Guardian Fund: “Spotify (SPOT) is One of the More Underrated Companies We Know”

Guardian Fund, an investment management firm, published its second quarter 2021 investor letter – a copy of which can be downloaded here.  A quarterly portfolio return of +16.85% measured in euros, net of fees and expenses was recorded by the fund for the first half of 2021. You can view the fund’s top 5 holdings to have an idea about their top bets for 2021.

In the Q2 2021 investor letter of Guardian Fund, the fund mentioned Spotify Technology S.A. (NYSE: SPOT), and discussed its stance on the firm. Spotify Technology S.A. is a Stockholm, Sweden-based music streaming services provider, that currently has a $50.1 billion market capitalization. SPOT delivered a -16.47% return since the beginning of the year, while its 12-month revenues are down by -5.54%. The stock closed at $262.83 per share on July 09, 2021.

Here is what Guardian Fund has to say about Spotify Technology S.A. in its Q2 2021 investor letter:

“What does the future of audio look like?

To us it seems strange that today the market of music, one of the most universally loved things, is as small as the global market for bananas.

Spotify, with 356 million monthly listeners, is on a mission to provide more monetization options for creators. This is gradually going to increase the size of the market. For example, podcasters now have easy tools to build their business.

One option for podcasters is to use Anchor (accounting for 80% of new shows on Spotify) and determine what is subscriber-only content. For the next two years this service will be free to the creator and from 2023 onwards Spotify will charge a fee of 5% of revenues. This is low and comparable to the 5% Epic Games charges for the Unreal Engine. People are free to use Anchor
and it offers tools for example to add video to the podcasts.

Through the Spotify Open Access Platform creators that have subscribers elsewhere will be able to let listeners hear the content on Spotify using the existing login system. It enables the hosts with a subscriber base to distribute using Spotify yet retaining the client relationship.

It has become a no-brainer for creators to use Spotify. Moreover, by becoming an open platform Spotify is moving away from the walled garden strategy that Facebook and Apple pursue. In fact, Spotify is doing things that are hard for Apple to copy as its business model is invested in controlling the garden. The opportunity for Spotify is to find services to provide around its platform just like Elastic does around the open source Elasticsearch or Google around search.

Better software will help the audio market to become bigger. The market for podcasts is much bigger than radio as it will be data-driven and more engaging. Another way to increase the market is to find better pricing tiers. Today, streaming music is one of the cheapest forms of entertainment of all at about 10 cents per hour. Daniel Ek said: “I believe an increase in value per hour is the most reliable signal we have in determining when we’re able to use price as a lever to grow our business.”

Besides experimenting with pricing tiers, the quality and effectiveness of targeted advertising is getting better and new technology will enable the long tail of advertisers. Then there are other lollapalooza effects coming from for example digital stable currencies enabling many people without access to mobile money, bank accounts, or credit cards, to pay for a Spotify subscription. This will drive conversion from freemium users to premium subscribers. Better tools to monetize audio may bring back the importance of the entrepreneurial spirit to the music industry. This means making decisions where to optimally spend advertising budgets to be discovered and to measure the returns on ad spend as well as to optimize strategy based on data generated by direct client relationships.

Today, most musicians neither have access to the relevant data nor entrepreneurial incentives to come into action to monetize their creation. I think it will change when creators do not need gatekeepers anymore because they have the tools to be in charge of their brand. We are going to see new strategies to monetize the super fans. For instance, a musician can partner with a TikTok star to use the music with a video, pay Spotify to be included in a playlist, use analytics to plan concerts, sell tickets, share content, merchandise, do podcasts, Clubhouse, YouTube, and all the things we cannot even imagine today yet will be normal in 2030; this month, Sony Music announced a strategic partnership with Roblox to bring Sony Music recording artists into the Roblox metaverse. Over 36 million people watched Lil Nas X performed the first-ever live virtual concert on Roblox including the debut of the hit song Holiday.

Spotify has 158 million paying users which is more than twice as much as the second player Apple with 72 million. Spotify can amortize content creation and acquisition among the large user base and recent moves show that it understands scale advantages and network effects (the former Netflix CFO Barry McCarthy and current co-CEO Ted Sarandos sit on the Spotify board). Recent investments in Locker Room and Green Room mark the start of live audio and social engagement. All of this is creating exclusive and differentiated content that will increase engagement. Already Spotify has relationships with Joe Rogan, the Obamas, the Kardashians, Ranveer Allahbadia, Prince Harry & Megan, many other podcasters and musicians. In a way, the music streaming service has become a client acquisition tool for Spotify’s other audio features.

The entire audio ecosystem, including labels like Universal, is going to benefit from a growing pie. Bill Ackman’s presentation on his investment in Universal Music Group gives some interesting insights into the music industry. It shows that the number of music streaming subscribers is likely to grow from about 400 million to over 1.5 billion in 2030. The revenue share of streaming as a percentage of the music industry (also digital and physical) will grow from 66% to over 90% by 2030. The share of profit will grow faster as margins are higher. Our expectation is that Spotify is likely to gain a larger share of the growing market.

Spotify is one of the more underrated companies we know. We are either wrong and then the downside is limited or we are going to make a home run owning it. The current valuation reflects that of a commoditized music streaming service which Spotify no longer is. The question is how much and when the value that it is building is going to translate into faster revenue growth. If earnings would positively surprise then the market value will soon be significantly higher.”

Based on our calculations, Spotify Technology S.A. (NYSE: SPOT) was not able to clinch a spot in our list of the 30 Most Popular Stocks Among Hedge Funds. Spotify Technology S.A. was in 46 hedge fund portfolios at the end of the first quarter of 2021, compared to 48 funds in the fourth quarter of 2020. SPOT delivered a -5.86% return in the past 3 months.

Hedge funds’ reputation as shrewd investors has been tarnished in the last decade as their hedged returns couldn’t keep up with the unhedged returns of the market indices. Our research has shown that hedge funds’ small-cap stock picks managed to beat the market by double digits annually between 1999 and 2016, but the margin of outperformance has been declining in recent years. Nevertheless, we were still able to identify in advance a select group of hedge fund holdings that outperformed the S&P 500 ETFs by 115 percentage points since March 2017 (see the details here). We were also able to identify in advance a select group of hedge fund holdings that underperformed the market by 10 percentage points annually between 2006 and 2017. Interestingly the margin of underperformance of these stocks has been increasing in recent years. Investors who are long the market and short these stocks would have returned more than 27% annually between 2015 and 2017. We have been tracking and sharing the list of these stocks since February 2017 in our quarterly newsletter.

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Disclosure: None. This article is originally published at Insider Monkey.