TIVP065: Spotify (SPOT): Investing in Music in the Age of AI w/ Shawn O’Malley & Daniel Mahncke

19:46Daniel Mahncke:And in a world of music ownership, you pay for every song that you want to listen to. Sampling is incredibly expensive. But in a digital rentership world for music rights, sampling is totally free. And that behavior shift is a huge part of why streaming actually ended up expanding music consumption. More people than ever stream music and listen to more music per capita than they did in the past, thanks to the affordability and convenience of streaming. It's one of the more tangible examples, I think, of how the internet has made our lives better. And so streaming was such an attractive and reasonable option that it actually made piracy very taboo.

20:33Daniel Mahncke:And so all of a sudden, it was like, okay, come on, man. You can't just fork up a few bucks to consume this content legally, right? And if you pirate music today, I think you're probably seen as a real pariah. I don't think I know anyone who does that or admits to doing that. You know, music is so abundant that it just feels weird to steal it. It's like stealing water, you know. Not to say everybody wants to pay for a Spotify premium account, but from ad-supported streaming options to TikTok, there are so many ways to consume music without breaking any laws today.

21:07Shawn O’Malley:Sometimes it's just funny that you only realize how much the world has changed when we look at these companies and then compare it to, you know, how it was 15 or 20 years ago when we were still children. And it's kind of crazy how far the entire industry has come since then. So that's basically how Spotify brought the recorded music industry back from the brink. And they made a product, you know, that was so good that it was actually better than stealing, as you just said. And that just ushered in what really is a golden age for music. I mean, the average person can listen to music so much more easily and with so much more discretion than would have even been imaginable 20 years ago.

21:41Shawn O’Malley:But how has Spotify actually found it? Because I think they actually saw a movie once, which is pretty interesting. So it's a good story to tell. And it seems like they rose up out of nowhere and then basically took over the entire industry. So I'm curious how Daniel Ek actually did that. And I'm sure that will give us a look into how he's lived up to the Elstil idea. As you know, my co-host Sean and I are obsessed with analyzing companies. But you probably have noticed from personal experience that talking stocks is not everyone's favorite hobby. And I'm reminded of that every time I bring up investing at dinner or when I'm out with friends.

22:16Shawn O’Malley:They tolerate it for about 10 minutes. But then I get this look. The one that says, we get it, you love stocks, but this is not the place. So Sean and I thought, why not build that place? And we did it. It's called the Intrinsic Value Community. Our members range from pilots and firefighters to lawyers and engineers, but also hedge fund managers. actual rocket scientists and CEOs. And despite those different backgrounds, what connects all of us is the passion for value investing and continuous learning. And each week we host live calls, covering everything from vetting the group's best stock pitches to analyzing portfolios, investing case studies and conversations with expert guest speakers who are either prominent portfolio managers, CEOs or authors.

22:59Shawn O’Malley:And the best thing is that if you ever miss a call, we have a library of recordings for watching back every single call we've ever hosted. And if you prefer reading over watching, well, then we have dedicated spaces in the community to share write-ups, discuss investing ideas, or just your thoughts on the general market. And multiple times a year, we bring the community from the virtual world into the real one, including private dinners in Omaha for Berkshire weekend and meetups in New York City to explore, hang out, and most importantly, talk stocks. Our last cohort of members brought together 20 incredibly thoughtful people, some of the sharpest investors that Sean and I have ever met.

23:38Shawn O’Malley:And if you want the chance to learn alongside people like that, you should join our wait list at theinvestorspodcast.com slash intrinsic value community. That's theinvestorspodcast.com slash intrinsic value community.

23:54Daniel Mahncke:Yeah, so Spotify was founded in Stockholm, Sweden by Daniel Eck, and also another gentleman named Martin Lorenzen. And as we have mentioned, the idea was to create a service that is better than piracy while still compensating the industry fairly. So just think about that for a second, right? It sounds incredibly difficult to balance. And in hindsight, it is actually really amazing to me that they did find a solution to this dilemma. And so really in the early days of Spotify, Daniel Ek argued that you can't legislate away piracy. You have to out compete it while still being able to route money back to music rights holders.

24:35Shawn O’Malley:And the vision for doing so was actually a model that we know as freemium, right?

24:40Daniel Mahncke:That's right, yeah. So Spotify didn't start by demanding a paid subscription. It started by letting folks use the product for free, supported by advertising, and then converting them over time to this paid subscription tier, which is basically still the business model today. And that free tier matters because it creates a top of the funnel that grows with very little friction. It's also a way to enter emerging markets and younger demographics like college students where there's just a much lower propensity to spend and much less likely that people are going to pay up front. And so what also mattered for them was that strategically in negotiations, Spotify could go to labels and say, we are going to rebuild paid consumption at scale with a model that can compete with piracy.

25:28Daniel Mahncke:And so the hard part there was the licensing, right? So labels are protective for good reason of their music rights. They own the most valuable input into these music streaming platforms. And so in Spotify's case, there was this kind of chicken and egg dynamic where you need a big catalog of music to be able to attract users, but you need users to justify paying for the catalog and being able to convince the labels to license their music in this way.

25:57Shawn O’Malley:That's funny because we talked in our Netflix episode about how you couldn't stand ads on Netflix and basically change the higher tier. Whereas, you know, I've absolutely no problem with the ads and I'm actually glad I can get cheaper access to Netflix because of it. On Disney though, Disney Plus, they show significantly more ads, which is quite disruptive to the entire viewing experience. So I think to some extent, it really depends on, you know, the medium and also the frequency of ads. On Spotify, for example, I could never have an ad supported tier, even if it would be, you know, and it is completely free.

26:27Shawn O’Malley:But getting back to the chicken and the act problem here, regarding users and the catalog of music and then artists, how did they break that paradox?

26:35Daniel Mahncke:I think part of the answer is going to sound really bureaucratic, but that is to say stakeholder alignment. was really important. And what that means is that early on, the music industry had skin in the game. The music labels had meaningful ownership stakes in Spotify's equity. So beyond just getting these new revenue streams from the success of Spotify, they also had a claim on a share of Spotify's profits. And even to this day, you see Universal Music Group owns about 3 % of Spotify. And so they would benefit as Spotify raised money at higher and higher valuations over time before eventually going public and then becoming profitable as a standalone business.

27:20Daniel Mahncke:So that's what I mean by stakeholder alignment. You had labels literally invested in the success of the Spotify business model.

27:29Shawn O’Malley:That's kind of ironic because, you know, the public narrative today is at least often that Spotify is exploiting their artists. But structurally, I mean, the labels were deeply embedded into Spotify's upside really much from the beginning. And I guess it's a whole nother conversation as to how people feel about labels. But as we talked about when we covered Universal Music Group, Taylor Swift is, after all, one of their clients. And I can assure you that the most famous and powerful artist in the world is probably not being exploited. you know, music labels generally create value for artists and help boost and market their albums.

28:01Shawn O’Malley:Point being, while it is still a contagious topic, more money being paid out in royalties to labels also means more money going to artists as well. Even if, you know, what's considered a fair splitting of those royalties remains up for debate.

28:16Daniel Mahncke:The distribution of the economics within in music, I think is a separate debate, right, of how labels split royalties with artists. But yeah, the key takeaway for me is Spotify is not operating against the industry. Ever since the beginning, it has been deeply intertwined with the success of music labels and musicians and artists.

28:39Shawn O’Malley:Okay, so let's talk a bit about what makes Spotify so sticky. I mean, in theory, canceling your Spotify subscription to switch over to, let's say, Apple Music or something else is pretty easy, but I've never really been able to bring myself to do it. Actually, I don't even think I've ever thought about even giving up Spotify at any point.

28:57Daniel Mahncke:It's funny you say, because like on a purely functional level, you press play, you hear a song, right? So it's easy to say that these music streaming platforms are something like a commodity, but unlike in video streaming, where Netflix can differentiate itself with unique content, every music platform basically has the same music available, which does make the underlying music rights something of a commodity. You can't live without them, but also everybody, at least all major streaming platforms basically have all of them, right? So the stickiness comes from everything that happens around the song on Spotify.

29:35Daniel Mahncke:And so I can really relate to basically playlists and libraries as kind of being something of a soft switching cost, right? I've spent so many years building playlists that reflect all these different periods of my life from when I was in college to road trips and vacations or different workout playlists at the gym and just everything in between. And so for people really motivated to switch, there are ways to import your playlists and downloads across apps. But I mean, come on, it's a friction. And, you know, it's not an insurmountable barrier but that is just one point that makes up this kind of switching cost mode where on the margins you're like yeah i'm pretty happy with spotify i don't need to like you know take on the burden of switching everything over and so going hand in hand with those personal connections to spotify like mine is that spotify has built a very finely tuned recommendation system that blends your habits with broader listener behavior and so they call it like collaborative filtering and it's very well tuned to helping you find new songs and so with Netflix we talked about people just loving the Netflix app because they trust the algorithm so much to suggest things for them to watch and that they'll like and it helps them discover new content and it's exactly the same on Spotify so much of the music I've come to listen to over the years has not come from word of mouth recommendations but from Spotify's suggestions or just simply autoplaying music related to what I was listening to once, you know, a playlist ends.

31:06Shawn O’Malley:Again, I can't compare Spotify to Apple because I've never used Apple Music, but I basically find new music by, you know, going through the radio option on Spotify. So I listen to a song or an artist that I like, obviously, and then I use that function to find songs that basically have a similar sound or vibe to them. I'm not sure anyone else does that. I don't often hear people talk about it. And I generally feel like I have a much different way of using Spotify compared to other people. I almost never download music, for example, and I don't have any playlists. And, you know, while Spotify has been incredibly good at turning user data into these viral moments, I never participate in those trends either.

31:42Shawn O’Malley:I mean, there's this Spotify wrapped that's probably the most obvious example. And so it's just a fun recap, but it's actually a phenomenon that has pretty much taken on a life of its own and serves as this really compelling organic marketing for Spotify on behalf of its users who want to just proudly show off their unique music taste most of the time. And basically at the end of every year, Instagram is just full of people posting their Spotify rap. I haven't done that once in my life. And I actually consider Spotify, I don't know why, to be a very private thing, which is kind of funny because there is literally nothing interesting about it.

32:17Shawn O’Malley:And yet I do feel music is pretty personal. And I honestly have no desire to share with anyone on Instagram what I listen to. I don't know how you feel about that.

32:26Daniel Mahncke:Yeah, I think I relate. I don't usually feel inclined to share my music listening habits or data with other people. But the one thing they do give you insights on the podcast that you listen to. So I do love to show off my top listen to podcasts and they give you some stat of the ridiculous amount of minutes and hours that you spent just listening to one podcast, hopefully the intrinsic value podcast for a lot of folks out there. And sometimes I do like to show that off because I guess it's, you know, it's kind of like when you put a book in your library and it's like, look at what I've read, look at what I've learned.

33:00Daniel Mahncke:It's a little bit of that. And so I think the other thing that we should talk about here is that's basically Spotify's specialization is, has led them to being hardware agnostic. And that has helped with really the entrenchment and penetration in market share that they've been able to earn. They do not care you're using an iPhone, a Samsung, a PC, a Fire TV, whatever brand of smartwatch you have, or Apple Play in your car. Almost no matter what piece of modern tech you are using, Spotify is probably compatible with it and actually probably works pretty well, too, in my experience. And so competitors like Apple and Alphabet and Amazon, they might be subtly biased to optimize their streaming apps to favor their own hardware products.

33:46Daniel Mahncke:whereas Spotify truly optimizes for Ubiquity. They don't carry any hardware preferences because they don't sell any hardware products. So they just make it work for everything. That is their focus.

33:59Shawn O’Malley:I actually asked myself whether that's also why I've never thought about switching to Apple Music. I don't know a single person that actually uses Apple Music and yet about half of our listeners probably right now are listening through Apple Music. And I guess this might be similar to the WhatsApp iMessage situation that we talked about when I covered Meta, with Apple Music and iMessage being much more important in the US just due to their higher iPhone penetration. And the hardware ubiquity obviously matters as well because, you know, music is just everywhere. People don't just sit down and then listen to music for said periods of time.

34:32Shawn O’Malley:You know, the way they sit down for shows and movies, audio is pretty much a companion media, right? It's always with you. And, you know, Spotify's flexibility there makes it really well adapted to, you know, the reality that we have many different types of devices, that we use daily while still wanting to be able to seamlessly stream music. I mean, I actually listen to music probably 70 % of the day. Whenever I can, I am listening to music. And it doesn't matter whether I'm on my phone or the MacBook or wherever I am too.

35:02Daniel Mahncke:I'm right there with you. And actually, so business model wise, I should say that Spotify has two core engines. And I think you can probably guess what they are based on just what we've talked about today, right? One, obviously, is subscriptions, referring to the premium users who pay a monthly fee for ad-free music and offline listening, like you and I, Daniel. I think you said you don't download music, but I always download music just so when I fly or when you're offline, I have all my music available. But it does take up a lot of space on your phone. So anyways, these premium subscriptions drive something like 90 % of revenues for Spotify.

35:41Daniel Mahncke:90%. And then obviously the second and much smaller engine of the business is their ad-supported listening. And so these are freemium users who generate advertising revenue for Spotify every time an ad break pops up. But again, this only makes up 10 % of their overall revenues, even though, and I think this caught you by surprise, Daniel, when we were chatting before the show, the majority of users on Spotify are actually free users. They don't pay a dollar for the service. which we kind of find unconscionable. We're so spoiled with ad-free music. But the majority of people globally are not paying for Spotify.

36:19Daniel Mahncke:Spotify has 750 million active monthly users, and only 290 million are premium, while 460 million are on free plans. And so basically, free users help to expand Spotify's reach and reduce these customer acquisition friction costs. but they're not actually profitable on their own. But over time, some portion of them, of course, convert to being paid subs. And Spotify's view is that the more value they can bake into a premium subscription, the longer people will stay subscribed and the more they'll pay for those subscriptions, dramatically increasing the lifetime value of each subscriber, which is fundamental to their intrinsic value.

37:10Shawn O’Malley:That's a pretty classic funnel. I mean, we mostly see it with all these subscription businesses that we see, especially the global ones. But I think Spotify's funnel is unique because the free product is actually a pretty strong product, not a watered down demo that you can't use, but you know, after one or two weeks it gets on your nerves. I mean, plenty of people, actually most people, as you just said, apparently are more than happy with not paying for premium. And yet the business still works because the people who can afford to bypass ads are more than happy to pay up to do so. It's probably, I would assume, one of the things that we often see where people in the United States or maybe Europe are willing to pay and they are basically making the margin for the company.

37:48Shawn O’Malley:But most people in emerging countries are using the free version, which is something that we talked about with Duolingo and many other companies as well.

37:56Daniel Mahncke:And so Spotify's biggest cost is royalties. And when we talk about big tech companies, They're usually what we would call fixed cost driven businesses, meaning they make an investment up front that can require a lot of money and expertise early on, like building a world class search engine with Google or Microsoft Office's software packages. But as these businesses expand, they can achieve greater and greater profit margins over time because costs do not scale incrementally one to one with revenues. We often refer to that as operating leverage. And you see that across any business where there are economies of scale.

38:37Daniel Mahncke:But it can be particularly dramatic in software since the distribution is all digital and the incremental cost of selling more software comes at a very high margin. And for Spotify, though, much like Uber, they have more of what we'd call a variable cost dominated business. So for every dollar of new revenue, a relatively fixed percentage of that must be paid out to music rights holders. And so for Uber to fulfill more rides and generate more revenue, they have to pay drivers for each ride. So it's similar in the sense that there's a very direct cost of growth that does not flatten out entirely with scale.

39:15Daniel Mahncke:To drive an incremental Spotify subscription or an incremental Uber ride, there's a direct cost to the driver or to the music labels that does not come with many other types of software businesses. And so Spotify does have some operating leverage in areas like with its R &D and overhead costs, where basically as the business scales, the R &D costs as a percentage of overall revenues can decline, leaving room for profit margin expansion. But still, structurally, the revenue share that goes out the door to music rights holders has created basically a ceiling on gross margins that limits how profitable the rest of the business can be.

39:58Daniel Mahncke:Even if you literally cut out every other cost, you could take out every other cost. And just in this imaginary world, Spotify has no costs. You'd think they'd have 100 % profit margin. The reality is something like almost two-thirds of every dollar still have to go to music rights holders. So that's what I mean when I say we have a variable cost model here. There's just no way to, at a certain point, you can't get past that ceiling. You can't get to a scale where margins fall any lower, or at least without diversifying their business model, which we'll talk about, is part of the ultimate strategy here.

40:34Shawn O’Malley:So whenever we have such a situation, the key question basically becomes, where or how can Spotify earn higher margin revenue streams that basically sit on top of its attention and distribution. So surely they want to improve their profit margins every single year. And we actually have seen operating profit margins rise from negative 5 % in just 2022 to nearly 13 % in 2025. So clearly there have been some benefits of scale already, even if the inflection hasn't been as dramatic as it would have been if Spotify was able to pay out a smaller and smaller percentage of royalties to labels as the platform is growing.

41:11Daniel Mahncke:Pricing power is going to be one lever here for them to use after more than a decade of not raising prices and effectively investing in their goodwill with customers. Spotify has been much more aggressive about taking price, especially in North America and Europe. But the interesting thing is that as Spotify has expanded internationally to gain traction in lower income markets, they have had to reduce prices for premium, which led their monthly average revenue per user to actually fall dramatically from$6.84 to what was a bottom of$4.29 in 2021. And that maybe doesn't sound like a lot, but that is a fall off by one third in the amount of monthly revenue they generate per user across their entire base of hundreds of millions of paid subs.

42:04Daniel Mahncke:So to have that kind of fall off shows they're generating much less from paid subscriptions across these places that they're growing into, like Latin America and Asia, where prices are cheaper. And I should say that it's not entirely due to international growth, right? it's not entirely fair to blame that because what you've seen them also do is they've rolled out family plans and student subscriptions and all these offerings that have contributed to reducing premium ARPUs average revenue per user over time. And more recently though, fortunately for Spotify shareholders, thanks to some of these price increases that they started to introduce, we've seen premium ARPUs compound at about 2 % a year since 2021.

42:46Daniel Mahncke:And I'm not going to act like that's a huge number, but it's definitely nice to see that number trending up and not continuing to just collapse as the business expands into these different areas. But yeah, I mean, they've gone from the US alone making up more than 60 % of revenues in 2015, seven years after Spotify first launched in 2008, to the US making up less than 40 % of total revenues today, even as the US business has grown 9x in that time. So US revenues have been growing very, very fast. But ex-US revenues outside the US are growing even faster. And that's how you have that change in the composition of revenues from international versus US.

43:31Shawn O’Malley:And it would be interesting to get even more details into the overview of different countries and regions. I think I pay even more here in Germany for my subscription than users in the US. And I actually Googled that. And I would imagine that's the case in a couple of European countries as well. But I also assume that, you know, outside of Northern Europe and the US, prices are just significantly lower. So you'll basically see this trend of, you know, an RPU decline overall going on at least, you know, having growth rates of about two to 4%, as you said, is not that exciting to shareholders.

44:01Daniel Mahncke:And the other outcome from this has been that outside the US and maybe Northern Europe, smaller percentages of people are inclined to pay up for premium music subscriptions. So So as international growth has accelerated, we haven't just seen premium revenues per user decline because of lower prices on those subscriptions, maybe outside of Germany. But we've also seen the percentage of premium subscribers, just as a total of all the users in these different countries, decline. So in 2019, for context, more than 46 % of Spotify's users paid for subscriptions. So basically, one in every two people were paying for Spotify.

44:43Daniel Mahncke:Today, that number is down to 38%. So the growth rate amongst free users has outpaced premium subscription growth. That's how you get this reality where the percentage of paid subs has declined as a percentage of the total. And so that's not necessarily a bad thing because it leaves the door open to Spotify being able to increase their earnings down the road dramatically as more and more of those users overcome the payroll friction to maybe eventually upgrade. even if it might take them longer to do so than with past cohorts of subscribers. So I do sort of see that as being maybe a leading indicator of their earnings power.

45:21Daniel Mahncke:But also at the same time, supporting a larger and larger base of unprofitable free users is not going to help the company's operating leverage, right? Just to go back to that conversation, you know, there is a cost. It's not a huge cost, but there is a cost to supporting streaming and putting up, enabling that bandwidth and the digital infrastructure to support an app where millions of people across the globe can just use it and it just works. There is a lot behind the scenes and the more people you stack onto that do come at a cost and it's not profitable to add them, then that kind of has a reverse operating leverage effect, a de-leveraging.

45:59Daniel Mahncke:And so yeah, just to paint some color around the unit economics of the ad-supported business here, in an entire year, an ad-supported free user generates less revenue than a paid subscriber does for Spotify in a month on average. So a whole year of revenue from an ad-supported user is less than what a premium sub does in just one month. And across the entire freemium user base, you're talking about making less than$4 per user in a year. And again, this is largely because as you scale into less wealthy international markets, the advertising value of those audiences is also relatively declining.

46:37Daniel Mahncke:So 1 ,000 listens or impressions from Bangladesh is not going to be as valuable to advertisers. They're not going to pay as much for those impressions as 1 ,000 listens from an audience of Americans, Germans, or Scandinavians. And so on top of that, Spotify just is not the best place to advertise. I mean, it's not bad. Don't get me wrong. But compared to what Meta and Google can do and the data that they have on you, it's just not even close, right? I mean, that's why you see Facebook and Google generating much more ad revenue per user globally than Spotify, because they have much, much better targeting and more fertile ground for advertisers.

47:20Daniel Mahncke:And you're much more likely to engage with an ad related to something you search on Google than with an ad that interrupts your music listening and just annoys you. And advertisers know that, which shapes how much they'll pay for ads on Spotify to reach even the same size audience as some of these other platforms.

47:38Shawn O’Malley:It's funny because I actually asked a random friend whether they thought Spotify generated

47:47Shawn O’Malley:about 50-50. And that's obviously completely off. But it's also sort of what you would expect off the top of your head if you're not someone who has otherwise studied subscription businesses. I mean, it's not unreasonable to think that since Spotify makes both options available, the unit economics might at least be somewhat similar. But, you know, obviously the reality is clearly the opposite. And even for me, it's a bit surprising to see just how much better Spotify does from, you know, having a user as a paid sub versus having them as an ad supported listener. And it's a subtle point, but you implied a few moments ago that you wouldn't be surprised if, you know, paid users as a percentage of the total on Spotify started to actually increase down the road.

48:28Shawn O’Malley:And at some point, the free tier will have helped Spotify penetrate just very deeply into these emerging economies. And as people in those countries get wealthier, get more reliant on Spotify, it is a reasonable argument to make that, you know, more of them will actually pay for Spotify than they currently do. And part of that is Spotify service becomes even more valuable over time to the user. I mean, your library of music grows, your playlists, if you actually have some, they deepen, the algorithm, you know, better understands you and the app obviously becomes more embedded across your devices and your habits.

49:02Shawn O’Malley:And as that perceived value rises, obviously, you know, the willingness to pay rises too in theory. And I mean, technically, that's what we have seen in the past with Spotify.

49:12Daniel Mahncke:That's true. And, you know, everyone has a different perceived value of Spotify. Some people, I'm sure, would pay twice as much for their Spotify subscription if they had to. We probably are closer to being in that camp. And that's why Spotify has been trying to create, or at least has talked about, the super premium tier with exclusive playlist building tools and probably more attractively like fan perks, which would include early access to concert tickets and early screenings of new music releases, stuff like that. And so actually for a while, people thought that lossless audio would be a big part of this super premium offering.

49:49Daniel Mahncke:But they ended up just rolling that out last year into the standard premium plan, which is something that Apple Music has bragged for a long time about having that Spotify didn't have. And so where we've seen less valuable customers drag down ARPU in the last few years, The hope is that by better monetizing superfans in wealthier developed markets, they can lift ARPUs further again beyond just the 2 % rate that we've seen compounding more recently and maybe re-accelerate it further.

50:19Shawn O’Malley:I mean, you know, these types of global subscription businesses, that's just always the million-dollar question, right? I mean, we tried figuring out, you know, the same for Duolingo just a couple of weeks ago, and they ran into a similar problem in markets outside the US or Europe, with the caveat that those customers for Duolingo now are arguably even more of the original target audience. Whereas for Spotify, it doesn't really matter if you sit in Europe or the US, everybody loves music the same way. Duolingo, you know, they're focused on people who mostly want to learn English as the main language.

50:49Shawn O’Malley:And obviously those people usually don't sit in the US. And those two podcasters talking about the business of Spotify. How does podcasting factor in? I mean, beyond what we have already discussed.

51:00Daniel Mahncke:Well, it's a good question. It's a timely question. And as you know, Daniel, great platform companies often start with one wedge. books, search, PCs, like we saw with Amazon, Google, Microsoft, respectively. And then they expand into broader categories by leveraging their user base, their data, having more financial resources at their disposal, and then just by having more distribution over time. And so clearly, Spotify's wedge was music streaming. That's how they broke into being a massive tech company and taking advantage of the benefits of that. And the expansion thus far has included podcasts, but also audiobooks.

51:39Daniel Mahncke:And, you know, many people don't even know there are audiobooks on Spotify or for a while it felt like it was something that was very overlooked. And Spotify's catalog of English audiobooks actually grew from 150 ,000 to 400 ,000 titles since they did the 2023 premium audiobooks launch with Audiobooks Plus. And so Audiobooks Plus is this recurring$12 add-on to your base subscription that unlocks an additional 15 hours of audio book listening every month on top of the 15 hours per month that's already included in premium. So basically, for the cost of a regular Spotify subscription plus another 15 hours of audio book consumption, you tack on another$12 to your monthly cost.

52:23Daniel Mahncke:And so I was actually pretty surprised to see that they want to capture all forms of reading now. So audiobooks are, of course, part of that. But in a partnership that they announced with bookshop.org, you can actually purchase physical versions of the audiobook you're listening to through Spotify. And so there's this other feature that my wife loves, and it's called PageMatch because she's an avid book reader and also an avid audiobook listener. And what PageMatch does is it lets you scan a page in a physical book, or like an ebook on a tablet. And it jumps to the matching point in the audiobook automatically for you and vice versa.

53:05Daniel Mahncke:So it's designed for switching formats without losing your place. And it's not like an incredibly ambitious business idea, but for people that spend a lot of time consuming audiobooks, which is I think a category I also fall into, it is really cool kind of thing to see anyways. And so I'm imagining that they get some kind of kickback for helping drive some physical book sales since they aren't actually taking inventory and selling the books in the way that maybe Amazon does. But this is only, of course, going to be a marginal driver of the business at best. And I have a sample size of one. I did a price comparison with Amazon for, of course, none other than the intelligent investor.

53:45Daniel Mahncke:It was a little bit disappointing to see that the same hardback version. Looks like maybe they're running a special sale, but still is 45 % cheaper on Amazon than buying it through Spotify's book sales partner. And so that was tough. It makes me maybe not as excited about buying books through Spotify. And unfortunately for Spotify, the shipping is probably a lot faster on Amazon too.

54:08Shawn O’Malley:Yeah, it doesn't seem that attractive. I wouldn't consider Spotify competition for Amazon looking at that business. And honestly, I mean, the$12 add-on seems way too expensive to me. I mean, it feels like it should be maybe half of that price and then include something like 30 hours of listening time at least. I mean, 15 hours a month, 30 total with what's included in premium is just really not a lot for some users. I mean, I listen to audiobooks from time to time and 30 hours, you quickly get there. And, you know, paying 12 additional dollars for just 15 hours is just, doesn't seem like a good value proposition to me.

54:40Shawn O’Malley:And, you know, they could probably have a really cheap tier that unlocks, I don't know, let's say an additional 10 hours of listening at maybe$4. And then, you know, a tier targeting more serious readers where for$20, they get 50 hours of reading or something like that on top of the 15 that are already included. But this currently, I don't know, it doesn't strike me as a pretty good value proposition.

55:00Daniel Mahncke:Yeah, I agree with you. And I don't love that the listening hours expire each month either. That kind of bothers me in principle, right? I mean, you implicitly paid for those hours and then they just vanish. I actually think it's like it's almost egregious compared to Audible's credit model where I've been a little bit bad about audiobook reading recently. So I have all these credits like piling up that I need to use. I can redeem them anytime for a book. They don't just go to waste on me. Whereas, yeah, it's like this use it or lose it model with the audiobook subscriptions. And I think that's because this is, you know, we talked about specialization really does matter.

55:39Daniel Mahncke:And well, audiobooks are outside of Spotify's core competency. And you can see the bias is kind of emerging here where I don't think they're able to or interested in or whatever it is. They're not providing the most compelling option that I think they could be. And yeah, part of that is just not understanding, in my opinion, how people interact with audiobooks. like library subscriptions are free, right? You check out a book at the library, you know, there's a time expiration on how long you can have the book, but it's also, it's free. Whereas with Spotify, if you're paying for something, it just rubs me the wrong way.

56:15Daniel Mahncke:I think you should keep those hours. I think they should roll over month to month. And obviously I think they're worried that people will pay and then like accrue this massive amount of hours. And then, I don't know though, if you paid for the hours, I think you should get to keep them.

56:27Shawn O’Malley:You should. I mean, that makes absolutely no sense to me. And even thanks for the reminder that I still have about a dozen credits on Audible left. I mean, actually, I think you lose them only when you cut off your subscription. Otherwise, they just keep accruing. And that's something that needs to happen for hours on Spotify too. As you said, it kind of feels like they don't fully understand who the audience is and what they're looking for. So I don't know. If you actually go into this basically new product, I think you should have a better understanding of who your customer is. And I think audiobooks were actually phase two of this wedge strategy into new verticals.

57:00Shawn O’Malley:I think first was podcasts, right?

57:03Daniel Mahncke:Yeah, that's right. So podcasts were step one. And they did it in a really splashy way with that exclusive Joe Rogan deal for like$100 million like five or six years ago that a lot of people probably remember. And in the meantime, they succeeded in bringing a lot of podcasters onto Spotify. And the idea, again, is pretty simple. Podcasts expand the amount of time spent on Spotify, which expands the perceived value of Spotify as a service and also increases their ad inventory that they can sell ads against. And so more podcasts hosted on Spotify means more advertising revenue for Spotify. And while music listening is ad-free for premium users, podcasts, to my chagrin, are not ad-free.

57:44Daniel Mahncke:So they can earn ad revenue from premium users who hear podcast ads on Spotify that are facilitated by Spotify's ad network. And to be clear, Spotify doesn't get a chunk of every podcast ad that happens on all the shows on their platform. But shows can opt into the Spotify ad network to unlock more programmatic advertising opportunities in exchange for splitting the revenues with Spotify. And so for Spotify, selling podcast ads can also have much better unit economics than music because they're not constrained by the same royalty payout dynamics as with music label. Rather than paying out two thirds of revenue from music streaming to labels and artists, the split for ad revenues on podcasts, at least, is closer to 50-50 from what I've seen through Spotify for creators or Megaphone, which is Spotify's podcast platform that they acquired.

58:38Shawn O’Malley:And podcasts also change the relationship with creators. With music, creators are mediated by labels. With podcasts, though, I mean, creators can be completely independent oftentimes. For sure.

58:50Daniel Mahncke:Yeah. Spotify has built an advertising marketplace where advertisers can buy access across a network of podcasts. So, you know, not just Spotify originals or exclusive, but also third party publishers can opt into it. And so this matters because podcast advertising has historically been very fragmented. Lots of shows like ours are run by small teams, as you know, and they don't have a sales force, but they don't have the time or expertise to negotiate and manage ad deals with dozens of different possible brands either. So they just end up under monetizing their content. And a centralized marketplace through Spotify solves a lot of that by helping to aggregate supply, which in this case, supply is just podcast content and aggregating demand, which is the people listening to that content and uses targeting data then to improve ad performance and make more compelling pitches to sponsors.

59:50Shawn O’Malley:And Spotify, on the other hand, you know, they can take really a meaningful cut because it's actually providing real infrastructure value. And it's not just about placing the ads. And it's also matching, targeting, and also measuring of how the ads actually perform. Yeah.

1:00:04Daniel Mahncke:And the take rate, if you want to call it that, on marketplace advertising can be far better than the economics of music subscription revenue that largely passes through to rights holders as we keep talking about. So Spotify will not suddenly become a pure play ad platform like meta to be clear. But these incremental ad dollars from podcasting that don't have to be split out with music labels can help improve Spotify's margins further over time. And so one important update to Spotify's approach to podcasting is that the company has evolved from wanting to win by owning the exclusive rights to shows, like trying to exclusively host the Joe Rogan show, to trying to win by being the best place for podcasts to monetize their shows.

1:00:52Daniel Mahncke:And so with Rogan, for example, they moved from having an exclusive deal on Spotify with him to a renewal in 2024 that relaxed that strict exclusivity and emphasized broader distribution. So now you can listen to the Joe Rogan podcast across a bunch of different platforms. And so basically what Spotify learned was that these exclusive deals can drive headlines. But the durable advantage that you want to have is owning the creator tool chain. So the content hosting, the performance measurement, the ad tech and the marketplace products so that even if shows are available elsewhere, Spotify is the platform where creators can most efficiently grow, understand and monetize their audience.

1:01:34Daniel Mahncke:That is very much the intention, at least. And so this all shows how Spotify works with both sides of the market, right, with creators and content consumers. Or it's just a fancy way to say people listening to stuff on Spotify. And so bringing video podcast functionality onto Spotify was also a big part of that and helped Spotify compete more with YouTube, which I'll say, by the way, if you did not know, you can watch the show every week on Spotify and see all the charts that we reference.

1:02:02Shawn O’Malley:actually sounds a bit crazy but i believe that youtube is actually the largest podcast platform in the world by now and we've seen this all again you know so blurred though i mean podcasts used to be a spotify and apple podcast thing mostly it felt like and now you can watch podcasts on netflix as well as youtube and also as you just said on spotify and actually i didn't even catch that I did say watch. Obviously, podcasts were audio only back in the day. So basically our entire concept of what a podcast even is has evolved. And Spotify, I wouldn't say has redefined that themselves, but they saw how YouTube was driving more impressions with podcasts by providing a video component and they jumped to build the technical infrastructure so that podcasters can upload video content directly to Spotify.

1:02:52Shawn O’Malley:And then for users, have it actually load and work well, which again, we talked about Netflix is incredibly important. You actually just have the infrastructure to make it possible to listen and watch this and, you know, really the highest quality possible. And that's easier said than done. But for the most part, they seem to have done a pretty good job with it. But, you know, I don't know, maybe folks in our audience can tell us if they have ever had any issues watching our show on Spotify. Anyways, looking back at the music side of the business again, I did want to ask you more about this marketplace feature that they now have and what exactly that means.

1:03:27Shawn O’Malley:I didn't know about that

1:03:28Daniel Mahncke:So Spotify is something they refer to as campaign kit within Spotify for Artists, which provides artists and labels the option to pay Spotify to promote their music, right? So new releases, targeted discovery, and with that sponsored recommendations and that sort of thing. And it's kind of similar to how sellers on Amazon can pay to have their product at the top of certain keyword search results. And as you can imagine, this is something Spotify tries to balance as Amazon does too. And so does Google on Google search. If you lean into paid promotions too much, then you dilute the quality of your search results and recommendations.

1:04:06Daniel Mahncke:And then the perceived value, in this case for Spotify, to users would decline because it's not as good for discovering music that you're interested in anymore. But at the same time, it's such a massive market opportunity. It would be sort of insane to not tap into it at all. And so Spotify is helping drive incremental discovery in streams in a way that music labels value. Spotify can also potentially renegotiate better overall economics in terms of how royalties are split with labels. So you'll basically see artists accept a lower rate of promotional royalty rights on certain streams from Spotify to reach a greater audience in exchange for help from the Spotify algo's recommendations boosting their music.

1:04:55Shawn O’Malley:So essentially, Spotify becomes less like a music retailer and more like a marketing channel then.

1:05:03Daniel Mahncke:That's right, yeah. And marketing budgets are large, recurring, and often less price sensitive than consumer subscriptions. And it also subtly shifts the power again, right? If Spotify owns Discovery, it's not just distributing music. it's influencing what becomes popular, whether labels choose to pay for that or not. And so that becomes a leverage point in these continuous negotiations that they have with labels on how to divide up the pie of revenues that Spotify generates in terms of doling out royalties to music rights holders.

1:05:39Shawn O’Malley:Spotify is definitely increasingly gaining leverage over labels, but it still surprises me that they haven't flexed their pricing power more with customers. I mean, in most markets, they went from 2011 to 2023 without any price hikes, as you mentioned before. And even still, I mean, US plans now cost only 30 % more than they did 15 years ago, which is very much not keeping pace with inflation. And basically, we've seen Spotify's inflation-adjusted price decrease for a long time now, while the service has actually gotten significantly better. At least that's how I feel from a consumer perspective.

1:06:14Shawn O’Malley:And I guess that's why people say, generally, technology is more deflationary than inflationary. So to me, one of the more exciting arguments for Spotify is to actually think about the earnings power, which is basically the difference between how much money they currently earn and how much money they could earn if they pulled all the strings to make as much money as possible. And clearly, they have much more pricing power and therefore also earnings power, but they don't yet tap into it. Because while that would be good short term, if you raise prices too dramatically, that could, of course, meaningfully increase churn over time.

1:06:48Shawn O’Malley:And that's kind of the balancing act that you have to strike. I mean, it's nice that for 15 years you didn't increase the pricing. But if you do it four times in a row now, even though the price from, you know, 2011 to today wouldn't be that much higher, it would still seem like they're very aggressively taking price right now for customers that are premium users today.

1:07:05Daniel Mahncke:So the interesting thing about these fixed royalty split arrangements with labels is that it applies to all music streaming platforms, right? It's not like this is exclusively an obstacle that Spotify has to wrestle with. And what that means is Spotify's competition then can't undercut them directly on price in any kind of sustainable way. If a platform tried to significantly undercut Spotify, that would hurt the amount of royalties generated for labels. And then labels could retaliate by revoking music rights from that competitor and effectively kill their product. And so for context, three music labels control most of the world's music rights.

1:07:43Daniel Mahncke:That's Universal, which is in our intrinsic value portfolio, and also Warner and then Sony Music. So it's not like you need hundreds of different players to decide to pull their rights. It is a very concentrated market where just one unhappy label can result in devastating consequences for a streaming platform. And so like I'm saying, if one of the big three doesn't like the pricing tactics of an existing and new streaming competitor, they could pull enough music off of their platform to then make it useless. So that is something of a barrier to entry. And if Apple Music is missing dozens of top artists like Taylor Swift, while Spotify isn't, then everyone is just going to switch over and vice versa.

1:08:29Daniel Mahncke:And that gets into this idea of music being a commodity. And the streaming platform has to have all of the available catalog of music in the world. Otherwise, the service is basically useless. And music rights holders know that. And that's why I talk about this negotiating leverage and this tension between them being very relevant to how you think about the long-term positioning of both Spotify and the music labels as businesses and how their intrinsic value can compound into the future. And so there are enough shared interests between Spotify and the labels that there is really sort of a tacit collusion that effectively creates a barrier to entry for new streaming platforms by putting a floor on the pricing that Spotify's competitors can leverage, if that makes sense.

1:09:19Shawn O’Malley:I feel like I brought up Netflix today half a dozen times, but it is quite interesting to compare that to the streaming industry. So Netflix, I mean, when they started, they didn't have the strongest IP. Disney, in my opinion, should have had a huge advantage over Netflix. And yet, Netflix did end up winning the streaming wars. And yet, with music, we wouldn't trust a similar dynamic. A big part of that is because music platforms like Spotify or Apple Music have the same music right now. And so if one platform ends its relationship with the labels, if they would miss out while other platforms still have that music, the dynamic in the movie streaming industry is that they're basically their own labels.

1:09:56Shawn O’Malley:I mean, Disney has its own IP, Netflix has its own IP, and the same goes for all of the other big platforms. So there's a constant trade-off for consumers. It doesn't exist in the same way with music streaming. So I've noticed, or at least heard, maybe it was even you talking about it, that Spotify is investing in actually improving its free tier now. So they basically want to strengthen, you know, the top of their funnel to make the free tier even more attractive than drive user growth. And that will hopefully convert in the long run to premium down the line. So how do you think about that?

1:10:26Daniel Mahncke:One of the things they did was loosen the shuffle only constraint on mobile. And so for years, Spotify Free on mobile pushed you into shuffle for playlists and albums. So you did not have complete control over which songs you could listen to on demand. The last September though, Spotify added this pick and play and search and play features, giving free listeners the ability to search for a specific track and start it immediately. And then that allows you to pick specific songs rather than being forced to accept into just whatever random shuffle is kind of put before you. And obviously that was one of the huge selling points of premium.

1:11:02Daniel Mahncke:So clearly that increases the value of the free subscriptions and loosens up the limitations on it to make it a better product. And the hope is that they can do that without cannibalizing premium subscriptions. Shuffle was terrible.

1:11:16Shawn O’Malley:That's one of the reasons why I would never settle for the non-premium version. But we haven't yet spent a lot of time talking about Daniel Ek and the management team at Spotify. So maybe let's do that. Actually, last night I was going through the Q4 earnings call and I wanted to read this passage from it. And actually it's not from ACK, but rather the new co-CEO, Gustav Söderström, talking about how they view AI. And he said, quote, My view is that new technology is seldom disruptive on its own. Significant disruption happens when new technologies enable new asymmetric business models. So for example, this is what Spotify did to music downloads.

1:11:54Shawn O’Malley:This is what Uber did to taxi services. So the question everyone should be asking is, does this evolution create new business models? Or are we mostly just seeing new technologies? For example, in SaaS, there's currently a lot of fear that the perceived business model will be challenged by more outcome-based models, which is reasonable. However, in the consumer space that we are in, we believe the dominant business model will continue to be ads plus subscription, both places where Spotify excels. This puts Spotify in an outstanding position because we already have the right business model. our job then just becomes leveraging these new technologies to our benefit, which is something that we've done consistently for the last 18 years.

1:12:39Shawn O’Malley:Personally, I don't see any risk for Spotify in terms of AI. I believe the market is just massively overreacting with, you know, SaaS companies too, but there's a lot more actual risk than I think in this case. I mean, first of all, I strongly believe that people want to listen to actual human artists. And secondly, even if AI music should become a bigger thing, I mean, that would actually be beneficial for Spotify too. So I don't know, I'd see no risk for another platform grabbing Spotify's market share either. I mean, the network effects are just way too strong, in my opinion.

1:13:11Daniel Mahncke:Well, in our intrinsic value community, we've debated ad nauseum, who will be the winners and losers of the rise of agentic commerce and SaaS apocalypse and all these narratives and markets right now. And while I still think the market is too sour on B2B SaaS companies, like Salesforce and Adobe. I definitely agree that B2C products like Spotify, Netflix, and Airbnb, to me, they are much better positioned to benefit from AI. It seems like much less of a disruptive threat.

1:13:43Shawn O’Malley:There's actually a bit more that Zitterstrom says that I think is also interesting. So I'll continue reading for a bit now. So quote, I'm excited about us being the first truly intelligent agentic media service that you can literally talk to. And this is not just a pipe dream. You can already talk to Spotify through the AI DJ casually, but also through prompting the playlist in sort of a deep research way. We're going to keep investing in that. What that means structurally for Spotify is that we are building a data set that never existed, which is the data set of language to music, language to podcast and language to books.

1:14:20Shawn O’Malley:We've had the song to song data set, but no one had the language to song data set. And continuing on, and I promise this is the last paragraph that I will read out, but it was actually pretty interesting. He said, I want to drive on a point here, which is this very specific data set. You may think this is a canonical data set, meaning there is a factual answer to, for example, what is workout music? There is no factual answer to what is workout music. You can just have an LLM commoditize it as a fact the way you can commoditize Wikipedia. You actually need to have many, many hundreds of millions of listeners across the world's market constantly telling you what it means for that specific person.

1:15:02Shawn O’Malley:This is a data set that we are building right now that no one else is really building. It doesn't exist at this scale and we see it improving every time we retain our models. I actually like the workout music example a lot because I know firsthand that there is no one answer to what workout music is. I have listened to probably hundreds of different playlists while working out. And I'm talking about totally different genres of music.

1:15:27Daniel Mahncke:It was funny. Yeah. Cause in the U S what hip hop is more likely to be workout music. Whereas in Europe, I think it'd be like house music or EDM is often more popular. And then I've heard like in Scandinavia, that metal is, it can be like really popular for workout music. So when you ask somebody like, what is workout music? It is funny that there's a lot of subjectivity to it. But Spotify has really good data on like they know who you are and what you consider workout music. And so when you speak to your AI DJ and say they're on workout music, it knows exactly what to put on. And I do think there's real value to that.

1:16:01Daniel Mahncke:I mean, right? I mean, it's a really interesting data set to have. And it's not something that ever would have occurred to me. But like, I mean, it makes perfect sense.

1:16:08Shawn O’Malley:I would say that overall, I probably feel good about Spotify's competitive positioning. But there's one foe out here that scares me a little bit. At this point, Apple Music and Amazon Music don't scare me, but YouTube does. I mean, can you just talk more about how they compete with Spotify and how substantial you think the threat actually is?

1:16:27Daniel Mahncke:So YouTube Music is a streaming platform just like Spotify, but the bundled offer they're able to give away, I think is hard for even Amazon and Apple to beat. And so by default, YouTube Premium subscriptions include YouTube Music. And YouTube Premium is a product I love personally because the ads on YouTube are so bad. And once you go ad-free on YouTube, it's impossible to go back because Daniel has told me. And YouTube is maybe the best product in the history of capitalism. I mean, seriously, what beats it? I mean, definitely not Facebook, not Snapchat, probably not Netflix, and sadly, probably not Spotify either.

1:17:05Daniel Mahncke:And so the amount of entertainment that exists on YouTube, it's unrivaled. It is unrivaled. It is the king of eyeballs and attention. And so TikTok is like an emerging rival to them. But still, the numbers are like vastly skewed in YouTube's favor. They're just in a league of their own. And they have two decades more worth of video content on their platform than TikTok does. And so not to say YouTube music on its own is anything that special. But the point being, when you can bundle your Spotify alternative into a product as compelling as YouTube Premium, getting no ads on videos and access to your own music streaming platform.

1:17:46Daniel Mahncke:For a minute, it does make you wonder whether how much of a threat that is to Spotify, right? And even for me, I was sitting there thinking like, should I be paying for Spotify separately? Should I just be buying YouTube Premium and getting my ad for YouTube and also all my music baked into that? And I couldn't, it made me a little nauseous to think about switching off of Spotify, Daniel. But if it was good enough to have me thinking about it, then for a lot of other people, it's probably compelling enough to get them to actually switch.

1:18:14Shawn O’Malley:Why didn't you end up doing it? What was the little nuance that made you think, no, I gotta keep Spotify?

1:18:20Daniel Mahncke:So they don't go out of their way to show this. But for half the price, YouTube does offer something called YouTube Premium Lite that I came across. And it does not include Apple Music, but it does so give this ad-free YouTube experience. And so I'm more inclined to do that and just keep Spotify on the side. And to do it, you know, when you're not taking advantage of the bundle offering from YouTube, it's going to be a little bit more expensive. But to me, that's preferable to switching over my music to a new platform that I just don't trust. Music is such an important part of my life that, yeah, I don't want to mess around with another algorithm that doesn't know me for recommendations.

1:19:00Daniel Mahncke:Like, no, that seems crazy to me. And so not everyone is going to see it that way. And you also have to kind of hunt for the premium light option. I don't think it's like super well known. And so they're very clearly trying to push everyone by default into the subscription that includes YouTube music, just the standard YouTube premium. And so if I were a Spotify shareholder, which should be clear, I'm not. That would be very scary to me. And, you know, especially because so much of Spotify's expected growth is expected to be in emerging markets going forward. And YouTube is very, very popular in countries like Indonesia, India, and the Philippines.

1:19:36Daniel Mahncke:So they have a huge advantage already. And then when you consider that the value of the YouTube premium bundle is better for more price-sensitive consumers, then you sort of say, hey, this YouTube offering is much better positioned to succeed in the fastest growing corners of the world than maybe Spotify is. And that gives me some pause.

1:19:57Shawn O’Malley:I'm actually, I'm looking it up right now and the numbers are pretty astonishing. YouTube Music is smaller than Spotify and paid music subs, but it is growing fast. I mean, Spotify has about 290 million premium subscribers, while YouTube disclosed having about 125 million YouTube Music and premium subscribers globally last spring. So I do think we can clearly say there is evidence of market share gains, even if it's hard to flesh out how many of those people are using YouTube music in place of Spotify. But I bet there are also, you know, a lot of people who pay for YouTube music and maybe don't even realize it or, you know, care while keeping the Spotify subscription to it.

1:20:38Shawn O’Malley:To some extent, that's probably what happened with me for the last couple of months. But yeah, there are some reports here saying that YouTube was the fastest growing music streaming platform last year and has actually displaced Apple in fourth place worldwide. So how does Spotify win over YouTube music though?

1:20:54Daniel Mahncke:So I have a friend who pays for Apple music and Spotify. And actually, I think he pays for YouTube premium. So he has access to three music streaming subscriptions. And that's a little bit extreme, but I don't think it is completely uncommon. But just, you know, Spotify, their biggest, most durable advantage, I believe, is their personalization. If Spotify keeps compounding its data and refining their tech for music discovery, playlisting, and personalized recommendations, it can remain the highest satisfaction music app that people want to pay up for, even if YouTube wins among some of these more price-sensitive bundle shoppers.

1:21:35Daniel Mahncke:And yeah, I mean, the YouTube premium bundle is really, really compelling. But still, my takeaway from seeing all these other big players try and fail to beat Spotify with bundling is that music does matter to a lot of people. Music and the role it has in people's lives warrants its own app that's hyper fixated solely on the best listening and user experience possible. And so am I willing to bundle like my home and car insurance? Like, sure, why not? It doesn't make a difference to me. I just want the best value. But music is entertainment. And I'm not trying to be like too romantic about it, but it is inherent to the human spirit.

1:22:11Daniel Mahncke:music resonates with everyone. Who doesn't like music? You don't meet people who categorically don't like music. It doesn't exist. And I don't want to ramble too far about it. But what I'm trying to say is I think a lot of people, maybe most people, at least in developed markets, appreciate the superior experience of Spotify enough to not be enticed by these apps where they're accepting a diminished user experience, maybe worse music suggestions, for example, in exchange for just saving a few bucks a month on some product bundle. And if that wasn't the case, I already think Apple and Amazon would have had much more success taking market share from Spotify.

1:22:49Daniel Mahncke:And so, yeah, YouTube gives me a little bit of hesitation, but even still, I don't see them being able to displace Spotify. Apple and Amazon might suffer because of YouTube. I think Spotify, they're kind of in a league of their own, and I would imagine that the damage to them would be much less so.

1:23:07Shawn O’Malley:I think I agree with that. I mean, I remember times about 15 years ago where I spent most of my time on YouTube watching music videos. So I wouldn't doubt that they, you know, could build an algorithm as good as Spotify's. And yet, I kind of liked the idea that Spotify is, you know, where I listen to music and that's it. And that's actually the case. Despite being a podcaster, I use Spotify to listen to mostly music. Podcasts are a thing for YouTube, as well as all other videos for me too. And I think that's probably about where we should stop and talk about valuation. So where do you want to begin with that?

1:23:43Shawn O’Malley:What's important if you look at the business of Spotify and trying to figure out how much is it worth today?

1:23:49Daniel Mahncke:To me, the biggest question is what level of profitability can Spotify achieve? And we know it won't be able to match the most high quality software businesses in the world and in cloud computing margins. But it does remind me, just to say it again, of Uber, where you have this incredibly valuable ecosystem restrained by a variable cost structure. And yet, Uber's margins have also started to explode upward in the last few years. And for both companies, where that lands, at what level of profitability they hit in a more mature business state, that's the key question. And so we've got a chart on screen showing Spotify's operating leverage over time.

1:24:28Daniel Mahncke:and it's been volatile. But ultimately, as revenues have compounded at 24 % a year for the last decade on average, you've seen margins track that. And since 2023, the inflection upward has been more dramatic than ever. And I'm not sure whether that operating profit line on the chart keeps shooting straight up or if it just gradually climbs upward, probably the ladder. But then still, the question is, where does it land? And clearly, these margins are largely thanks to scale. As Spotify grows, its margins have, for the most part, improved over time. So that tells me the core business is working.

1:25:04Daniel Mahncke:And recently, their investments into podcasts and audiobooks also seem to be paying off. And I'd probably draw up three cases. In a more pessimistic scenario, you'd probably argue, look, most of the margin gains Spotify has achieved have already come to fruition. And in five years from now, margins will probably be similar or marginally higher at best. And then in a base case, I'd probably argue, okay, they're going to keep scaling and raising prices and also looking to invest in areas outside of their arrangement with music labels where they can maybe earn higher margin revenues. And so realistically, this will never be a 30 % operating margin business like with some of the Mag 7 companies.

1:25:42Daniel Mahncke:But in five years from now, can they achieve like 18 to 20 % margins, you know, up from 13 % today? Yeah, I think that's possible. That seems, you know, pretty realistic to me. And then if you were looking at this really optimistic bull case scenario that is still plausible, like not wildly optimistic, it's probably not hard to envision their flywheel just really kicking further into year for like free user growth just explodes internationally while the percentage of people converting to premium rises over time after a lot of that initial expansion is finished. And maybe they're even able to renegotiate a modestly more favorable agreement with labels.

1:26:20Daniel Mahncke:And then Spotify, in that case, could probably double its operating margins to like 25%. And so that's a lot of talk about margins. But profit margins indicate the quality of the business. So we're really talking about how good of a business is Spotify and how good can it become over time as we try to think about the intrinsic value of the company.

1:26:41Shawn O’Malley:For me, it depends on the price you have to pay, as always. But the fact that Spotify's margins seem to be capped at a rather low level has always been a fact that made it a bit less attractive to me. I've also heard our colleague, you know, Stig Brodersen of The Investor's Podcast complain about Spotify's dilution. But actually, it doesn't look anywhere close to being as bad as some other companies we've looked at here on the show.

1:27:05Daniel Mahncke:Oh, absolutely. Yeah. going back to the time of their IPO around 2018 and 2019, you're talking about stock-based comp to revenue of less than 2%. And so I guess you can't say that Spotify is actually a Silicon Valley company, but we've definitely seen way worse from some of these other tech giants. And as a share of revenue, stock-based comp peaked in 2022 and has been sharply declining since while they've been periodically buying back shares in the meantime. And last year, they actually bought back more stock than they ever had before, nearly$700 million worth. So that's a way to make up for the dilution.

1:27:41Daniel Mahncke:And as a result, we've seen Spotify's total share count only compound at 1.7 % a year since 2021. And I can already envision Stig telling us how painful that is. And it is painful to be diluted by 1 % to 2 % a year every single year. Because of that, it just adds up. But if Spotify has the earnings power that they think they do, the dilution is definitely not extreme enough for me to cite that as a reason for not wanting to own the company. So if we put it all together, where did you land with the valuation? Across those three scenarios that I worked on imagining and then weighting each of those scenarios by like very approximately how plausible I think they are, how likely they are to happen.

1:28:27Daniel Mahncke:And then you go through the process of trying to find fair exit multiples for what would people be willing to pay for this version of the business that you're imagining down the road. And without getting lost in the weeds of that whole conversation, I see like a target price of about$400. That's when we feel like we'd really be getting good intrinsic value with Spotify. and probably something more like a fair value where fair value means that if you just buy it at that price, you're going to get an average return over time. Yeah, that would be about$500. So at the time of recording to me, Spotify is somewhere in the middle of that range, probably fairly valued, not unattractively priced either after it's declined 25 % in the last six months, but it's not a screaming buy at this price.

1:29:15Daniel Mahncke:And so a big part of that analysis, like I said, is figuring out the exit multiples in each scenario. And so for me, I compared the market's valuations of Spotify, Uber, and Airbnb over time in terms of operating profits, enterprise value. And Spotify currently trades at 33 times operating profits and Uber trades at 27 times and Airbnb trades at 25 times. And so in my base case, I have that valuation, that exit multiple trending down to 25 times operating profit to show some multiple compression as the business matures. But still, that's not like a super, super cheap valuation by any means. So you're still expecting the market to be willing to pay a premium for Spotify down the road.

1:29:57Daniel Mahncke:And so you're anticipating that the market will continue to price Spotify as a top tier, very promising business like those other names I've mentioned that also happen to be intrinsic value portfolio holdings of ours. And I think it can continue to be priced that way. but it is good to be aware of the assumptions you're making, right? It's not the most conservative valuation ever. And that's because of some of the biases I probably have to be more optimistic about Spotify's future because of how I feel about it as a user. But I was careful to not be crazy aggressive, I think. And so anyways, despite my love for Spotify as a user, I'm not quite falling over myself yet to buy it at these prices.

1:30:41Daniel Mahncke:But I think it's going to be one of those cases where in a few weeks or months, if we get another leg down and the stock sell off, I would be ready to pull the trigger and initiate a position. But I don't know. That's enough about how I think about it. How do you feel about this one, Daniel?

1:30:56Shawn O’Malley:Well, I think a couple of years ago, I would have made the mistake, you know, to bet against Netflix when this doing wars started due to the tough competition. And in hindsight, backing Netflix would have been the right decision. And it's actually, as you mentioned, in our portfolio right now. And in this case, it somewhat feels similar as in Spotify seems to have won the music streaming business already. But as you said, this is a space with, you know, limited margin potential. And the areas to expand into are the ones where you really have to go to war, you know, with YouTube and the other heavyweights in the business once again.

1:31:30Shawn O’Malley:And personally, I do think that will be difficult. And there's also the possibility that bundles like the ones that YouTube can offer will be more successful in monetizing more price sensitive users outside of the US and outside of Europe. And when you combine all of that with the valuation that's not yet a screaming buy, I think it's a good decision to hold off for now. And if we should see a price, you know, closer to the$400, I think that's where we get pretty excited about it. As a user, you know, I'm totally sold on the company.

1:31:58Daniel Mahncke:Spotify is one of those that like every time I dig into it and I've dug into it a few times over the years I think okay this is like I should have enough conviction after this and I'll probably be inclined to buy it and I don't know every time I get excited about it and then I really think about like you're saying like what the road forward looks like for Spotify and like man it seems like for Spotify to expand into other verticals they will be much more directly competing with companies like YouTube. And so there's a lot of room to run in the music business. So I would be very optimistic on that.

1:32:34Daniel Mahncke:But that's also priced into the stock, I would say. And there's not a lot of additional upside to capture just from continuing to raise prices on premium subscriptions and getting more international growth. A lot of that is priced in. And so what they do in these new verticals is really going to be one of the bigger determinants of how they compound intrinsic value for years and years to come. And that's where I have less conviction. And so, I don't know, I could spend another two hours on Spotify. I think this has been a lot of fun. I just, in the interest of time, let's move ahead and look at what we've got for next week.

1:33:09Daniel Mahncke:So why don't you give listeners some hints for your pitch?

1:33:13Shawn O’Malley:Well, actually this time, we might actually skip the hints for the first time because next week we will be covering basically all of the Constellation spinoffs and some of these smaller VMS companies that we have talked about or that we kind of teased in our Constellation Software episode. And I think that will be a pretty, pretty interesting episode. We will cover companies like Topicus, Lumine, Signity, and some more. And I think it will be interesting. You will basically have the angle of VMS businesses, but this time not looking at it from the biggest company in the space with Constellation Software, but actually from the angle of the companies that mostly acquires.

1:33:48Shawn O’Malley:We'll also look at some companies that are not necessarily part of the Constellation software family, at least not yet. So I think it will be a quite interesting one.

1:33:57Daniel Mahncke:All right. I'm excited. Okay, folks, on that note, since we started this episode talking about some important Swedish words, let's use the Swedish proverb as today's quote to wrap things up. So translated, it goes, there's no bad weather, just bad clothes. And it's kind of cheeky, but I feel that way about investing, right? There are almost no bad investments, just bad prices paid for investments. At a cheap enough price, almost any investment opportunity can offer good value and qualify maybe really, really cheap in some cases. But still, there is always probably a cheap enough price to justify things.

1:34:37Daniel Mahncke:So we're waiting for a little bit of a cheaper price with Spotify before we can really get comfortable with it. But with that, we will see you again next week.

1:34:48Shawn O’Malley:Thanks for listening to TIP. Follow the Intrinsic Value Podcast on your favorite podcast app and visit theinvestorspodcast.com for show notes and educational resources. This podcast is for informational and entertainment purposes only and does not provide financial, investment, tax or legal advice. The content is impersonal and does not consider your objectives, financial situation or needs. Investing involves risk, including possible loss of principle and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions.

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