Spotify: A Case Study in Value Compounding

One of the most important considerations in consumer-facing technology investing is asking whether the
product alleviates pain points, reduces friction or enhances convenience. Whether it is Amazon, Netflix or
Peloton, all winning consumer platforms exhibit these attributes. With its best-in-class user experience
(UX), along with class-leading music discovery and curation, so too does Spotify. It has all the makings of
a company on its ways to platform dominance. Spotify is the category leader in music streaming with 299
million subscribers across 92 countries. With 35% of the global music streaming market, the company has
nearly twice the market share of Apple Music, at 19%. Spotify has compounded its leading position in
recent years adding premium subscribers at twice the rate of Apple. While Spotify’s growth has been
impressive, we think the adoption of music streaming is still in early innings.

Music streaming has changed so much over the past few years in response to the digital revolution and
has already produced an epochal shift in how people listen to music (See Exhibit 1 for the evolution of the
music industry), with most of the adoption taking place through mobile phones. While historically mobile
phones have provided the onramp to music streaming consumption, the next phase of growth will be
driven by a plethora of emerging platforms including connected cars, gaming devices, workout equipment
and smart speakers (owned by millions). Music streaming is tailor-made for the emerging music
everywhere lifestyle. The surfeit of products designed for music streaming enables one to listen to the
same podcast or playlist while doing a morning workout, commuting to the office (headphones or
connected car), working on your office PC and upon returning to home relaxing with a smart speaker.

The transition across devices and activities is seamless allowing one to pick up where they left off no
matter their activity. The integration of music everywhere into our lives exponentially increases the value
of music streaming, moving it from a nice-to-have to a must-have service. As device proliferation
accelerates, Spotify’s position as the category leader makes it most likely to be designed into device
presets. Just as Google Maps is pre-loaded on car dashboard screens so too is Spotify. This creates a
virtuous feedback loop with scale leading to design integration, which in turn drives scale higher through
new consumer trials. This is similar to what we have seen with Sirius’ dominance of satellite radio. Spotify
is already available on 300 devices across 80 hardware brands. With that kind of hardware footprint, it
becomes very difficult to dislodge incumbency.

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While the market tends to categorize music streaming customers on a like per like basis, Spotify users are
more passionate. Spotify listeners are twice as engaged as Apple Music users and three times as engaged
as Amazon Music Unlimited users. Other than an operating system (which is perhaps the right way to
think of Spotify – audio OS), there are few software programs or apps that generate the daily usage of
Spotify. The average Spotify user spends 25 hours a month on the service, topping even Facebook at 19
hours a month and Instagram at 14 hours per month. With each music streaming service offering up
largely identical music libraries, conventional wisdom suggests there is little in the way of competitive
differentiation making the music streaming platforms commodity businesses.

This would be true if one did not care about user experience, search functionality or social integration.
The very fact that the average Spotify user is on the platform an entire day a month suggests that ease of
use and value of discovery are paramount. There is no doubt that Spotify’s platform is sticky with 70% of
churned users returning within 45 days. This is indicative of its competitive differentiation, something we
believe the market has not caught on to yet. Ultimately, we think the economic spoils from music
subscription will be greater than video platforms as most users will only subscribe to one platform.

Labels and other actors: “You Can’t Always Get What You Want.”

The primary bear case on Spotify is that they will forever be in the music labels’ clutches, with 80% of
current streaming hours supplied by four labels (record label or record company). Not only that, but at
present Spotify benefits little from operating leverage with variable costs rising in tandem with streaming.
Not surprisingly, it is much more lucrative to collect royalties (labels) then it is to pay royalties (Spotify).
To know where we are going, it is helpful to know where we’ve been. Prior to streaming, the music
industry endured fifteen years of stagnation and decline with recorded music revenues dropping from
$14.6 billion in 1999 to $6.7 billion in 2015 (a 68% drop in inflation adjusted terms). It was only once music
streaming gained traction that the industry was able to return to growth. Last year, music streaming
represented 80% of the music industry’s revenue.

Before music streaming, it made sense for music labels to collect the lion’s share of profits. After all, labels
funded the retail network, oversaw the capital-intensive business of producing and distributing physical
media and discovered and promoted stars. Many of those tasks have been rendered obsolete by music
streaming. The retail network no longer exists and instead it is Spotify that is funding the build-out of
music streaming (See Exhibit 2 for industry competitive feature analysis). Streaming has all but eradicated
physical media optimizing label cost structures and promotion is aided considerably by Spotify’s data
tools. Despite the seismic shift in industry structure, industry profit pool participation is little changed. In
fact, with labels capturing 65% of music publishing profits, one could rightfully accuse the labels of
economic plundering. Current music streaming profit dynamics are unsustainable. It makes no sense for
Spotify to continue to finance the build out of global music streaming while the music labels reap all the
spoils.

Ultimately, we think a sort of détente will prevail with label economic participation curtailed to better
reflect their contemporary contribution to the eco-system. With streaming responsible for the resurgence
of the music industry, the labels need Spotify for maximum distribution. While in theory the labels could
pull their catalogues from Spotify to extract leverage, such a move would sabotage their relationships
with music artists who would see their earnings drop precipitously. Rather than play hardball with Spotify,
it makes more sense to give up a few points of margin in exchange for a thriving global music industry
with double digit growth rates as far as the eye can see. Over time, we expect Spotify to capture the
economics of the music industry value commensurate with its importance to this service-ecosystem.

Apart from shifts in industry value creation, music streaming is upending how consumers discover new
artists. With exploratory music streamers broadening their horizons, the music industry may well be less
star-driven in the future. A digital distribution model has fewer gatekeepers than terrestrial radio and

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retail networks. This allows for an organic discovery process rather than a prescribed feting of the next
big thing by label hype machines. While bandwagon effects can be amplified in digital environments, there
is growing evidence that the enhanced discoverability of Spotify’s platform is making music listening more
diffuse. To wit, “a couple of years ago…the top 90% of listening was about 16,000 artists, that’s now grown
to 32,000 artists.” (43,000 in 2019). The net effect should be broader market participation by independent
artists, which would weaken label’s power over time. In addition, we expect enhanced discoverability to
increase the globalization of music resulting in an erosion of US-centric labels’ market power and
increased supply from non-domestic labels where supply tends to be more fragmented. In summary, the
importance of search in surfacing music content is bound to diminish the music label’s hoarding of
industry profits.

A David Among Goliaths

Apart from supplier power, the other mark against Spotify concerns its ability to ward off the strategic
advances of tech behemoths Amazon and Apple (See Exhibit 3 for industry competitive position). These
concerns are not misguided as Apple has demonstrated its ability to take significant share, growing from
a standing start in 2015 to 19% market share last year. A large active base of over one billion connected
iPhones gives Apple a head-start in establishing a connection with non-music streaming customers and a
significant advantage in Customer Acquisition Cost (CAC). Amazon has also had success (13% market
share) with a cut rate offering of $8.00 for Amazon Prime members. Like Apple, Amazon enjoys device
advantages due to its Alexa smart speakers as well as Alexa design integration on non-Amazon hardware.

Native design in smart speakers is a critical onramp for music subscribers as a request to play music
defaults to Amazon Music. Last, there is YouTube (5% market share), which benefits from its ubiquity on
our screens. As a competitive slate, this is a murderers’ row. All three dominate globally, possess deep
pockets and enjoy low CAC. Moreover, each is happy to utilize music as a loss-leader to sell more phones
(Apple), serve more ads (Google), or in Amazon’s case, deepen its commitment to its ecosystem. It would
seem that Spotify’s die is cast.

Despite their advantages, each of Spotify’s competitors’ ability to scale globally is constrained. In
Amazon’s case, it is a market issue. Amazon is in 45 markets relative to the 92 markets in which Spotify
has planted its flag. Further, Spotify has done a better job of localizing music offerings than its American
counterparts. For Apple, gains have been constrained by the company’s inability to gain significant
traction outside of its iOS operating system, which currently hovers around 25% on a global basis. Last,
while YouTube is everywhere, its model will always be subpar due to an artist payout ratio per stream
only 1/6th that of Spotify – Digital Music News put it thusly, “once again, please don’t ever make a career
out of your earnings on the popular video platform. Trust us, you’ll regret it.” It is worth nothing, that
despite competitor inroads, Spotify remains the undisputed category leader. For observers it is difficult to
digest, for in this case the market leader is a David rather than a Goliath.

Data Flywheel Compounds Advantages

With more and more businesses harvesting data through Artificial intelligence (AI), scale supremacy is
critical. With digital platform businesses, the quantity of data fed to algorithms determines their efficacy.
The data spun off by scaled platforms, particularly those with frequent consumer engagement (Facebook,
Google, Instagram, Zillow) generate superior insights due to data sets which are an order of magnitude
larger than competitor data sets. In Spotify’s case, it uses data insights gleaned from its users’ listening
habits to improve its recommendations for daily and weekly playlists.

With data training the algorithms, scaled businesses’ advantages compound at ever quickening rates. For
example, at two times the size of Apple and twice the engagement, Spotify is collecting four times as much
data as Apple. This enables the company to feed its recommendation engines more data compounding its

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advantages. Further, since Spotify has the most global reach, it is best able to cross-pollinate songs across
borders leading to increased listening utility and enhanced discoverability.

While superior data collection provides Spotify a competitive advantage within music streaming, it also
enables the company to sit astride emerging audio categories outside of music. Such categories include
books, courses, meditations, sports, news, talk radio, podcasts, concerts and live events. Due to the
variety of platforms, apps and exclusives, searching for many of these categories is unruly. By aggregating
content and serving as a central depository of all things’ audio, Spotify can remove frictional search costs
and become a one-stop-shop for audio content, a sort of Google for audio search. Given its scale and data
flywheel there is a more than outside chance this becomes reality.

Discovery and Curation – You Get Me Spotify, You Really Get Me

“At the end of the day, margin flows to whoever owns demand creation. So, demand creation is
everything, both in terms of driving a virtuous cycle of engagement, conversion, retention, and lifetime
value.” (Former Spotify CFO Barry McCarthy). Many have complained about the challenge of finding
something to watch on Netflix, a platform which clearly fails in curation and algorithmic matching. With
music, the challenge can be even more daunting. For example, Spotify has over 50 million songs on its
platform, making a robust discovery and curation system even more important.

Discovery is Spotify’s superpower. Spotify has always understood that its primary mission is to serve as a
portal to music discovery. Playlists are the backbone of Spotify’s discovery focused UX with over four
billion playlists on its platform. By providing best-in-class discovery and personalization tools, Spotify
creates a virtuous flywheel of demand — with discovery driving engagement and engagement feeding
data algorithms further improving personalization. The success of playlists in keeping listeners engaged is
reflected in listener data with a third of listening time spent on Spotify generated playlists and a third of
listening time spent on user generated playlists (Exhibit 4 customers affinity map).

Spotify offers a playlist for every genre and every occasion with its editorial team constantly refining over
4,500 global playlists. The company’s most important playlist is Discovery Weekly, a new playlist delivered
each week made just for you premised on your taste (or lack thereof). The product has been a monster
hit generating 5.3 billion hours in listening since launching in 2015. By rearranging commoditized content
in new ways with continual updating, Spotify is in its own way creating a form of original content. This
should ultimately enable Spotify to better aggregate demand increasing its leverage over music suppliers.
The more Spotify users tailor their listening experience to their preferences the less likely they are to
leave. Importantly, playlists cannot be shared across music platforms increasing customer retention.
Switching costs typically denote a learning curve, but in Spotify’s case it’s premised on a personalization
curve. We all know the best entrée to music is often through an audiophile friend.

With the largest base of users, coupled with the best integration in social media, Spotify offers the easiest
way to find your friend’s playlist. With social at the center of playlist sharing, playlists are inherently
scalable, building a stealth layer of network effects. Spotify already has the largest userbase and most
engaged users naturally amplifying existing network effects. Of course, Spotify’s competitors can produce
playlists and curate content as well, but they are technology companies first whereas Spotify has passion
for music in its cultural DNA (Exhibit 5 customer journey map). That spirit is embodied by Spotify’s
RapCaviar, the most influential playlist in music. With over 13 million followers, RapCaviar breaks new
stars, runs concert tours and moves culture. Just like New York’s Hot 97 used to confer star status on
emerging hip hop artists so too does RapCaviar serve as a star maker for aspiring rappers of today.

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Two-Sided Marketplace, Now with B Sides

“The problem is Spotify has data that we don’t have. They can see data before our labels can see it, so
they have an opportunity to jump and make an investment on an artist that’s not a guess or based on gut,
the way everywhere here in this room has to work – it’s based on hard knowledge and facts.” (Richard
Burgess, CEO of the American Association of Independent Music). While the future balance of power
between labels and Spotify will have outsized influence on Spotify’s future margin structure, we expect
to see short-term initiatives provide margin relief as well. Chief among these are Spotify’s Two-Sided-
Marketplace platform. As the nexus of global music distribution, Spotify collects a treasure trove of data.

As such, it is uniquely positioned to deliver value to artists and record companies through richly featured
data analytics. For artists, Spotify data can illustrate demand and preferences by geography and
demographics. With behavioral data on 300 million users, artists can see which playlists are driving
consumption and learn about their fans. For labels, Spotify can serve as a talent scout, dissecting listening
data and offering insights into how to position and market artists. The opportunity for record labels to
utilize Spotify’s data is enormous. Music labels spend roughly $4 billion a year in artist advances, logistics
and marketing costs. Historically, much of this spending has been spent on Led Zeppelin tour parties. The
opportunity to revamp marketing dollars is vast and Spotify’s data is the key change agent toward
optimizing label spend. There is a lot of soft middle ground here for the labels and Spotify to divvy up.

Spotify’s Two-Sided Marketplace should allow a wholesale transfer of many of these marketing dollars to
its coffers while simultaneously having a material impact on music label’s ROI. The distribution agreement
reached between UMG and Spotify this month suggests closer cooperation between the two companies
on the utilization of Spotify’s data – UMG commits to “deepen its leading role as an early adoption of
future (marketing) products and provide valuable feedback to Spotify’s development team.”

Spotify also plans to utilize its Two-Sided Marketplace to allow for sponsored listings. Sponsored listings
are a form of advertising in which labels or musicians can advertise a song to a user matched by Spotify’s
algorithms. There are almost no incremental costs for Spotify as songs are merely inserted into existing
playlists. On the artist side of the marketplace, Spotify has made a number of advances to burgeoning
stars to trial direct relationships. According to media reports, Spotify has offered musicians that sign direct
a 50% revenue share of music streams, higher than the 30% share offered by labels. While such efforts
are a signal to labels of the disintermediation risk poised by music streaming platforms, we expect them
to remain a small component of Spotify’s business.

At present, Spotify does not have the resources to match the marketing firepower labels spend on roster
stars. Nonetheless, it is an important arrow to have in its quiver as the industry evolves and is a signal for
labels to play nice. With the ability to license and promote artists, musicians may choose to increasingly
go direct. Chance the Rapper is perhaps most famous for eschewing labels to go direct and yet his star
has not dimmed without label promotion. As far back as 2012, Metallica realized its label, Warner Music
Group, was not critical for reaching its fans or the buying public. As a result, the band ended its contract
with the label and licensed its entire music catalogue to Spotify.

Podcasts: The New Talk Radio

Podcasting is a small market but growing rapidly. From its humble beginnings as a platform for audio
bloggers to shout into the void, podcasting is now a $1.3 billion market growing at a 22% compound
annual growth rate (CAGR). According to an annual survey commissioned by Edison Research and Triton
Digital, one third of Americans listen to podcasts monthly with one quarter listening on a weekly basis.
Podcast listeners are a deeply engaged bunch consuming six hours per week. Podcast listeners tend to be
upwardly mobile with roughly half making over $75 thousand in annual income and one third having a
graduate degree.

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On Spotify’s platform, engagement with podcasts rose 100% over year-over-year with an additional 20
million monthly average users listening to podcasts over the last six months. In recent months, Spotify has
accelerated its push into podcasting, announcing deals with Michelle Obama, DC Comics, Kim Kardashian
and the Joe Rogan Experience. Spotify’s exclusive with the Joe Rogan Experience podcast could be a game
changer since it will be spread across 300 million existing Spotify users, not to mention Joe Rogan’s
audience of 190 million monthly downloads, suggesting its potential for transformational impact could be
even greater. Relative to consumption hours, podcasts are woefully under-monetized with radio
generating four times as much revenue per hour.

Spotify’s embrace of podcasts is significant for two reasons; first, the flurry of activity underscores
Spotify’s commitment to an audio first (inclusive of audio outside music such as courses, podcasts,
meditations and books) market posture. The audio first mentality offers the potential to turn Spotify into
the Google of audio search – where one begins their search for all audio things. Second, Spotify’s
increasing investments in podcasts should lead to a shift in its cost structure with fixed costs replacing the
variable costs paid to music labels. This is similar to Netflix’s shift from licensed content to original content.
Like Netflix, Spotify’s move toward greater in-house content should drive operating leverage. It makes
sense to spend heavily now as this is a business where scale begets more scale. As we have seen with
Netflix, scale players can pay more for content due to their ability to spread content spend across a
broader base of subscribers. On a global basis, this is a significant advantage and one that Spotify should
pursue aggressively.

Management – Thinking Fast and Slow

We are big fans of management teams that ignore Wall Street. The first rule of winning is knowing what
game you’re playing. Since inception, Spotify has never wavered in its mission to be the best audio
platform in the world and the best partner to artists and record labels. How a small Nordic-based upstart
realigned the global music industry around its vision for music as a service while vanquishing the world’s
most profitable company (Apple), the most widely used website service in the world (Google), and the
world’s most powerful company (Amazon), all while being at the mercy of consolidated suppliers with
money to burn will someday be a master class taught at the world’s best business schools. It is too soon
to say Spotify has vanquished its competitors but thus far it has pressed its advantage and widened its
lead.

Mr. Ek (Spotify CEO) has imbued Spotify with several cultural attributes that leave it well equipped to win
the prize. First, and probably most important, has been focus. Ek understood early that music is a business
about passion and creating a healthy ecosystem would require an artist’s mindset rather than that of a
software engineer. That singularity of purpose informs its software. Apple Music is an add-on thrown in
to drive revenues whereas Spotify feels like the music geek at your local record store guiding your
browsing. Second, Spotify has put the customer at the center of everything it does. Like Amazon, Netflix,
and Costco, investment spend is geared toward elevating the user experience above all else. This is not
done in the spirit of charity but in the recognition that customers have choice and scaled Internet
platforms win the spoils.

Daniel Ek put it best, “engagement drives usage, usage drives data insights, data insights drive a better
user experience. A better user experience drives longer lifetime value even if we have to postpone
probability in the pursuit of growth.” It takes a unique mix of urgency and strategic planning to both focus
on the long-term but relentlessly innovate in the short-term. Long-term thinking invites a plodding
approach and an innovate or die approach often leads to sloppy decision making and capital allocation.
Given the cognitive dissonance at the center of these two approaches it takes a master tactician to play
along the continuum.

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 Pricing Power – Through the Looking Glass

Unlimited on-demand streaming of a catalog of 50 million songs across devices and without commercials
for $9.99 a month is one of the best deals around. Especially when you consider that Spotify has not
changed its pricing since its US launch in 2011. Adjusting for inflation alone would equate to a price of
$11.45 in today’s dollars. Subscription services with increased engagement offer substantial consumer
utility. While the price remains the same, increased engagement means lower costs for each unit of
content consumed (songs for a service such as Spotify and shows or movies for a service like Netflix), a
sort of personal operating leverage for consumers. This means marginal costs for extra music
consumption is zero. In economics, this is known as a “consumer surplus,” which reflects the difference
between the price consumers are paying for a service and the price they are willing to pay. Given the
steadily growing engagement of Spotify consumers, it is our contention that the company benefits from
a substantial consumer surplus which will be monetized in the future.

Many look at Spotify’s stagnant pricing and view it as proof of a commodity business. This is a dangerous
assumption to make. Like Netflix, we believe Spotify has one of the longest pricing power runways in all
of business. The decision to not flex pricing now is a conscious decision to hoover up as much market
share as possible. As Spotify’s churn statistics indicate, it is difficult for Spotify customers to leave.
Playlists, social integration, curation and user experience create enduring habits. The degree of
personalization over time makes Spotify very sticky and positions it well to commoditize suppliers rather
than the other way around. Given the winner take most nature of globally scaled internet businesses it
makes sense to optimize for consumer lock-in now while consumer habits are still being formed. As long
as engagement continues to inflect higher, monetization will come.

POSSIBLE DISCUSSION QUESTIONS

1. Identify the major actors in this service-ecosystem and explain how Spotify deal with the different actors
in this music ecosystem.

2. Spotify adopted the business model platform. How the company create a two-sided market?

3. Customers traditionally play a specific role in markets following institutions as consumers. How Spotify's
users can change roles over time in this ecosystem?

4. How technology, and Artificial intelligence in particular, is essential to:

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Exhibit 1 - The evolution of the music industry

Exhibit 2 - Industry competitive feature analysis

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Exhibit 3 - Industry competitive position

Exhibit 4 - customers affinity map

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Exhibit 5 - customer journey map

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