Spotify Technology (NYSE:SPOT): A pioneer of the freemium model and an expert at getting users to pay up

Music was a product, now it is a service and Spotify Technology (NYSE:SPOT) has the largest market share with just over 30%. The company is famous not just because it has so many users (nearly 700m) but also it has such a significant proportion of users as paying users (268m).

For comparison’s sake, Duolingo has under 7%, and Dropbox under 3%. How has Spotify succeeded? Well, its shown that it is worth paying for.

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Overview of Spotify Technology (NYSE:SPOT)

Spotify was founded in Stockholm, Sweden in 2006 by Daniel Ek and Martin Lorentzon and the service was launched in 2008. It pioneered the freemium model, essentially offering a free tier with ads, then a paid tier without them.

Spotify went public in April 2018, but it took the unconventional path of a direct listing rather than a traditional IPO.

Over time, Spotify has broadened from purely music streaming into podcasts, audiobooks, and other audio offerings, which has helped it stand out from competitors including Apple Music and YouTube.

2024 saw its first annual net profit of ~€1.1 billion and revenue of ~€15.6 billion (roughly 18% growth). Of course, user numbers keep growing, but paid users do too – at double-digit rates in many markets.

Once onboard, users stay, and the switching cost is significant for a number of reasons including the strong brand equity of Spotify, and how it customises to users’ own interests (i.e. personalised recommendations).

Why it has succeeded in getting users to pay

Well one reason was mentioned above – the cost of switching and the meaningful benefit of upgrading in not having ads and certain other features blocked such as playback.

As users invest in playlists, favourites, recommendations, the transition to paid becomes easier and more likely.

Moreover, Spotify offers tiers and pricing adapted to different geographies, which can increase paid adoption in markets with more affordable paid options. Options such as family accounts make paid tiers more cost effective per person, encouraging upgrading.

And don’t forget that Spotify uses promotions, regional offers, and pricing strategies to convert free users into paid. We’d imagine some of those are right.

How Spotify stands out

Many of these features are also competitive differentiation. Spotify is often praised for its recommendation engine, e.g., “Discover Weekly”, “Release Radar”, and “Blend” playlists. As are its features beyond music (i.e. audiobooks and podcasts). We mentioned that these incentivise users to stay, but it also gives Spotify a large dataset.

Also don’t forget that Spotify supports a very wide range of devices (smartphones, tablets, computers, consoles, smart speakers, car systems). That broad device coverage also serves as a competitive edge.

Of course, having free users is also an advantage. Some competitors, particularly Apple, do not offer a free tier. You may say this is an advantage to Apple in having all users paying and this is true, but it has a smaller user base. Having a large one helps engagement, social sharing, and discovery.

We would also note that Spotify clearly has market power in that it is able to pass on (reasonable) price increases. Its ARPU (~€4.70 monthly for premium globally) is lower than what one might expect for services like Apple Music.

A positive outlook, but some risks to be aware of

Spotify consensus estimates suggest decent top-line growth for the next few years. The company uses the calendar year and analysts expect revenues of €17.2bn, up from €15.7bn the year before, and for EPS of €5.88 (up from €5.50). Then in 2026, €19.9bn revenue and €11.89 EPS. In 2027, €22.6bn revenue and €15.46 EPS.

Their mean target price is US$738.05, up from US$656.68 currently. The lowest estimate amongst 38 analysts is US$473.06 and the highest is $902.60. Nonetheless, its high multiples are something to be aware of. It is 37.4x EV/EBITDA, 48.9x P/E and 1.5x PEG. For comparison’s sake, Netflix is 35x. Some may say you shouldn’t buy it just because of the multiples.

The company could correct just because it is high, or if it succumbs to other risks. As such a global company, forex is a meaningful headwind – appreciation in the Euro and USD can have a negative impact on other currencies. Also consider that royalties and licensing remain a big cost input for music streaming companies like Spotify. Any increase in content cost pressure could squeeze margins.

And of course, competition is intense and new initiatives can take time and money to scale to meaningful revenue.

Conclusion

Overall, Spotify is in a relatively strong position. It has a large enough user base and profit to begin with not to mention a very large free base to convert. The next few years are likely to see continued double-digit revenue growth (15-18 %+), margin expansion, and stronger cash flows.

Of course, this is far from certain to eventuate and the biggest risk is execution.