Spotify (Part I) - The Pirate Slayer
The Global Audio Platform
The 2000s - What a Time to be a Pirate
The internet was terrible for the music industry. The internet made pirating, and the sharing of pirated music, extremely easy. In the 90s many of us would have pirated music by burning CDs. It was quite common, but there was still a lot of friction in this process as you had to burn a CD one at a time and most CDs could only be written over once. As the speed of the internet increased in the early 2000s, peer-to-peer (P2P) file sharing platforms like Napster, LimeWire, and The Pirate Bay exploded in popularity. This really put the squeeze on the music industry as it became much easier for consumers to freely access almost all the world’s music. The improvement in music playing devices like MP3 players, iPods and mobile phones also made it easier for consumers to enjoy their pirated content.
Technology made pirating frictionless and gave it scale. It was great outcome for consumers but it was a rough time for the music industry as industry revenues fell by 41% from 1999 to 2014. Piracy was killing the music industry.
While it is hard to find concrete data on music piracy, research reports indicate that LimeWire was installed on 36% of computers globally, with the bulk of traffic on the platform being used to share copyrighted material. Piracy was also quite prevalent amongst wealthier countries and young/technologically savvy cohorts. Countries like Sweden, Australia and Finland were notorious consumers of pirated content.
Spotify - The Music Industry’s Growth Engine
However, in 2015 the recorded music industry began growing for the first time this millennium. This is largely due to the growth in Spotify and the adoption of streaming. By 2021 the recorded music revenue industry reached $15b in the US, which surpassed its 1999 peak of $14.6b.
Spotify delivered a product that was so good that consumers began paying for music again. Reports indicate that global music piracy declined by 65% from 2017 to 2021, while piracy has been all but eliminated in regions like Norway. This is quite extraordinary - especially when you consider that piracy had only gotten easier over the years (i.e., smartphones were more powerful, the internet became faster, cheap VPNs, pirated music streaming sites etc).
Thanks to technological improvements and Spotify achieving product-market fit, consumers began willingly paying for a product that they were previously getting for free. This is a clear example of a business with product-led growth and pricing power. While it seemed like the internet was going to kill the music industry, the internet eventually enabled Spotify - a business that would slay the pirates and help drive the music industry to record heights.
The Spotify Machine
Spotify is the world’s leading music streaming and audio platform with close to 500m monthly active users and a presence in over 180 countries. Spotify has a leading market position with a 38% share of global subscribers (ex-China) and has the highest retention of all streaming competitors.
Despite many investors perceiving the music streaming industry to be commoditized, Spotify has been able to grow paying subscribers at significantly higher rates than competitors, while also expanding gross margins, reducing churn, and increasing prices. Spotify’s performance runs counter to the notion that its product is commoditized. If Spotify’s product was truly commoditized, they wouldn’t be winning a disproportionate share of the industry while also increasing margins/user retention.
While the music catalogues across streaming services may be identical (aka commoditized), the streaming product and the user experience is not identical.
Why does Spotify win?
1. Industry leading User Experience
A superior user experience is a competitive advantage. While some investors might not think of user experience as a significant moat, two of the greatest businesses of our generation - Apple and Amazon - provide great case studies on the power of User Experience.
Apple’s key competitive advantage has been its focus and investment into user experience. Even Steve Jobs said as much himself:
“One of the things I’ve always found is that you’ve got to start with the customer experience and work backwards for the technology. You can’t start with the technology and try to figure out where you’re going to try to sell it . . . and as we have tried to come up with a strategy and a vision for Apple, it started with ‘What incredible benefits can we give to the customer? Where can we take the customer?’ Not starting with ‘Let’s sit down with the engineers and figure out what awesome technology we have and then how are we going to market that?’ And I think that’s the right path to take.” – Steve Jobs, WWDC 1997
User Experience was one of Steve Jobs’ top priorities and a critical factor that helped Apple become the world’s most valuable company.
Jeff Bezos has said on multiple occasions that Amazon’s competitive advantage is their obsessive customer focus. He explained his business philosophy in a 1999 interview when the interviewer was giving him a hard time because Amazon was not a “pure internet play”. It’s a great interview so I’ve included it below.
“If there’s one thing Amazon.com is about, it’s obsessive attention to the customer experience . . . It doesn’t matter to me whether we’re a pure internet play, what matters to me is ‘do we provide the best customer service?’ Internet, shminternet . . . . They [investors] should be investing in a company that obsesses over customer experience. In the long term there’s never any misalignment between customer interest and shareholder interests.” - Jeff Bezos, 1999 interview
Tying this in with Spotify, they have also adopted this philosophy of focusing on user experience as a key business strategy.
“We believe our superior user experience is what has enabled Spotify to become the largest global music streaming subscription service. Investing in the user experience has and will continue to generate significant benefits for our platform . . . . The vast majority of the content we offer to users is licensed to Spotify on a non-exclusive basis. We believe that personalization, not exclusivity, is key to our continued success.” – Spotify’s F-1 (Prospectus)
Spotify has continuously invested in maintaining a superior user experience (interesting UX case studies 1 & 2) since its inception, which has allowed it to outcompete its well-funded competitors and incumbents. In an industry where businesses are all selling the same product or service (i.e., be it mobile phones like Apple, books/retail like Amazon, or music catalogues like Spotify), user experience becomes critical to drive differentiation and competitive advantage.
A tangible example Spotify executing and benefiting from this philosophy has been their investments into the single user interface. When Spotify launched podcasts it would have been much easier for Spotify to launch a separate podcast app from a development perspective. However, Spotify invested in imbedding podcasting functionalities into their core app to create a seamless user experience.
“When we entered podcasts, we were strongly advised to follow the status quo and, instead of creating an integrated app, create a standalone podcast app, because that would be easier for us….. But we asked ourselves, why should the user have to adapt to the format by switching software? Shouldn't the software adapt to the user?” - Gustav Söderström, Chief Research & Development Officer – Spotify 2022 Investor Day
This is what allowed Spotify to go from 0 to 100 in the podcast market. As soon as Spotify began investing in podcasts the category already had distribution to Spotify’s then ~200m users, as opposed to having zero users and trying to scale that organically. This obviously has material financial benefits as Spotify has gone from a distant third in podcasts to becoming the market leader in a span of 3 years.
Spotify followed Steve Jobs and Jeff Bezos’ philosophy of starting with the customer experience, then building the technology/product (aka internet, shminternet). This sole focus on user experience is what has allowed Spotify to dominate the audio market and drive differentiation in a seemingly commoditized market.
(Note: I get that it is a bit ironic that I am referencing Jobs and Bezos’ philosophy on UX, with regards to why Spotify is beating peers like Apple Music and Amazon Music!)
2 - Unique discovery engine and personalization = Engagement
A key area where Spotify’s product stands out in user reviews is their strong music discovery engine and great personalized playlists. Spotify currently drives 22 billion artist discoveries every month, of which 1/3 of those new discoveries are made through Spotify’s personalized playlists. This discovery engine is a key driver of engagement (i.e., use of the product), which is a major KPI for any media business. Spotify’s unique discovery engine and personalization is what allows it to have market leading engagement, even within the Apple ecosystem. Apple’s own data below shows Spotify having a significant engagement advantage across all competitors amongst iOS users. Higher engagement means more value for users, which ultimately results in more benefits for Spotify (i.e., be it lower churn, more ad impressions, pricing power).
3 - Superior tech stack helping Spotify becoming the audio Superapp
Spotify adopted a microservices architecture early in its lifecycle, which has allowed it to develop new products and deploy improvements much quicker and more effectively. A microservices architecture is when components of an application are broken out and deployed individually, as opposed to a traditional monolithic architecture where one code base runs all the components of an application.
It is easier for a company to start off with a monolithic architecture as it is simpler to manage and is more cost effective. However, at scale, shipping changes and launching new features within a large monolithic architecture becomes very problematic as this would require updating and testing the entire application. This results in a slower development cadence and can prevent scalability. It also eventually leads to tech debt which can be very detrimental to growth.
While Spotify’s investments into its microservices architecture was more cumbersome and costly early on, it has paid dividends as it is what enables Spotify to quickly launch new verticals within the same application, giving it major distribution advantages (i.e., as opposed to Apple and YouTube which still run multiple apps across audio streaming).
4 - Unrivalled audio distribution creating Network Effects
Spotify’s market leading position as an audio platform enables it to create valuable (indirect) network effects. In Spotify’s infancy its network effects were not that strong. While the platform did possess some network effects (i.e., more users = more value for artists), the network lacked density given its single product focus.
As Spotify evolved into an audio platform they have been able to create strong network effects. I’ve tried to illustrate Spotify’s current network in the diagram below. It is a lot messier than the previous graphic – which is a good thing. The denser (or uglier) the chart, the stronger the network effects. As Spotify’s network strengthens it delivers more value to users and partners, making them less likely to leave (and more likely to pay) – which ultimately increases the value of the Spotify.
A tangible example of this is Spotify’s podcast launch, which increased user engagement (i.e., lower churn, more ad impressions) and resulted in a 76% increase in the lifetime value of each ad-supported user. As Spotify further launches additional verticals like audiobooks and reels, engagement will continue to increase which will further densify Spotify’s network and increase its value.
Summary
Spotify’s superior user experience and growing network effects has enabled it to drive differentiation and have a competitive advantage in a seemingly commoditized market.
Spotify recently reaccelerated its user growth (which is difficult at this scale) and is in a great position to more than double its user base to 1b in ~5 years. Although revenue growth will slow in 2023, they are shedding their bull market fat and their recent user growth acceleration bodes well for future revenue growth.
While Spotify is still loss making, it has been free cash flow positive since 2016 and will comfortably self-fund its growth with minimal dilution to shareholders. If you assume a normalized operating margin of 12.5% (management long-term guidance of 20%), Spotify is currently on ~11x normalized operating income. In my view, it will be a much more valuable business over time.
This was part one of my posts on Spotify. In my next post I’ll dive into Spotify’s financial profile and share some more detailed analysis.