Deep Dive into Spotify: How Many Tencent Musics is it Worth?

1. The reasons for the profit gap among the three major platforms

Objectively speaking, Spotify's loss problem is not serious, as most of the time in history it has struggled around the breakeven line rather than huge losses. In fact, it achieved an operating profit of 170 million euros in the first quarter of 2024. However, due to the minimal improvement in comprehensive gross profit margin (up 1 percentage point compared to the previous period), there have been fluctuations between profit and loss in the past. Therefore, the market actually hopes for a more stable trend of profit improvement.

In the previous in-depth analysis, the Dolphin concluded by qualitatively discussing Spotify's profit issue, comparing its business model, industry chain position, and competitive landscape with Netflix and Tencent Music, and concluded that Spotify's profit has special reasons.

However, the extent to which these factors weaken profitability needs to be quantitatively assessed. By comparing the "customer lifetime value" and "average cost per acquisition" of To C Internet users, we can more intuitively feel the impact of different factors on profitability.

Let's start with the formulas:

Subscription LTV = User usage period * Average revenue per user * Gross profit margin = 1/Monthly churn rate * Average monthly ARPPU * Gross profit margin.

Customer Acquisition Cost CAC = Sales expenses / Total new additions = Sales expenses / (Monthly churn rate * Average subscription users * Number of months in the period + Net new subscription users)

Through calculations, we find that:

a. Comparison of user lifetime value LTV: Netflix > Spotify > Tencent Music;

b. Comparison of CAC: Tencent Music < Spotify < Netflix;

c. LTV/CAC comparison, i.e., user ROI comparison: Netflix > Tencent Music > Spotify .

The comparison of the three sets of formulas can quantitatively explain some issues:

(1) Netflix vs Spotify

In terms of user value, Netflix significantly outperforms Spotify in churn rate, ARPPU, and gross profit margin, reflecting Netflix's significant advantages in competition, user payment power, and industry chain pricing power.

Although Netflix's customer acquisition cost is higher than Spotify's (reflecting that in the long video track, user stickiness relies more on promoting new content to maintain), but in terms of individual user ROI, Netflix is still much higher than Spotify.（2）Netflix vs Tencent Music

In absolute terms, the user value of Netflix is greater than Tencent Music, mainly due to the higher willingness of European and American users to pay. Additionally, Netflix has a lower user churn rate compared to Tencent Music, which we believe is mainly due to the disparity in per capita disposable income among regional users.

If we exclude the differences in exchange rates and user disposable income, and simply compare user ROI, in reality, Netflix and Tencent Music are quite similar. Looking at the factors in the formula, Tencent Music relies on higher customer acquisition efficiency (competitive advantage, Tencent ecosystem traffic) to make up for the differences in user retention and willingness to pay.

However, there are differences in content acquisition methods between the two (Tencent Music is an aggregation platform, while Netflix mostly produces its own content), with similar gross profit margins, which may also imply an established pattern in content payment.

（3）Spotify vs Tencent Music

Although they belong to the same industry, the business models of pure music services are mostly similar (Tencent Music's LTV calculation only considers music subscription members). However, due to different markets, Spotify and Tencent Music have significant differences in user value, customer acquisition costs, and user ROI.

Similar to the conclusion drawn from comparing with Netflix, Tencent Music relies on lower customer acquisition costs and higher bargaining power in the industry chain to bridge the gap in user purchasing power (ARPPU, paid retention) with Spotify.

Interestingly, Spotify has a higher LTV due to the pricing of ARPPU values in developed markets in Europe and America, but due to higher customer acquisition costs, Spotify is actually less profitable than Tencent Music from a profitability perspective.

Tencent Music has high customer acquisition efficiency, partly due to competition and partly due to traffic from its parent company. However, if we consider that the conversion rate from free to paid users for Tencent Music is significantly lower than Spotify, it indicates that the traffic brought by Tencent's parent company has a greater impact on Tencent Music's customer acquisition efficiency— with the same marketing expenses, Tencent Music can attract more total traffic (free users + paid users) compared to Spotify.

Netflix and Tencent Music each have their own advantages, but a common advantage is—having a higher bargaining power in the industry chain. Initially, there may be doubts as to why Spotify cannot weaken the bargaining power of external copyright holders by delving into the upstream like Netflix? However, after comparing the differences between the long video (series, movies) and music tracks, we found that, just as Spotify's management understands their positioning, music streaming is more suitable as a simple aggregation distribution platform.

The difference in strategic positioning is the key to the difference in business models between Netflix and Spotify, which in turn leads to completely different profit rhythms for Netflix and Spotify. I believe that the different choices made by the two companies are not a matter of superiority or inferiority, but are closely related to the differences in the tracks they are in

(1) Demand: Users have more "demanding" requirements for long video content

For most ordinary users, music is more like background music, allowing them to work, study, do housework, drive, etc. while listening to music. However, video content usually requires users to set aside a specific time period, so users care more about the quality of the content experience during this time.

(2) Supply: The threshold for music content production is relatively lower

This is easy to understand. Whether it's songwriting, composing, or recording, the technical equipment in the market is relatively complete. At least in the content production process, grassroots musicians are not much behind well-known musicians signed by record companies. The main disadvantage lies in the promotion and distribution process. However, driven by social platform algorithms, independent musicians are also bridging the gap in promotion. On the other hand, the demand for manpower and technology in producing professional film and television content is significantly higher, so high-quality content generally comes from professional film and television studios/companies.

Combining the above two points (1) and (2), it can be seen that: the long video track is supply-driven, so focusing on upstream content is the right approach. While in the music track, when users' demand for new releases is not as rigid, and there is not a shortage of content supply after meeting the necessary content, the platform's usability is more likely to attract user attention.

Summary: Through qualitative and quantitative analysis, it is clear that Spotify's profitability is not as good as Netflix and Tencent Music due to some objective and rigid issues. It's no wonder that even when Netflix has been profitable for many years and gradually improving, the market still doubts Spotify's long-term profitability.

An optimistic and ideal stable improvement in profitability operating assumption is: in the future, Spotify's bargaining power in the industry chain will increase. Considering only the gross profit margin after copyright content costs, it will decrease from the current 67% to slightly higher levels around 40%-45% like Netflix and Tencent Music, i.e., music content costs / (music subscriptions + music advertising revenue) = around 50%.

However, because Spotify does not have a parent company to drive traffic and its content and products do not have significant differences that are hard to catch up with peers, optimizing the customer acquisition cost for paid users is estimated to be difficult. In addition, in other indicators, Spotify is already significantly ahead of its peers, so relying solely on product feature optimization to further improve is equally challenging, or the short-term effect is too slow.

2. Handling high copyright revenue sharing disputes, a long and arduous task

Spotify's management probably also sees the same solution to improve profitability - reducing upstream revenue sharing, including royalties paid to songwriters for their music copyrights, as well as recording copyrights for record companies and artists. In fact, in recent years, the main reason for the continuous increase in upstream revenue sharing comes from the royalty rates of songwriting copyrights.

Using the United States, the largest music market, as an example, the Copyright Royalty Board (CRB) negotiates the royalty rates (copyrights) with the National Music Publishers' Association (NMPA) and the Digital Media Association (DiMA) every 5 years to determine the future 5-year copyright royalty rates. The most recent negotiation was in 2022 to determine the 2023-2027 future five-year copyright royalty rates, which increased from 15.1% to 15.35%. Looking back over the past 8 years, the royalty rates have risen too quickly.

The rigidity of the copyright rates is determined by industry associations, while the market concentration of recording copyrights is another steel plate that cannot be kicked in the short term. Although the market share of top music labels on Spotify has been declining year by year, they still hold an absolute monopoly share of 74%.

In this regard, whether it is songwriting copyrights or recording copyrights, if negotiating directly with record companies and copyright agencies to lower the revenue sharing, it is highly likely that all three parties will not be happy (streaming platforms previously jointly appealed against high copyright royalty rates and were rejected), so Spotify chose to "take a detour."

In October last year, Spotify announced the addition of 15 hours of audiobooks to Premium standard members, which at the time could still be explained as an attempt to accelerate user penetration and payment conversion for audiobooks (independent audiobook packages), especially since in the previous year, in 2022, Spotify spent $120 million to acquire the audiobook company Findaway. However, with the launch of bundled subscription packages for music + audiobooks, the strategy behind these operations, Dolphin believes, has fired the first shot in the invisible adjustment of copyright revenue sharing.

The bundled package launched by Spotify in the United States in March this year means that based on the price of independent music membership, users only need to pay an additional $1 to listen to all platform resources such as music, audiobooks, podcasts, etc. In other words, the original $9.9 standalone audiobook package, now for users who are already music members (Premium series), different package types (individual, couple,When bundled, you can get the same content for 1-2 USD at a discount of 1-2 USD.

However, according to the relevant revenue recognition rules for bundled services, only $6.3 USD of the $11.99 USD bundled package fee (originally $10.99 USD, with a $1 USD increase for June standard members) is related to music services ($10.99 USD is for music alone, $9.99 USD is for audiobooks alone) . If a user subscribes to the standalone music service package, the revenue related to music services is the entire package price, which is $10.99 USD, resulting in a direct decrease of 40%.

Through calculations, Dolphin estimates that this will directly reduce the income of copyright agencies and songwriters involved in hard-linked music-related revenue by 16%. On the other hand, the benefit to Spotify is that if this adjustment is promoted globally and all member users upgrade to bundled packages, Spotify's subscription business gross margin can directly increase by up to 3 percentage points (assuming that users who subscribe to bundled packages do not listen to audiobooks much). If half of the users upgrade, it can also increase the subscription gross margin from 30% in 1Q24 to 31.5%, directly increasing the gross profit by 200 million euros above the original expectations (+5%).

The revenue sharing agreement for audio copyrights is different (with protection agreements, actual charges will be based on single play charges, single user charges, overall revenue sharing, etc.), so this bundled adjustment will not have much impact on its audio copyright revenue sharing.

Although Spotify claims that the introduction of bundled services will encourage more potential users to subscribe or invisibly increase payments due to more choices, it is mostly beneficial for music content providers. However, Dolphin believes that content providers, including audio copyrights (labels, artists' ownership) and distribution copyrights (copyright agencies, songwriters), need to be considered separately in terms of profit clarity:

a. Audio copyrights are protected by agreements, which are advantageous without harm.

b. Distribution copyrights are likely to lose some income. Although bundled packages may stimulate the conversion of some potential users and increase the overall subscription revenue, it may not necessarily compensate for the negative impact on distribution copyright agencies due to the overall reduction in revenue sharing ratios.

If the incremental effect of payment conversion is average, then in a market where the overall pie has not significantly expanded, Spotify profits, naturally corresponding to the loss of benefits for copyright agencies. Although the three major record companies mainly earn income from audio copyrights, they also engage in distribution business. Therefore, shortly after Spotify announced bundled packages, Sony was the first to protest, pointing out that this adjustment will lead to a 20% decrease in its music distribution revenue on SpotifySubsequently, MLC (a non-profit digital music copyright management organization) also sued Spotify, accusing it of intentionally reducing the royalties payable to copyright owners by bundling services.

The tug-of-war between Spotify and upstream content providers is still ongoing. Dolphin believes that in the short term, it is not ruled out that Spotify may offer concessions through other means privately. However, music streaming platforms are struggling with high copyright revenue sharing, and this revenue sharing dispute will eventually come to the forefront from behind the scenes.

3. Long audio content mainly serves as a traffic driver and cannot support performance

Apart from music, can additional effective monetization be achieved through other derivative businesses? Chinese music streaming platforms Tencent Music and Cloud Music have chosen "live streaming + K song" (before live streaming governance), while Spotify currently seems to focus on **long audio content centered around "podcasts and audiobooks," as well as a creative tool platform Marketplace for musicians.

However, Dolphin believes that there is a fundamental difference in monetization capabilities between live streaming and long audio content.

For Tencent Music, live streaming is a true business expansion. Before the impact of short video competition and regulatory governance, social entertainment (live streaming + K song) revenue accounted for 60%-70% of Tencent Music's total revenue. Even though 55% of the live streaming revenue needs to be shared with the hosts, compared to the music subscription business that was still operating at a gross loss at that time, social entertainment was clearly the main profit driver for Tencent Music.

However, the role of podcasts and audiobooks is not to increase revenue but to enrich member benefits, playing a role in future hidden price increases. After all, in terms of market size, both the podcast and audiobook markets are too small. According to Statista, the global streaming music revenue scale in 2023 (including recording, channel distribution, and the entire industry chain) is approximately $38 billion, which is already considered small compared to the hundreds of billions in the video content track. The podcast market in 2023 is less than 1/10, at only $3.5 billion. Audiobooks are slightly larger at $6.83 billion. Overall, the current scale of long audio content is just about $10 billion.

Even in such a small market for long audio content, Spotify only takes a 5% cut for podcast subscriptions and 50% for podcast advertising revenue. Audiobooks are offered free for half a year as a member benefit, with paid subscriptions just starting this year. However, user willingness to pay for audiobooks independently is evidently not satisfactory for the company, which is why they recently launched bundled packages with music content.

1. Podcasts: Monetization still relies on digital advertising

The main monetization method for podcasts currently is advertising, with fewer scenarios for standalone subscriptions (only certain specialized institutions offer paid podcast content). If we only look at podcast advertising revenue, the CAGR from 2020 to 2023 is 30%, which naturally slows down. Therefore, the actual scale expansion in the future is relatively limitedHowever, overseas consulting firm Fortune Business Insights is more optimistic, projecting the podcast market to reach $17.6 billion by 2030, implying a CAGR of 23% from 2023 to 2030.

Currently, Spotify's podcast advertising revenue accounts for approximately 12%, but there is still room for monetization based on the market share of its content library.

Therefore, the practice of enriching the membership content library with podcast content is becoming more popular on streaming platforms. For example, starting from the pandemic period, YouTube and Amazon have heavily invested in podcast content, incorporating them into the membership benefits of YouTube Premium and Amazon Prime, respectively. Even though Apple has launched the "Podcasts" app separately, the majority of the content is available for free listening, with only a small portion included in the membership benefits.

Spotify has always used podcast content to increase user penetration and stickiness, so it is not insistent on charging separately. Most audio content is free to listen to, interspersed with ads. Spotify shares ad revenue with creators on a 50-50 basis, or invests exclusively to acquire rights.

In 2021, Spotify introduced podcast subscription functionality, allowing users to directly pay creators subscription fees ranging from $2.99/month to $7.99/month, as determined by the creators themselves. However, as the platform, Spotify only started taking a 5% cut from podcast creators starting in 2023, so podcast subscription fees do not have a significant impact on Spotify's performance, with advertising remaining the main revenue source.

Podcasts have been a profit burden for Spotify in the past. This is because Spotify invested in acquiring some podcasts created by celebrities, such as spending hundreds of millions of euros to create "The Joe Rogan Experience" and other exclusive programs. However, looking at the current Top 10 podcast rankings on Spotify, only 1-2 self-funded programs are on the list. Company executives have also acknowledged in conference calls that some investments in podcast content have been ineffective.

Based on Dolphin Jun's analysis, it is estimated that the podcast costs in 2023 will be around 500-600 million euros. Although the podcast business has now turned a profit in 1Q24, the company expects the long-term gross profit margin of the podcast business to reach 40%. Therefore, we believe the company will continue to slow down investments in "exclusive podcast content" to further reduce the burden on the gross profit margin of the advertising business.2. Audiobooks: Starting Paid Subscriptions This Year

Recently, there has been a lot of discussion about Spotify bundling audiobooks with music memberships, especially since it has been over a year since Spotify's acquisition of Findaway by the end of 2022. Therefore, it is time to seek monetization. Dolphin will briefly discuss the audiobook market.

The audiobook market is not large. According to the third-party consulting firm Grand View Research, the global market size of audiobooks is estimated to be around $6.83 billion in 2023. However, the outlook is not bleak, with a good future growth rate. It is expected that the compound annual growth rate from 2024 to 2030 will be 26.2%, reaching a billion-dollar scale by 2030.

Similar to music and podcasts, North America is still expected to be the largest regional market for audiobooks, accounting for approximately 45%. However, Spotify is not the platform with the largest advantage, and the user penetration rate in the audiobook market does not show the dominance seen in the music streaming market with Spotify.

Taking the North American market as an example, in addition to Spotify, Audible, Amazon, Apple, Google audiobooks, and Downpour all have good user feedback and usage penetration. Therefore, when Spotify launched standalone paid audiobooks earlier this year, it probably did not monetize well after testing for 2-3 months, leading them back to the bundled sales strategy.

4. Valuation: Focus on Calculating the Fundamental Value of Music

Dolphin believes that the monetization of podcasts, audiobooks, Marketplace creator tools, and other businesses is still in the early stages. From the perspective of industry scale, these are unlikely to effectively support Spotify's performance in the future. Therefore, from a neutral expectation perspective, the key to Spotify's valuation lies in calculating the fundamental value of music (mainly subscription-based, with advertising as a supplement). Other derivative businesses can be continuously monitored. If they perform well in the future, they can be seen as opportunities to drive the stock price upwards when market sentiment is positive. However, it is definitely not advisable to prematurely enter potential optimistic expectations at the moment.

For the fundamental value of music, it mainly involves two issues: revenue prospects and profit margins.

1. Revenue Prospects

According to Statista data, global pure streaming music subscription revenue in 2023 was $19.3 billion (including $3.7 billion from China). Spotify's subscription revenue was €11.6 billion, and since Spotify has stated that it will not enter the Chinese market, its market share in the markets it can reach is close to 80%. Such a high market share mainly comes from three aspects:

Spotify's subscription user base accounts for 46% of the market outside of China;

Spotify's control over the high-paying user market in Europe and America;

Platforms like YouTube and Amazon, which bundle music services into comprehensive memberships, are not included in the above market size. If we consider the overall market size by multiplying Spotify's average per capita payment amount (which is basically the same as these platforms' individual prices) by the estimated number of music users, the overall market size would need to increase by at least $10 billion. Spotify's market share (excluding China) would then adjust to 48%.

Although the market share has decreased significantly compared to the previous algorithm, a market share close to 50% is still considered high in a stable competitive industry. Considering that Spotify may face a complex competitive environment, everything depends on whether the giants are eager to focus on "music payment" in this not-so-broad track. Meanwhile, Spotify has overall advantages compared to its peers, so we assume that Spotify can maintain its current market share.

In the previous article, Dolphin mentioned the lack of price advantage after the price increase, but our concerns were alleviated by Spotify's subsequent launch of the pure music content package Basic series. The Basic series basically maintains the price before the Premium price increase (equivalent to the current prices of other competitors), but does not include the 15 hours of audiobook service per month, allowing users with different needs to choose.

Therefore, in the revenue outlook assumption, Dolphin expects that Spotify will continue to maintain its current competitive advantage and is expected to capture more than half of the market size as it expands into more emerging countries and regions.

Due to space constraints, only the revenue forecast results are shown here. Feel free to discuss in the comments.

2. Medium to Long-term Profitability

We have discussed Spotify's profitability issue extensively in the previous article and the first part of this article. By comparing with Netflix and Tencent Music, we can identify the crux of the problem - the relatively "rigid" cost of copyright content.

However, due to the high proportion of this expenditure and the limited incremental revenue that other derivative businesses and non-copyright content can bring (we estimate that podcast revenue accounts for less than 5% in 2023, and Marketplace revenue accounts for less than 1%), it is difficult to quickly and effectively help cover copyright costs. Therefore:

(1) If we rely solely on the increase in non-music business to improve the gross profit margin naturally, then Spotify's current valuation is relatively high:

• In 2023, the comprehensive gross profit margin is 25.6%. Without optimizing the upstream recording copyright costs, relying solely on bundled packages to invisibly compress the distribution royalties cost, the overall speed of gross profit margin improvement will be very slow, and the medium to long-term level will be around 30%, lower than the current levels of Netflix/Tencent Music, which are 47%/41% respectivelyIn this case, even with continuous cost optimization (announcing a 17% layoff by the end of 2023), the operating profit margin in the medium to long term may only be around 13%.

Looking at it this way, the current market value corresponds to an EBITDA of 32x in 25 years, but the pace of profit improvement after 25 years (three-year CAGR of 12%) clearly cannot support such a high valuation.

(2) If, in terms of music, the split of recording copyright royalties can also be effectively reduced, from the current 67% to 60% (the level of Netflix/Tencent Music in the first two years), then Spotify's current valuation is reasonable:

• Optimizing the split of recording copyright royalties cannot be achieved overnight. Assuming that the medium to long-term copyright costs (recording copyright + distribution copyright) can decrease to 60% over 5 years, it means that the operating profit margin in the long term of 2029 is expected to reach 20% (slightly lower than Netflix's current profit level, but similar to the level in 2023).

Based on the DCF valuation method, assuming a perpetual growth rate of 3%, WACC=11.44%, the valuation is $68 billion.

From a relative valuation perspective, the current market value corresponds to 25 times EBITDA in 25 years, in the turning point of high-speed profit improvement and compared to peers in the US stock market, this valuation belongs to the neutral slightly lower range.

(3) If the proportion of music content costs can be optimized to around 40%-50% like Netflix/Tencent Music currently, then Spotify's valuation has considerable upside potential:

• As Spotify is currently in a phase driven by the logic of price increases, it is necessary to have an optimistic valuation to help us understand how much positive expectations have entered the current market sentiment. If we continue to use our imagination, we assume further concessions from the upstream, that is, a major change in the music industry chain within five years, with music content costs accounting for 50% of subscription + advertising revenue, the long-term operating profit margin is expected to be optimized to 25% by 2029.

With a current market value of $62 billion, corresponding to an EBITDA of only 23x in 2025, and under the above assumptions, the profit growth rate CAGR for the next three years from 2025 to 2027 is as high as 34%, so the current valuation is clearly undervalued. If we use the DCF valuation method, assuming a perpetual growth rate of 3%, WACC=11.44%, then the optimistic valuation is $84 billion, with a 26% upside relative to the current valuation.

Summary:

Overall, our pessimistic/neutral/optimistic valuations for Spotify are $45 billion/$68 billion/$84 billion (vs Tencent Music's $22-27 billion). Although our neutral expected valuation for Spotify is similar to the current market value, there are still some positive expectations of upstream concessions behind itTherefore, if the music label cannot see the trend of softening attitudes, then in the short term, Spotify's current market value is somewhat premium compared to rational valuation.

However, from an optimistic perspective, Spotify's current valuation is not overly frothy, and due to the market's relatively accepted logic of price increases and profit turning points, it may even lean more towards being bullish on the margin, making it unsuitable for short selling.

In this relatively awkward price period, Dolphin Jun suggests continuing to pay attention, especially since there may be a decline in user subscriptions after the short-term price increase starting from Q3 (referring to the same period last year). When third-party data discloses Spotify's user churn, the stock price may adjust accordingly, providing opportunities to focus on more cost-effective options.

(End of content)

Dolphin Jun's "Spotify" historical research:

In-depth

First coverage on June 13, 2024 (Part 1) " More expensive than Apple Music, where does Spotify's confidence come from? "

Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure