Richard Windsor
19 March 2017

Spotify - Patience Pays

shareholders will see more value by being patient

Spotify is closing in on finally doing a deal with the record labels that will remove the last obstacle to the company going public. Spotify and three of the largest record labels have been dancing around each other for a significant period of time without coming to any definitive agreement. This is crucial because without the content from these three labels. Spotify would be unable to provide its current service.

We have long argued that as Spotify’s user base grows, so does its negotiating power and that the longer it took to arrive at an agreement, the better it is for Spotify. However, the time for Spotify to go public is approaching fast and without a deal with Universal, Sony and Warner, any valuation that Spotify would achieve at IPO would be materially impacted. Furthermore, with this hanging over its head, the stock would be very volatile in the public market as, in theory, the labels could wipe Spotify out at any time by pulling their music from its service.

In practice, this is never going to happen because with every month that passes, the labels need Spotify more than it needs the labels and we are pretty sure that if they were going to pull their music from Spotify, they would have done so ages ago. This is because streaming is now the only source of growth in the music industry without which the labels would lose what has become their most important route to market.

Spotify is unique in that it is the only major platform to have a free-tier and adding in those users takes Spotify’s total user count well north of 100m. This is hugely significant, as although these users do not pay Spotify directly, they generate vast amounts of data which can be used to improve and train its algorithms. This is critical because it is those algorithms that allow Spotify to both understand the music it has on its platform as well as accurately match it to the users that it has.

In the long-term, this gives Spotify the opportunity to cut the labels out completely which would have the effect of substantially enriching both artists as well as shareholders of Spotify. This is why Spotify is not keen to do a deal with the labels that limits the provision of music to free users as data collection and algorithm training would most likely be impacted. The other side of the coin is that we suspect that Spotify has guided its investors to a time when it can IPO, giving existing shareholders visibility as to when they will see a return on their investments. We believe that doing an IPO without a signed deal with all three of the biggest labels has difficulty written all over it which is why Spotify is considering caving in to some of the labels’ demands. Although this will bring some short-term benefits to Spotify and its shareholders, a deal in the short-term could delay Spotify’s ability to supplant the labels which we have long believed is where the real upside lies. This is because this is how Spotify goes from earning $0.30 on the subscription dollar to $0.50 or more.

Hence, the best outcome for shareholders will be achieved by being patient and letting the IPO exit window slip for as long as required for Spotify to become powerful enough to dictate terms to the labels. We continue to see only a minor threat from Apple Music as Spotify is still adding paid subscribers much more quickly and shows every sign of having better artificial intelligence with which to differentiate its service. Whether Spotify can convince its shareholder of the merits of delaying their exit remains to be seen

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