Dear Partners,
The purpose of this note is to share with our investors the evolution of our thinking on Spotify throughout our investment journey. We believe this reflection is not only valuable for understanding the company but also serves as an important exercise for us. Writing out our thoughts helps clarify our perspectives and sharpen our decision-making process. Moreover, revisiting these writings in the future provides an opportunity to learn from past experiences—both the successes and the mistakes.
Spotify has been a particularly compelling case study in this regard—one that offers valuable lessons not only about the company itself but also about the challenges and nuances of long-term investing.
In our 2022 year-end investment letter, we posed a critical question: “Spotify (SPOT) is currently selling for about $15 billion. Does this make any sense?” Fast forward to today, Spotify’s stock has appreciated more than six-fold since that time, valued today at $100 billion.
Our journey with Spotify has been both interesting and instructive—an excellent case study for all investors. We first invested in Spotify in 2018, shortly after its IPO. At that time, the stock debuted at $132 per share. Today, it trades at $500 per share, delivering an annualized return of 23% over 6.5 years for those who invested right after the IPO. While this may sound like an unequivocal success, the story reveals some crucial lessons about investing.
If you had held the stock from its IPO until the end of 2023—a span of 4.5 years—you would have seen little to no return on your investment. All the gains for a long-term investor materialized in the last 10-12 months (refer to the chart below). This illustrates a key truth about investing: returns often come in unpredictable bursts, and timing the market is next to impossible. As we have written about many times, the stock market rewards patience, but it doesn’t always deliver those rewards on your schedule. Investing is hard, but those willing to endure the periods of uncertainty and stagnation are often handsomely rewarded in the long run—assuming, of course, that you’re right about the business.
Throughout our holding period, we often wrestled with doubts about whether Spotify, which initially appeared to fit all our investment criteria, still deserved a place in our portfolio. At various points, we questioned whether Spotify was merely a great product that people love—without being the great business with strong economics that we typically seek.
As investors, it’s essential to distinguish between a popular product and a business capable of generating durable, high-quality earnings. While Spotify undeniably captured the hearts of millions with its innovation and user experience, we sometimes wondered whether it could overcome the structural challenges of its industry, particularly its reliance on music labels and its thin margins.
The Peak of Our Concerns (Q2 2023)
Revisiting our notes from Q2 2023, it’s clear that our confidence in Spotify as an investment was beginning to waver. At the time, we were grappling with serious concerns about the company’s business model, which was not evolving in the way we had hoped. While Spotify had achieved remarkable growth—expanding its Monthly Active Users (MAUs) from 207 million in 2018 to over 500 million by mid-2023—we struggled to understand how this scale could translate into meaningful profitability.
Despite doubling its premium subscribers and driving strong user engagement, Spotify’s gross margins remained stuck at 25%, and its free cash flow had fallen sharply—from $209 million in 2018 to just $21 million in 2022. In contrast, the music labels, which owe much of their success to Spotify’s platform but still command significant power in the industry, have thrived. For example, Universal Music Group (UMG) saw its revenues grow from $6.9 billion in 2018 to $11 billion in 2022, with free cash flow more than doubling from $857 million to $1.9 billion. While Spotify’s growth has been impressive, much of the value it created has flowed to the music labels, leaving Spotify struggling to turn its scale into sustainable profitability.
One key insight from a Universal Music Group: The Gatekeepers of Music podcast highlights the inherent bargaining power dynamics between music labels and streaming platforms. The way we consume music differs fundamentally from how we consume video. With music, we often listen to the same songs repeatedly, whereas with video, once we’ve watched a season or a movie, we’re unlikely to revisit it—or may watch it only once more. This difference gives platforms like Netflix the ability to use their scale to develop new intellectual property (IP) that keeps users engaged in their ecosystem. In music, however, the old catalog is just as important as new releases. Roughly 37% of Spotify’s playlists are weighted toward new music, while 39% are weighted toward catalog content. This reliance on older music gives significant power to the IP owners—the major labels. If the music industry operated like the video industry, Spotify could bypass the labels by heavily investing in new music and signing emerging artists, much like Netflix does with original content. However, music consumers overwhelmingly demand access to both the latest hits and the old catalog. Without that catalog—owned primarily by three major labels—streaming platforms have no product.
As a result, we became increasingly concerned that Spotify’s original structural challenges were unlikely to change. Universal Music Group (UMG), Warner, and Sony collectively control the vast majority of the music catalog, and they extract 70–75 cents of every dollar Spotify generates. This dynamic effectively caps Spotify’s margin potential, no matter how much it grows.
Moreover, we questioned Spotify’s push into podcasting and audiobooks. While these verticals offer the promise of higher margins, Spotify appeared to lack a clear path to differentiate itself from competitors like Apple, YouTube, and Amazon. Without strong differentiation, these initiatives risked becoming commoditized, adding further pressure to Spotify’s already thin margins.
This led us to a critical question: If Spotify cannot achieve profitability with 500+ million users, how will additional scale change this dynamic? At the time, we were starting to believe that it wouldn’t. Spotify seemed stuck in a commoditized space, generating enormous value for the music labels but struggling to capture sufficient value for itself.
Our Thoughts Today
In 2024, Spotify has finally started showing signs that it could potentially become not just a great product but a great business as well. Throughout our holding period, we have always viewed Daniel Ek as an exceptional founder and CEO—someone capable of navigating Spotify through the complexities of the music streaming industry. But does the stratospheric +165% rise in SPOT’s stock price this year influence our renewed optimism? We don’t think so.
As long-term investors, we strive to follow Warren Buffett’s timeless advice to treat Mr. Market as a tool to serve us, not a guide for our decisions. Stock price movements alone should never dictate our assessment of a business. With that in mind, we to set aside the recent rally and focus solely on the business fundamentals. The key question is: What has changed?
To begin, lets first acknowledge that Spotify’s ability to grow its user base and premium subscribers has been nothing short of remarkable. By the end of 2024, Monthly Active Users (MAUs) are projected to reach 665 million, while Premium subscribers are estimated to grow to 260 million (please see chart below). These figures represent continued momentum in expanding its global footprint and reinforcing its position as the leading audio platform.
Revenue Growth Re-Acceleration
One of the most notable developments in 2024 has been Spotify’s ability to meaningfully re-accelerate its revenue growth. After a period of deceleration—where quarterly revenue growth slowed to nearly 10% in Q2 and Q3 of 2023—the company has rebounded strongly, posting growth in the high teens. This resurgence has been driven largely by successful price increases across key markets, demonstrating Spotify’s newfound pricing power.
This shift has not gone unnoticed by Mr. Market, as investors have welcomed the company’s ability to grow both its top line and its margins simultaneously. Price increases have historically been a delicate balancing act for Spotify, given concerns about user churn. The fact that these adjustments have been met with minimal resistance is a positive signal that Spotify’s value proposition remains strong, even at higher price points.
Gross Margins: A Key Turning Point
Gross margins have always been our primary focal point when assessing Spotify’s business model. For years, we were concerned that gross margins were stuck at around 25%, which meant that Spotify was paying 75 cents of every dollar to music labels. This left little room for profitability or reinvestment, despite the company’s impressive growth in user base and the continually improving quality of its platform. However, in 2024, Spotify has finally started to demonstrate that it is possible to meaningfully improve its economics.
The company is estimated to achieve ~32% gross margins in Q4 2024, signaling significant progress. Several factors have driven this improvement. Spotify’s marketplace program, which helps artists and labels promote their content, has developed well and contributed positively to gross margins. Additionally, efficiencies in streaming delivery costs, payment processing, and favorable U.S. publishing rates have provided further tailwinds. These factors contributed to the margin gains seen in both Q2 and Q3 of this year.
The improvement in Premium gross margins is even more impressive, with the latest quarter posting 33.5%. This demonstrates that it is indeed possible for Spotify to improve its economics in its core subscription business. Moreover, Spotify has addressed past missteps in the podcasting space. Initially, the company spent heavily on proprietary podcast content, attempting to replicate Netflix’s strategy of exclusive originals. This approach failed to deliver the desired results and weighed heavily on Spotify’s Free Gross Margins, particularly between Q1 2022 and Q1 2023 (see the graph below).
However, Spotify has learned from those early mistakes, pivoting away from that strategy and focusing instead on scaling its advertising segment and improving the profitability of podcasts. These adjustments have led to margin improvements and positioned the company to capitalize on significant opportunities in advertising (a topic we’ll explore later in this write-up). If successful, we believe that Spotify’s gross margins could eventually reach 40%, a level that would fundamentally reshape the company’s business model and valuation potential.
Source: Rowan Street Capital LLC, Spotify quarterly filings
Gross margins are one of the Key Performance Indicators (KPI) upon which future valuations will be built, and this progress forms the foundation of our renewed optimism in the long-term prospects of the company.
Daniel Ek on the Q3 ‘24 earnings call:
“In terms of our recent gross margin improvement, we are very pleased with the strides we made this year. The significant rate of improvement in our gross margin in 2024, which exceeded even our own plans has been exceptional and should be viewed as such. Looking ahead, we see a substantial runway to grow margins and income over the long run, which will be driven by continuing focus on improving our product and business via targeted investments, disciplined management and improving monetization.”
Operating Expense Discipline
Coinciding with improvements in gross margins, Spotify has also demonstrated impressive cost discipline with its operating expenses. From the chart below, it’s evident how R&D and SG&A expenses have come down as a percentage of revenues since mid-2023. This discipline, combined with gross margin improvements, has significantly improved Spotify’s overall profitability.
To put it all together, these advancements have directly flowed through to operating margins, which recently reached 13.1% (see below). For a company that has been unprofitable since its inception, this marks a transformative shift. As the chart below illustrates, Spotify has not only moved out of the red but is now showing operating leverage that we once struggled to envision.
Previously, we questioned whether Spotify could ever achieve even a 10% operating margin, but the company’s recent performance has forced us to reevaluate. Given its current trajectory, there is a realistic path for Spotify to achieve operating margins of 20% in the future. This is a fundamental realization for us, as it changes the narrative around Spotify’s long-term potential from a purely growth-focused platform to a potentially highly profitable business.
This combination of disciplined cost management, gross margin expansion, and improving operating margins forms the cornerstone of our renewed optimism in Spotify’s ability to generate significant shareholder value over time.
Free Cash Flow: A Critical Milestone
Consistent with the improvement in operating profits, Spotify has experienced a significant boost in its free cash flow generation. Over the past 12 months, the company has produced €1.8 billion in free cash flow—a dramatic increase compared to the €200-250 million range where it had been stuck since 2018 (refer to chart below).
Source: Spotify Q3 2024 shareholder deck
The Exciting Role of Advertising in Spotify’s Future
As investors in both Spotify (SPOT) and The Trade Desk (TTD), we found recent comments from The Trade Desk CEO Jeff Green particularly illuminating regarding Spotify’s advertising potential.
”Digital audio is at the early stages of its evolution. The channel is in a similar position to where Connected TV (CTV) was a few years ago. Consumers in the U.S. spend an average of three hours per day consuming digital audio, up significantly over the last five years, and advertisers are eager to capitalize on this emerging advertising channel. At the moment, advertisers are looking for clear trusted signals to inform what they buy. Trust but verify, has become a mantra around the open Internet. Just a few weeks ago, media reported on our major expanded partnership with Spotify. They will be deploying both UID2 and OpenPath, so that advertisers can find as much addressability and insight as possible for Spotify's high-value ad impressions. I don't think there's a company in the media universe that's been more successful than Spotify at building a subscription model. In the audio world, Spotify gives us access to almost all of the world's music for a low monthly subscription. In many ways, Spotify has been at the forefront of this mass consumer shift to digital audio. I think they are in the process of becoming well positioned to get incremental users due to a good ad experience and to get incremental ad budgets for the exact same reason. You only have to listen to their most recent earnings report to understand how seriously they are taking the ad-supported side of their business and building out their programmatic capabilities over the next several years. We are very excited to partner with them in this work and to help our advertiser clients make the most of this fast-growing channel, where listeners are highly engaged and leaned in. Our partnership with Spotify is one of the inventory partnerships that I'm most optimistic about.”
Here what Daniek Ek said on the earnings call in regards to Spotify’s Ad Exchange and working with The Trade Desk:
”Our ad business today has been heavily reliant on direct sales and top funnel brand spend. And therefore, what we've seen over the years is that the type of ads business that we built has an exposure to macro trends. So with this, we have now diversified and changed our platform and built this Spotify ad exchange, and moved on with the Trade Desk as a test pilot. What we do see is that 2025 will be a year of testing and trying out this and we will see the impact going into 2026. It is early days. We are new to the auction environment and it's important that we are very deliberate and careful about how we roll out the supply into these channels, but we are also at the same time, very excited that this will help us to change.“
This initiative aligns perfectly with Spotify’s broader strategy to expand its advertising segment, which we believe could be a game-changer for its financial profile. With the growing importance of digital audio, highly engaged users, and advancements in programmatic ad technologies, Spotify is positioning itself as a key player in what could become one of the fastest-growing advertising channels in the years ahead.
Valuations and Future Growth Prospects
All the improvements we’ve discussed in this write-up have not gone unnoticed by Mr. Market. Since hitting its lows in 2022, Spotify’s stock surged by +138% in 2023 and is up another +165% so far in 2024. This dramatic recovery reflects a significant shift in investor sentiment—from maximum pessimism to heightened optimism in less than two years.
When we published our write-up at the end of 2023, SPOT was trading at approximately 6x Gross Profits—a valuation that reflected widespread skepticism about the company’s ability to improve its economics. Today, the stock is trading at 21x trailing Gross Profits (see below), representing a 3.5x jump in valuation multiple. This sharp re-rating underscores the market’s renewed confidence in Spotify’s ability to deliver sustainable profitability and long-term growth.
Looking ahead, revenues for 2024 are estimated to be €15.6 billion, and we believe they could grow to €26+ billion by 2027. This assumes Spotify can grow its Premium subscriber base to 360+ million and increase ARPU from the current €4.62 to over €5.00—both of which we see as achievable. Additionally, we anticipate that the ad-supported business, fueled by Spotify’s ad-tech efforts, could start growing at a much faster pace, potentially doubling from the current €1.9 billion to €3.6 billion by 2027 (obviously this is still a big IF and depends on the success of Spotify’s ad-exchange platform and partnership with TTD).
We are also optimistic about Spotify’s gross margin expansion, which could reach 35% by 2027, driven by continued improvements in Premium margins and Free Gross Margins profitability. Under this scenario, gross profits could exceed €9 billion by 2027—a 26% annual growth rate from €4.6 billion in 2024. If Spotify manages to maintain lean operating expenses as demonstrated in 2024, operating margins could rise to 15% by 2027, resulting in €4 billion in operating profits—a remarkable 43% compound annual growth rate from €1.4 billion in 2024.
Hinging on these assumptions, valuations could top $120 billion by 2027, which from current valuations would deliver 6–9% annualized returns (IRR) over the next three years. While this is a decent ‘market-like’ return, it’s a stark difference from the 45% annualized returns (IRR) we were forecasting in our January 2023 note. This highlights how much of the future growth and profitability is already priced into the stock after its substantial re-rating over the past two years.
Our Position Sizing and What We Do From Here
At Rowan Street, we run a concentrated strategy. We’ve always believed in owning our 10-12 best ideas rather than spreading our time and capital across 25 or even 100 positions, as is common in the industry. Great investment opportunities are rare, and the ability to focus capital on them is one of the most valuable aspects of our strategy. However, this approach comes with trade-offs: it leads to bumpier returns and often draws more attention to mistakes when things don’t go as planned. This is the price we willingly pay for the potential of achieving above-average returns over the long term.
How Our Approach Has Evolved
Since we started Rowan Street in 2015, our approach to portfolio management has evolved. After initiating our position in Spotify in 2018, it gradually became our largest holding over the following years. This was driven by our confidence in the company’s management, long-term potential, and attractive valuations—especially compared to other ideas that appeared “pricey” at the time.
Looking back at our 2020 notes, we were enthusiastic about Spotify’s future. The stock was trading at an undemanding 4x forward 2021 revenues, and we saw an immense opportunity to generate value for our investors. Spotify has been led by Daniel Ek, who is widely regarded as one of the most innovative and forward-thinking entrepreneurs in the digital media space. Under his leadership, the company has addressed a multi-billion-user opportunity and positioned itself to lead the nascent podcasting industry. We believed it could eventually disrupt music labels, empower independent musicians, and improve gross margins over time.
With this conviction, Spotify’s weighting in our portfolio grew to over 20%. However, in hindsight, this was a “forced bet,” driven by our optimism about the business rather than the natural evolution of the portfolio.
Lessons Learned and Guiding Principles
The drawdown of 2022 forced us to reassess our approach to portfolio management. It was a valuable learning experience that led us to adopt an important new guiding principle:
Let the portfolio concentrate itself in winners naturally, rather than forcing a position. Positions that go up and become larger pieces of the portfolio have earned that right. Those that go down and become less significant have earned their fate. The reality is that our portfolio gravitates toward winners if we simply let it. It’s easier to sleep at night when your largest position got that way by going up, rather than being an under-performer you keep adding to, trying to prove the market wrong.
This principle allows us to reward companies that demonstrate sustained success while avoiding the “emotional trap” of doubling down on under-performers.
Position Adjustment: A Shift in Approach
By Q4 2023, despite Spotify’s stock price running up to $240, our confidence in the business model was waning. Our analysis suggested that operating margins were unlikely to exceed 8% over the next 3-4 years—well below what we expect from an exceptional business. While we respected Daniel Ek’s leadership and admired Spotify’s accomplishments, we remained concerned about its lack of a strong moat and the poor returns on reinvested capital.
At over 20% of our portfolio, Spotify’s weighting felt disproportionate to its business quality. We made the decision to trim Spotify back to a core 10% weighting, consistent with our portfolio structure. In hindsight, while it may have been much more lucrative to hold all our shares as the stock ended up doubling since then (investing is hard), this decision was guided by our new principle of letting positions earn their way to higher weightings.
Where We Stand Today
Fast forward to today, Spotify now represents 15% of our portfolio—not because we forced it, but because it has earned that position through appreciation. By sticking to our principle, we avoided emotional over-investment and allowed the portfolio to naturally concentrate in a winner.
This evolution highlights the importance of staying flexible and learning from experience. Our decision to trim Spotify was about sticking to a disciplined approach of aligning our portfolio with businesses that consistently demonstrate extraordinary performance and the ability to compound value over time. Spotify remains a company we respect, and its current weighting reflects our ongoing commitment to letting winners prove themselves.
Best regards,
Alex and Joe
DISCLOSURES
The information contained in this letter is provided for informational purposes only, is not complete, and does not contain certain material information about our fund, including important disclosures relating to the risks, fees, expenses, liquidity restrictions and other terms of investing, and is subject to change without notice. The information contained herein does not take into account the particular investment objective or financial or other circumstances of any individual investor. An investment in our fund is suitable only for qualified investors that fully understand the risks of such an investment. An investor should review thoroughly with his or her adviser the funds definitive private placement memorandum before making an investment determination. Rowan Street is not acting as an investment adviser or otherwise making any recommendation as to an investor’s decision to invest in our funds. This document does not constitute an offer of investment advisory services by Rowan Street, nor an offering of limited partnership interests our fund; any such offering will be made solely pursuant to the fund’s private placement memorandum. An investment in our fund will be subject to a variety of risks (which are described in the fund’s definitive private placement memorandum), and there can be no assurance that the fund’s investment objective will be met or that the fund will achieve results comparable to those described in this letter, or that the fund will make any profit or will be able to avoid incurring losses. As with any investment vehicle, past performance cannot ensure any level of future results. IF applicable, fund performance information gives effect to any investments made by the fund in certain public offerings, participation in which may be restricted with respect to certain investors. As a result, performance for the specified periods with respect to any such restricted investors may differ materially from the performance of the fund. All performance information for the fund is stated net of all fees and expenses, reinvestment of interest and dividends and include allocation for incentive interest and have not been audited (except for certain year end numbers). The methodology used to determine the Top 5 holdings is the largest portfolio positions by weight. The top 5 do not reflect all fund positions. The Top 5 can and will vary at any given point and there is no guarantee the fund will meet any specific level of performance. Net returns presented are net of fund expenses and pro-forma performance fees. Rowan Street Capital does not charge fixed management fees. Investment Advisory services are offered through Synergy Asset Management, an SEC Registered Advisor. Investment in this fund, offered as Rowan Street Capital, LLC, is affiliated by common ownership to Synergy Asset Management through its General Partner, Rowan Street Advisors, LLC.
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