We still have our doubts about whether no-moat Spotify can create an economic network effect moat source. While Spotify's premium subscriber base continues to grow, which drove the third-quarter top line above S&P Capital IQ's consensus expectations, monetization per subscriber also continues to decline. On the podcast front, it appears that additional content is helping reduce churn and increase engagement. The quarter was also profitable because of slightly higher gross margin, cost control on R&D and sales and marketing, plus lower social charges related to stock-based compensation. However, we continue to think that labels will limit premium revenue gross margin expansion, and the firm likely will continue to attract listeners through lower prices or more sales and marketing as it competes with big names such as Apple and Amazon.
While management's fourth-quarter guidance implied full-year revenue higher than consensus expectations, it was in line with our initial projection. We made only slight adjustments to our estimates and are maintaining our $130 per share fair value estimate for Spotify. The stock is up 14% in reaction to the strong third quarter and is now trading slightly above our fair value estimate. We recommend waiting for a pullback before investing in this name.
Spotify reported total revenue of EUR 1.7 billion, up 28% from last year, driven by premium subscriber count, which increased 30% year over year to 113 million. The firm's total monthly active users of 248 million (up 30%) also included ad-supported users of 141 million, which were up 29%. While churn improved 19 basis points from last year, according to management, average revenue generated per user remained weak. ARPU of premium subscribers was down 4% from the previous quarter and 1% from last year to $4.67, as Spotify continues to market aggressively by offering the service at lower prices.
Swedish-based Spotify is the world's leading music streaming service provider. We foresee the fast-growing digital streaming space as becoming the primary distribution platform of choice within the ever-changing music industry. We believe Spotify can benefit from various network effects that will help the firm increase its users and amass valuable intangible assets associated with user data and listening preferences. However, it faces intense competition and has a (mostly) variable cost structure that may limit Spotify's future operating leverage and profitability. Thus, we do not have sufficient confidence that it will generate excess returns on capital over the next 10 years.
In our view, while Spotify is ahead of the pack in the growing music streaming market, it faces stiff competition from behemoths such as Apple, Google, and Amazon. Unlike Spotify, these firms don't rely solely on streaming music to drive profitability and can potentially run at break-even, or even as loss leaders, while monetizing users via other products and services. It might also be harder for Spotify to steal share from these competitors over time, as Apple Music users are probably entrenched with other Apple products, Amazon Music with Echo, and so on. Thus, they might be relatively more loyal to these music platforms than the users an operating-system-agnostic platform like Spotify can capture.
Competition aside, we think Spotify may be at the mercy of the record labels in the music industry, as it will need access to content to continue attracting more listeners. While the distribution side of the industry (Spotify, YouTube, Apple, terrestrial and digital radio, and so on) is fragmented, over 80% of licensing is controlled by the big three major record labels: Universal Music Group, Sony, and Warner Music Group. As these licensors gather royalties from Spotify and its peers, they maintain pricing leverage as content remains king.
We consider Spotify a no-moat company. While we foresee several potential moat sources for Spotify, we don't have tremendous confidence that any of these characteristics will enable the company to generate excess returns on invested capital today. Ultimately, we do think the firm can effectively monetize its listeners and the content it provides. In fact, based on user and ad revenue growth, we model a 20% total revenue compound annual growth rate for the firm through 2021. However, given doubts about how much of Spotify's revenue will go to the bottom line, we do not expect the firm to generate excess returns on capital.
We believe Spotify may benefit from three different types of network effect associated with its streaming music platform, although none of these guarantee excess returns on capital, by our estimation.
First, the firm benefits from a platform network effect. The firm has aggressively expanded its content library, which allowed it to attract users to the platform. In turn, Spotify's strong user growth has attracted more artists from both major labels and independent ones. We think this flywheel effect will continue as more users attract more artists and labels, which attract even more users, and so on.
Second, we think Spotify benefits from an indirect network effect associated with playlists and curation. As more users listen to more music, Spotify can improve its algorithms and provide all users with better playlists that more closely match their listening preferences. As Spotify's algorithms improve, the company can better retain its existing users while also potentially attracting more users to its service. To a lesser extent, Spotify's users have even developed a bit of a direct network effect, where users share playlists with one another and, in turn, attract more users to Spotify, even without a corresponding increase in artist or label content.
Third, we believe that Spotify also benefits from a network effect between users and advertisers. As the firm gains more listeners, leading to more hours of content consumed, we think it can attract more advertisers, generating more ad dollars. The ad revenue allows Spotify's service to remain free for users, as users implicitly agree to listen to ads in exchange for the free service. This network effect has a cap, though, as Spotify obviously can't serve its users nothing but ads. In turn, this limits Spotify's ad inventory, which also limits the growth of the advertiser network effect to the growth of the user base, assuming Spotify is currently maxing out how much ad time can be played per user.
In addition to these network effects, Spotify may also benefit from intangible assets associated with user data. Spotify's collection of user demographics and music preferences is likely a treasure trove of information that is attractive to advertisers, both within the music industry and from outside parties. Premium subscribers do not receive ads, but the firm's last reported base of 92 million free subscribers will receive targeted ads. As free users listen to more music and Spotify collects more data, it is likely to attract more advertising buyers. The firm also can use the data to learn more about fans of various artists, help them attract and invite fans to their live events, sell artists' labeled merchandise, and more. In our view, these additional services can further attract artists to the platform.
However, none of these favorable characteristics will translate to tremendous certainty about future bottom-line growth, in our view. This uncertainty is based mainly on the fact that part of the firm's cost of revenue, the content acquisition cost, remains variable, likely limiting Spotify's gross margin expansion. Regardless of revenue earned from premium subscribers or advertising, Spotify must pay record labels and publishers a royalty for the content streamed to its users. Without any ownership of the more than 35 million tracks currently in its library, Spotify, along with other music streaming providers, will remain significantly dependent on record labels, which it will continue to pay for content consumption.
Spotify has guided for a long-term gross margin of 30%-35%, and in our view, the revenue type that can drive most gross margin expansion is advertising revenue. The firm may prosper from either a rise in freemium users and, in turn, the number of advertisements shown, or from average revenue per user, by selling more ad inventory per user and/or extracting higher ad prices. Like many websites and apps, Spotify will need to strike the fine balance between serving ads to its users in order to offer a free service, and serving too many ads and thus driving users away. Spotify's balance is somewhat unusual in that an ad not only creates revenue for the firm, but it also lowers costs, as it leads to fewer songs being played and, in turn, modestly lower royalties to be paid. That said, if Spotify serves too many ads, reducing royalties owed and driving gross margin expansion as a result, it may turn away users. Also, Spotify's royalty costs are different from terrestrial radio, as Spotify pays both labels and publishers/songwriters, whereas terrestrial radio broadcasters only pay publishers.
Another aspect of the potential gross margin expansion could come from the premium side. However, it is based on the assumption that premium ARPUs are more likely to approach the firm's standard subscription price per month. As the firm's user base strengthens, Spotify could lower its discount offers slightly, particularly for potential premium subscribers. Such a strategy could narrow the gap between the firm's premium ARPUs and the standard $9.99 monthly rate that it charges its premium subscribers.
The other potential route to operating leverage for Spotify is if it can reduce operating expenses, either in R&D or in declining customer acquisition costs. However, it faces competition from much larger companies such as Apple, Amazon, and Google, which will be willing to aggressively acquire listeners by spending more on marketing and/or offering their services at a discount for a longer period. Further, it is likely that none of these firms are running their streaming music businesses as high-margin profitability drivers; rather, they are aiming to keep users within their respective ecosystems and monetize via other methods. Thus, we think these companies could more easily retain listeners, given their larger overall ecosystems of offerings, so we believe a sizable reduction in Spotify's customer acquisition costs will be difficult.
Spotify is in the early stages of building an ecosystem where the firm is aiming not only to offer a variety of content including podcast and video, but also to remain ubiquitous and make all its content available everywhere, including on various apps, in cars, and on hardware provided by competitors such as Apple, Google, and Amazon. In addition, the firm is focusing on creators, as it can help them learn more about their fans, more effectively plan the location and timing of their events, sell a variety of artist merchandise, and overall become more easily and quickly recognizable. While we applaud these strategies, they do not differ much from what some of Spotify's competitors, including Pandora with around 78 million monthly active users, are doing.
Our fair value estimate is $130 per share, which implies a 2019 enterprise value/sales multiple of 3. We project strong top-line growth for Spotify at a 10-year CAGR of 17%. We project that Spotify will become profitable in 2021 and will improve its current negative margin to an operating margin of over 11% by 2027.
Revenue growth will be driven by growth in the firm's overall users for both premium and ad-supported services, along with continuing growth in online ad spending. We have modeled an 11% 10-year CAGR for premium and ad-supported users through 2028, with a consistent ratio of paying and freemium users over our forecast period. Looking at just the next five years, we expect those users to grow at 17% per year. As the firm's user base strengthens, we expect fewer discount offerings, particularly to potential premium subscribers. For this reason, we expect premium ARPU to increase at a 3% 10-year CAGR to $6.74 by 2028, from $4.81 in 2018. With an increase in ad inventory sales, plus growth in freemium users, ad-supported ARPU can grow at an average annual rate of 17% to $2 through 2028, up from $0.42 in 2018.
We also anticipate gross margin accretion over time, from 26% in 2018 to 32% in 2028. Part of the firm's cost of revenue, the royalties paid to labels, remains variable, as this accounts for a percentage of revenue and we do not expect it to decline or vary much over the years. Regardless of revenue earned from premium subscribers or advertising, Spotify must pay record labels and publishers a royalty for the content streamed to its users. Part of the gross margin expansion that we have modeled does come from the premium side. However, it assumes that premium ARPUs are more likely to approach the firm's standard subscription price per month. We also think ad revenue growth can drive gross margin expansion.
Our fair value uncertainty rating for Spotify is very high, in light of potential near-term volatility associated with Spotify's direct share listing (rather than a traditional IPO), as well as uncertainty around the company's future growth rates and profitability profile.
We believe the greatest risk for Spotify is competition, as large firms like Apple, Google, and Amazon may undertake more aggressive strategies to grow listeners. Another significant risk is associated with royalties owed to large record labels. These labels may have the power to raise the royalties that Spotify owes on songs, especially if Spotify starts to become too powerful or popular. Plus, while Spotify may be able to reach distribution agreements directly with artists, doing so may put the firm at a further disadvantage when negotiating with record labels. Another risk may stem from any potential downturn in online advertising, which could weigh on revenue growth.
Last, as we have witnessed historically, the entire music industry faces the risk of disruptive distribution technologies, such as the shifts from cassette tapes to CDs and, more importantly, in the late 1990s with technological innovation for music download and file sharing, which led to rampant piracy and crushed many well-established music business models.
We assign a stewardship rating of Standard to Spotify's management team. While the firm has been around for only 12 years and officially launched its service 10 years ago, we commend the team for navigating Spotify through various negotiation phases with record labels while at the same time expanding its user base. In addition, we think the experience of CFO Barry McCarthy is very valuable. McCarthy is a veteran of the media and entertainment business and was Netflix's CFO for over 10 years until 2015. He was also a board member of one of Spotify's competitors, Pandora, for around two years. McCarthy joined Spotify's board in 2014 and held the position until he was named CFO in July 2015. He is also in charge of Spotify's ad-supported business, which bodes well for growth of that segment.
Daniel Ek is the cofounder, CEO, and chairman of Spotify. He has an extensive background in both technology and online advertising. Ek, along with Martin Lorentzon, founded Spotify in 2006. Lorentzon is currently a board member of Spotify. Similar to Ek, he has experience in online marketing as he founded TradeDoubler, an online ad firm that acquired one of Ek's earlier startups, Advertigo, in 2006. Ek and Lorentzon have 37% and 43.5% voting power.
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