Universal Music (NL:UMG) has finally come to the market, an event long-awaited by many and by this analyst for almost exactly five years – it was in September 2016, when I attended a teach-in on the European media sector at a bulge-bracket firm, that I spotted an investment opportunity.
A rated media analyst walked through the various industries and stocks in his sector. I was intrigued by his explanation of the music-streaming business, which was then considered a positive for Vivendi, the French mass-media conglomerate. Music-streaming apps, such as Spotify (US:SPOT), charge their customers $10 or £10 per month. Their economics then were, and likely still are, broadly:
- 60 per cent of revenues goes to the record company
- 10 per cent goes to the publisher
- the remaining 30 per cent is their gross margin
- they then have to advertise, acquire customers, administer and develop the service.
At the time, Spotify was a private company, although there was a pretty active secondary market in the shares. The analyst back in 2016 explained that music was $10bn in his sum-of-the-parts calculation for Vivendi, which made it quite cheap. At the time, I knew a little about Spotify, having helped review a July 2015 placing of stock by a wealth manager when its valuation had been $8.5bn.
Spotify’s Gross Margins and Consensus Estimates
Source: Behind the Balance Sheet from Sentieo data
Today, Spotify is valued at $42.5bn, almost exactly five times its 2015 valuation, but in fact it has had a less stellar performance on the stock market than some equivalent stocks, having risen 50 per cent since IPO compared with video streaming service Netflix (US:NFLX) more than doubling over the same period, for example. But it remains lossmaking, so investors are taking quite a lot on trust – for many growth companies, the benefit of low interest rates is that the value of those far-off years (when the business will become profitable) are worth more today than formerly when interest rates and the related discount rates were higher.
Spotify: Good Performer since IPO, but lagging Netflix
Source: Behind the Balance Sheet from Sentieo data
I believe that music is an inherently more attractive industry than video for two simple reasons:
- in contrast to film, customers will listen to a music track over and over again – it takes a lot to get tired of a brilliant song, whereas the lifespan of a movie or serial is relatively short. I would prefer to own a song than an episode of a video series for example.
- Music is ageless. You can listen to a piece of music from this year, from the 1980s (a brilliant decade for music in my view), the 1950s or the 1850s. A piece recorded digitally today will sound just as good, irrespective of the time it was conceived and an old recording that has been remastered will sound almost the same. My kids will happily listen to The Beatles but try to show them a movie from the 1960s and they will automatically view it with suspicion. Black and white? Forget it!
From a consumer perspective, Spotify is similar to Netflix – a monthly streaming service subscription. But the business models for the two are quite different. Spotify buys in almost all its content from the big music labels, whereas for several years, Netflix has increasingly commissioned its own content. Spotify pays away a share of its revenue and its margins will therefore be capped. Netflix theoretically could make unlimited margins if it manages to persuade enough people to subscribe at a high price and manages its content spend. So far, it has been spending a lot on content and has been focused on growing its subscriber base. For Spotify, the challenge is a better user interface rather than differentiated content (I am deliberately simplifying the comparison).
SPOT vs UMG
The purpose of this article is not to compare Spotify with Netflix – we might look at why Netflix is valued at $270bn and Spotify at 16 per cent of that valuation another time. In this piece, I want to compare Spotify with Universal Music. Back in 2016, the two valuations of Spotify (secondary market plus add a bit for growth in the interim) vs the analyst’s estimate for UMG were very similar and I thought that was odd.
Vivendi’s subsidiary, Universal Music, had a global market share of over 30 per cent. Its share of Spotify’s revenues would be 18 per cent of the group’s sales (30 per cent of the 60 per cent record label royalties). Spotify’s <30 per cent gross margin and high customer acquisition costs mean that it is currently lossmaking. Long term, I thought it unlikely that its selling, general and administration (SG&A) costs would be less than 12 per cent of revenues. Hence, pre costs, UMG’s share of SPOT’s revenues was probably worth more than Spotify in its then form.
UMG, of course, has to pay royalties to artists, but it also collects streaming revenues from other services (Apple, Amazon, TenCent, Deezer and 400 others when I last looked). Spotify has just over 30 per cent of the global streaming business, so the value gap in streaming between UMG and Spotify is clear. And streaming today is roughly two-thirds of UMG’s revenues; it also has a publishing business and various other interests, so there is another significant pool of value on top.
Now that UMG has been floated, we can compare its valuation with that of Spotify. UMG as I write has a market cap of €42bn, or $50bn – its debt is broadly cancelled out by listed stakes in Spotify and TenCent Music Entertainment and other investments. So there is a $7bn-$8bn gap between the two companies.
In a steady-state environment, UMG should clearly be worth considerably more than Spotify and the current gap is less than this simple back-of-the-envelope calculation would yield. Why is this? One reason might be that it’s new to the stock market; but usually there is a lot of hype around such IPOs – they tend to drift off later.
More likely is that the stock market is ascribing a lot of value to Spotify’s future income streams and assuming that UMG will have a declining market share. The stock market seems to believe that Spotify will gain the upper hand over time for a variety of reasons:
- The royalty rate may be renegotiated with UMG taking a lower share of Spotify’s revenues. This is of course a possibility, but UMG is one of Spotify’s most important labels, if not the most important, so it’s hard to gauge how much scope there might be for Spotify to improve its terms.
- UMG has the right to its current roster until copyright runs out. Thereafter, Spotify can presumably stream the content for free or at least pay the reduced royalty to the publisher. Generally copyright lasts 50-70 years after an author’s death, but music is slightly different. This is an area where I don’t claim any specialism. There have been US legal claims by artists to terminate UMG’s rights post 35 years, and much of the roster will be that old or older – 1986 would be that cut-off. The record companies have generally got around this by using “made for hire” wording in contracts which circumvents the relevant US legislation. This is hard to judge, but the reversion of rights to favour Spotify is likely to be a long way off and I doubt there is much in the price for this.
- The biggest opportunity for Spotify to accrue benefit at the expense of UMG is where new artists decide they don’t need a label and go direct. The royalty rate will be significantly reduced allowing Spotify to improve margins massively in the case of independent artists – let’s assume that the artist takes 15 per cent and Spotify’s margins improve by 15 per cent. This is a massive increase for a company forecast to make 8 per cent margins in 2025, but how fast can this impact Spotify’s bottom line? Even in 2030, I for one will still be listening to The Beatles, Bruce Springsteen and U2.
Back in 2016, a simple back-of-the-envelope calculation suggested that UMG was worth more than twice the analyst’s estimate, and we decided to get involved. In the interests of full disclosure, I have been involved in Bollore and Vivendi in the past and I now own UMG (and not Spotify). How this pans out, I don’t know, and I can certainly make a positive case for Spotify stock, particularly relative to Netflix. I plan to return to that topic in a future article.
For now, I plan to stick with UMG. There is potential upside from price hikes, new sources of revenue such as gaming and wider geographical penetration, but I need to do significantly more work to bring myself up to date – the summary above is of my analysis five years ago and of course things change. And then I didn’t have access to UMG financial data, which I now plan to analyse. But I hope this article illustrates an important valuation technique – it can be extremely helpful to compare business models and the valuation of two companies in a sector.
Stephen Clapham is founder of Behind the Balance Sheet and author of The Smart Money Method.
