The Challenges Ahead for Spotify

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Spotify (NYSE: SPOT) finally went public last week, and while its opening week wasn't too rough, the company has plenty of challenges lying ahead.

In this segment from Industry Focus: Tech, analyst Dylan Lewis and Motley Fool contributor Evan Niu discuss some of the biggest challenges facing Spotify. Find out why the company has some serious scale issues, what makes leverage such a difficult game for Spotify, how record label contracts eat away at so much of the company's scalability potential, and more.

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A full transcript follows the video.

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This video was recorded on April 6, 2018.

Dylan Lewis: We've talked in the past about how maybe the best option for them, or something that would be certainly very interesting, is getting more involved or disintermediating the music industry. There might be something there. But we have to look at current valuation and what they do, and right now, that's where we're at. It's going to be bits and pieces from a whole bunch of different businesses.

I think something that might be helpful is also looking at, how does their valuation stack up looking at the number of MAUs they have. This is something that we do with social media companies sometimes. And you think, OK, they're in the neighborhood of about $25 billion, and they have about 160 million monthly actives. I think that puts them around $160 or so a member. And the problem is, not all of those people are paying for the service, and they're not going to derive the same value from all those people. So, even trying to do it that way, it's a difficult business to wrap your head around from a valuation perspective.

Evan Niu: Right, exactly. I definitely see a lot of potential in the platform and the company. But there's also a lot of challenges that I think prospective investors should look at, particularly around profitability and scalability. Because most of the time, investors like companies -- especially for companies that focus on software as services -- because they can usually scale very well. But Spotify will not have that benefit because their largest cost is royalties to the record labels, and the royalties are paid out on a per-stream basis, which means it's a variable cost. So, as hours streamed engagement goes up, so does the cost revenue associated with delivering that content. So, you're not going to really have very much operating leverage, if any.

And as you mentioned before, we had talked about this idea of connecting listeners to artists directly and cutting out the role of the middleman, even though they'll always be there, to some extent. If you think about it like, because these costs are tied to the usage, there's a very good chance a lot of this engagement is very concentrated in these major artists and record labels, which means that those costs are still unlikely to come down even if they make a lot of success and progress with growing the other side of the business that's connecting artists directly. So, it's going to be pretty tough to really expand profitability.

Lewis: Yeah. This relationship with cost is actually something similar to what we've talked about in the past with Snap, where if you have a variable cost that rises with usage, that means that leverage is just going to be tough to come by. Evan, looking at the business for them, though, do you see anything that gives you some signs that there's a chance they could improve profitability down the road?

Niu: I mean, the biggest piece of it is really these record labels and the licensing deals with them. They did renegotiate them in 2017, which has been a huge help for them in terms of improving their gross margin. But that's really the only way that they can get any type of a really meaningful relief on these royalties. And with them just renegotiating these a year ago, it seems unlikely that they're going renegotiate them any time soon. They're probably good for another couple of years, in which case, is there some other catalyst in the near-term that can really help profitability? I don't know.

Lewis: I guess it would have to be something like a new business segment or a meaningful new operation that they get into that has some sort of dramatically different margin profile than what we're seeing on the streaming side.

Dylan Lewis has no position in any of the stocks mentioned. Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.