.

The only way to solve it was to build something that was better and compensate the music industry, which is what he did. In 2006, he sold his ad tech startup. I think he was 23 years old at the time, which netted him a fair amount of money. and that allowed him to develop Spotify with Martin Lorentzen in Stockholm, Sweden. It took two years to make the deals with the record companies and the app was launched in 2008. By 2011, they had a million users. And then from that point, they've obviously grown and grown

and they IPO'd in April of 2018. I read somewhere that Sean Parker, who I believe came up with Napster and he was one of the early investors in Facebook, if I'm not mistaken. Yeah, or he was a part of it, whatever. Yeah. Apparently called Daniel Ek and said, this is exactly what I wanted to build. You hit the nail on the head. So I guess there's validation from Sean Parker. But yeah, you want to get into the valuation numbers? Sure. And these will be slightly dated. So I think there'll be a day of trading before this comes out on Sunday. So just reference that the stock's been moving a lot up

and down. So the numbers might be a little different. Market cap right now is 35.6 billion ticker is SPOT, so spot, and the price is $192.74. EV to sales, a 4.37 EV to free cash flow of 126, which is very high. They're just hitting break even on the free cash flow number, so I don't think that is really something you'd want to value them on. Just because they're right around break even, things can move really quickly up and down on those free cash flow margins. less than one percent stock based compensation dilution based on the last quarterly revenue probably will be higher in other quarters because um well i don't know like what i mean it just will be just because they're a large company and i think that was just a one-time thing they also

have no dividend margin adjusted price to sales is 80 based on low gross margins and last quarter was not the best sales growth. Typically, they have been growing their sales at about 30%. The last quarter was 22%, if I'm getting that right. Yeah, you are. That had to do with the strong dollar or the currency exchange effects. Right.

A lot of companies this past quarter have been dealing with that. And I think it's just because of the, like we said, the currency exchange in terms of there was huge swings in prices due to coronavirus, i believe in the economies that were impacted so yeah the dollar was strong so that kind of hurt them um they have negative working capital just a little bit so it's almost close to net zero working capital that is mainly due to high accrued expenses which are likely due to their

contract liabilities with the labels which i think a lot of people know about they have to pay a ton of their revenue out to the labels which is why they get even though they're high growing tech stock or you know that's probably what you define them as they have a lower price to sales than a lot of other people just because their gross margins are lower. They have not much long-term debt except about $600 million in lease liabilities. So the balance sheet is pretty clean. Not many liabilities down the road outside of those label liabilities that they're going to have to pay either every year, every quarter, whatever those payment structures are. Yeah. I'll dig into the earnings. Their total monthly active users were 286 million this

quarter up 31% year over year. And that 30% number is usually steady. They tend to have 30% user growth. And so ad supported was 163 million. That makes up more than their premium subscribers, which was 130 million. And those two sort of switch in terms of which is growing faster because you start to get that transition if I'm not mistaken, right? Yeah. So think of it, if the long-term trend holds, if say right now, monthly active users that are free are growing 32%, you should expect in a year that premium users should be growing at a similar rate if the long-term trends of the customer acquisition holds. And that's been going on for the last like six years. So I would think it should continue for the time being.

And they had $2 billion in first quarter revenue up 22% year over year. I had to swap them out. It was euros to dollars. So they report in euros. I had to switch it. So maybe double check me on a lot of these, but 2 billion in first quarter revenue up 22% year over year. Gross margins were 25.5% versus 24.7% last year. Their first quarter operating loss was $18.5 million. And ARPU was $4.82 down 6% year over year. Like I said, there's those cheaper entry periods for new users. Free cash flow was negative 23 million for the quarter. They typically have positive free cash flow. And they said that they saw this coming. This was their first operating cash outflow in nine quarters. And apparently it was due to timing shifts in certain

payments to licensors. And I'm not totally, I don't totally understand that entire process and how much they paid versus what they were expecting to pay. They said it was better than they expected though they finished the quarter with roughly two billion dollars in cash cash equivalents restricted cash and short-term investments all right next up is digging trenches which is the moat rating so what do you think for spotify so this is probably where you're going to see that shareholder bias come out um i'm going to go with a two maybe higher um i think they're starting to And obviously, in terms of users, so what was it, 283 million overall users or something like that, and then 130 million paying. As of the last reported, Apple was the second.

They had 60 million subscribers. So they're crushing it in terms of user count. They have a robust platform. There's a lot of retention. I believe there was a number that said, and you might want to double check this for me, but there was a number that said when users walk away within like the first three months, 70% come back or something like that. So I think that's a sign of that sort of platform validation right there.

I think it's strong. I'm going to go to. Yeah, I think it's strong as well. The fact that they've been able to compete, grow at a faster rate and have higher usage rates than apple youtube amazon which are very uh capital whatever you'd call it they have a lot of money all three of those companies have insane amounts of money spotify is able to compete with them strongly i think they've built that moat at least personally i'm not leaving spotify as a user i don't think a lot of people are hr so i think that's just really strong you're going to retain

someone like that especially with the discovery tools you're built your own playlist you have everything locked in on there the switching costs while not very high to cancel your account everything's embedded and the the spotify tools have built those uh playlists for you they they know how your music tastes and podcast tastes are another source of sort of business validation is that basically everything they do gets copied by right yes yes yes i don't know i don't know if that offers a moat necessarily but if all these other cat all these other companies are playing catch up it's usually a good sign for the yeah that's not that i wouldn't yeah that's not part of the moat i just think that's a positive all right further reading what are you looking at

well i hope it's not much because i follow this company so closely so i think i understand most of the business but however i want to try and figure out their long-term music plans because it is a little confusing what their roadmap is they did start to sign artists directly so we thought they were trying to break away from the labels and that was in late 2018 but they backed away from that now they're trying the promotional tools with the two-sided marketplace we'll see how that goes uh but it seems like music they're gonna you know keep the labels for a while not try to you know keep them happy at least for the next few years here but after that who knows just keeping a watch on on that yeah and so that's sort of my further reading is the music industry

broadly because and it's spotify has almost become a pretty polarizing stock because people look at the gross margins and they say the labels control that business. And so I'm curious, how easy is it for artists to bypass the labels? Do artists want to bypass the labels? If Spotify works on this two-sided platform, is it better for artists to just skip the labels overall? And the other thing is, are we going to start to see price gouging possibly from those labels because they're worried that all right spotify is going to take a lot of the artists you know and it's instead of a like win-win situation it becomes sort of a competition between the two yeah i would argue that the labels are already price gouging them uh taking you know whatever 60 of the revenue

is and not really doing much of the work spotify does a lot of the work as well as the artist i would argue that yeah but that that is the big downside with spotify and something that you need to keep an eye on because that relationship is important but it's also something that you would hope they can renegotiate to better terms down the line right uh future growth opportunities what are you looking at so the big future growth opportunities as you probably have heard they acquired the joe rogan podcast for three years for i think 100 million dollars or you know varying depending on incentives and how much demand he gets but i would say that their future growth opportunity is expanding the definition of a podcast to basically just on demand spoken word

examples that can include video recorded vetted shows example they're launching that with the joe rogan experience which again is the number one show in the world they also have the harry potter thing they're doing where it's basically reading chapters of the book and putting them in a podcast which i think is very interesting they could also launch basically audiobooks in podcast format, which I think is kind of something that's merging together closer all the time. And they can also sell audio books, but I don't think they're going to do that. And you can also allow people to record live shows through Spotify. Some shows would probably be for that. It would help because they also own Anchor. And maybe if Anchor got better recording

tools, this could really work. But you could have, if you record, say, our show straight on Spotify and we didn't want to edit it at all. We were just like, all right, we're going to do this one live. It's okay. If there's a couple of mistakes or something like that, it gets recorded live. You could watch it or listen to it live. And then it becomes an embedded downloadable show or streamable show right after it airs. Yeah. I'm also curious on sort of the audio book industry. You don't want to end up having to sell individual audio books. I don't think that's a favorable business, but maybe if they're hiring authors or making like exclusive books buying out rights to books um and adding audiobooks to the platform that might be an

interesting idea yeah because i think personally i would want to listen to an ad supported audiobook yeah and then um my future growth opportunity is just owning the podcast production side so that does not mean content uh like the content side so not excluding joe rogan so i'm talking about the anchor acquisition that they already made so that they that was a big boost in that and 60% of the podcasts on Spotify are powered by anchor and 70% of the new ones are powered by anchor. So owning and enhancing the production side is the audio equivalent of vertically integrating your supply chain. Because I mean, if that's the future of the business, that's what's going to help the gross margins. You want to own that supply chain. So I think

there's a few ways that they can enhance anchor. And maybe this is me just griping as someone who uses anchor uh one first of all i'm not griping because i like the service good yeah it's a good service they have improved it um but i think it could be better right so the first step to doing that i'd say is to acquire or build a competitive recording product like audacity and embed it into the anchor recording feature because you can record on anchor but no one really does that they just upload the audio files probably from audacity or some sort of recording uh product like that. The second one would be dual-sided advertising on Anchor. So letting a podcast like us advertise on other podcasts. I think all that extra functionality, if you add that, is going to

gain more podcasts coming to Anchor and obviously more podcasts equals more advertisers. And that's what a lot of people come to Anchor for is those advertisements. So yeah, just enhancing the production side. Yeah, definitely. All right. Highlights and lowlights to end it. Okay. My highlights there's a scott galloway quote and you've said this before they own the most expensive real estate in the world and that is the bottom bar on the home iphone home screen and so that's kind of where everything stems from is that audience and owning that real estate real estate their entire music catalog has essentially been a long-winded customer acquisition cost and we're starting to see that play out hopefully it's not in the future it doesn't have to be um but it

hasn't been a profitable business to just be an audio distributor or sorry music distributor now Daniel Eck who is in and of himself a highlight for me is building out all the necessary functionality to essentially own audio and spoken word if you can get it all there's I think he posed a question on a podcast or something it was why is the why are the eyes 10 times more important than the ears or 10 times more valuable and i don't think they are i spend probably as much if not more of my time consuming content through my ears than watching like netflix so i think the ears are as valuable and right now if you're comparing let's say you compare like netflix to spotify netflix is priced like they're far more valuable i think the ears have a long

long way to grow in that sense but to the negative to the downfalls of the business it's a really competitive space big tech does have their hands all over the audio industry and while it's existential for and and brett biffin's headquartered that it's existential for spotify to thrive it's not for these big tech companies but they have unlimited capital to basically throw at this like yeah and then on the flip side though you could argue that the products just aren't as good you could you could um but it's almost like if they're if they want to take down spotify i guess they they have unlimited bullets they i mean they can just keep throwing everything at it knowing full well their product might not do it but they could make pricing that's going to lose

them a shit ton of money and maybe compete with spotify that way yeah they could but the argument that's arguments been around for what since like 2017 2018 has not come to fruition whatsoever uh so i think while it is a good thing to consider i think it's almost a dead argument at this point yeah what about you uh management's a highlight for me i think x is really good he understands the game they're playing podcast ambitions are strong i think that is a larger addressable market than people think it's only a billion dollar industry right now but it is definitely going to absorb all the on-demand radio or sorry it's going to absorb all the radio industry which is easily a 20 billion dollar market and that's all going to come to on-demand or the majority of

it is their ability to grow faster than their competitors within while competing with big tech i think is also strong it shows that they are a great company and that they are a company that is solely focusing on audio so again you said that as well low lights for me though tough margins right now. So they're not going to be very profitable, but also the labels are going to gouge them for the next few years, at least on the music side. Hopefully they can get leverage over the labels with scale and the ability to go into podcast. If that becomes say a quarter of their revenue, then they can renegotiate the deals with better terms. But you've already said the thing about the big tech. I mean, everyone has those three concerns, labels, gross margins,

big tech there's things to consider uh but i think i mean we'll get into the ratings here but i think the the highlights really outweigh the low lights of the risks there yeah and i guess that is why we are shareholders so uh what is your rating for the stock right now right now so i own the stock so it's going to be high uh but with the big price appreciation the last few weeks it's going to be a little lower one it was hindsight's 2020 but when it was in below like 150 around you know 140 160 even down to 120 which has been for a while it was really really high like above nine right now probably like 86 87 could add shares if i have a lot of money coming in but it's definitely something that i'm going to hold right now and i'm still really really bullish in the long term but

when the valuation gets up there you do have to bring that rating down a little bit you can't just fool yourself into still thinking this is a nine five at almost $200 a share. Yeah. I'm going to go 8.5, sort of in the same area as you, this would be above a nine for me. It was above a nine for me when I was buying humble brag, I guess between one 20 and one 50. Um, but there's, it's hard to rate a stock. That's like your second or third largest holding because you're basically just like, you're not buying it necessarily. You're not adding to it, but you're definitely not selling it. You're keeping it. So, um, yeah, I'll just go 8.5, obviously bullish, but not currently buying shares. Yeah. Yeah. That makes sense. I think

we're on the same page there. Eight, six for me, eight, five for Ryan. That's going to do it for this episode. Thank you guys for listening. Remember we are taking the summer hiatus because of Ryan's job and my trip. So we'll probably post on that and that we'll talk about that in the next few shows that we're wrapping up for the summer. But we will be back. Just as a reminder, we'll be back in the fall. Remember to follow us on Twitter at Chitchat Money. Email us at chitchatmoneypodcast at gmail.com. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. Thank you guys for listening. We will see you next time. Oh

This family is on the brink of civil war. On September 18th, Mobland, the hit original series, is back on Paramount+. We are the Hurricanes. Don't know them yet? Then Google us. From the underworld of Guy Ritchie. Do you want to step up the ladder? I want Cormac dead.

Starring Tom Hardy, Pierce Brosnan, and Helen Mirren. Do I have to do everything myself? You want a war? I'll give you a war! Mobland. New season hits September 18th on Paramount+.