Spotify – Free foundation

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Apple Music still making no dent.

  • Spotify has crossed 60m paid users and while its absolute level of growth is slowing due to the law of large numbers, it is still adding paying subscribers at the very healthy rate of 2m per month.
  • In September 2016 Spotify hit 40m, passed 50m in March 2017 and hit 60m at the end of July 2017.
  • For the last 18 months, Spotify has been steadily adding subscribers at around 2m per month which is showing no signs of slowing down.
  • This has held steady for the last 5 months indicating that Apple Music is having very little impact on Spotify despite the substantial advantage Apple has in owning the App Store and having complete control over the iPhone.
  • I continue to believe that this is for two reasons
    • First:  Spotify remains fundamentally a better service.
    • This is driven by the fact that the music is now incidental in that anyone can create a service with 40m tracks and a search box.
    • Where Spotify is different is that it uses the data that it collects from all of its users in order to make its service better.
    • Apple also does this but Spotify’s AI in music continues to meaningfully outperform Apple’s.
    • By understanding the characteristics of the music offered by its service and the preferences of its listeners, it can accurately match the two together.
    • This also allows it to come up with innovative services that keeps its service fresh and one step ahead of the competition.
    • Second: Spotify has a large and engaged free tier of users that serve as the funnel for conversion into paid users.
    • Free users get to spend time with the service without paying for it, making it much easier to make these users understand why the service is better than anything else available.
    • This meaningfully offsets the disadvantage that Spotify has compared to Apple when it comes to marketing.
    • These free users generate data which Spotify can use to train its algorithms which can in turn be used to make the service better.
    • Apple also has a lot of data but has not been nearly as good at turning raw data into actionable intelligence with which it can improve its service.
  • The net result is that Spotify’s position is strengthening with every new user that it adds and between them, Apple and Spotify account for almost all of the growth in the recorded music industry.
  • Consequently, I remain unconcerned that Apple will be able to put real pressure on Spotify and think that its path to better profitability remains clear as the labels increasingly need Spotify more than Spotify needs the labels.
  • This position is becoming clearer as Spotify was able to strike a better deal with Universal (see here) and the outlook is that the rest of the industry will be signed on similar terms.
  • I still think that the key issue for Spotify going forward is to maintain momentum of growth of its free users.
  • It is the free user pool that has been the foundation of its outperformance of Apple, meaning that the free tier will be critical to keep the paid tier (where the real money will be made) increasing at this very healthy rate.
  • I continue to think that there is enough space in this market for 2 big players and with those spots filled, it is the fortunes of Pandora, Tidal, Deezer and so on that trouble me now.

SoundCloud – Clouds of red

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Management does not have the luxury of choice.

  • Poor monetisation strategy and a lack of fiscal discipline is likely to ensure that SoundCloud ends up being forcibly acquired by one of its rivals when it finally runs out of money.
  • From looking at the contenders, I think Google Music looks like the best fit.
  • Despite raising $70m in debt in March 2017, the company is in dire financial straits and it was forced to close offices and lay off 40% of its workforce last week saving an estimated €16.7m.
  • Given that the company lost around €50m in 2016, this looks set to only prolong the stay of execution until sometime in Q4 2017.
  • The company has said that it wants to take back control of its destiny (from its venture investors presumably) but with no money coming in and great difficulty in raising more, management does not have the luxury of choice.
  • The big question is the user base.
  • SoundCloud last updated this figure 3 years ago when it said that it had 175m MaU but there is concern that the success of Spotify’s free tier and YouTube have taken a big bite out that number.
  • This will have a material impact on any potential acquisition later in the year, but for the moment the main concern remains cash flow or the lack thereof.
  • I see two problems:
    • First: monetisation. Assuming that SoundCloud still has 175m users, it is currently generating $0.02 per user per month in revenues.
    • This compares very poorly to Spotify which I estimate generates $2.54 per user per month despite the majority of its users being on its free tier.
    • The fact that Spotify is 127x better at monetising its users than SoundCloud is, more than accounts for differences in catalogue and user base and shines the light squarely on SoundCloud’s lack of execution.
    • Anecdotally, as a regular SoundCloud listener on its free tier, I have never heard or seen a single advertisement, further reinforcing my opinion on execution.
    • Second: fiscal discipline: SoundCloud has had nice offices in Berlin and elsewhere, has offered free catered lunches twice a week and gifted new employees MacBooks and headphones as well as other freebies.
    • What is more, I think management has had its head in the sand with regard to the financial car crash that has brought it to its current predicament which potentially could have been avoided if it had been faced head-on.
    • The net result of the sudden layoffs is that morale has come crashing down and I understand that the people that SoundCloud badly needs to keep if it is to fix its monetisation problem, are now looking to leave.
  • The biggest problem I see is that the financial problems will absorb much of management’s time in trying to raise more money, meaning that the real problems of the business go unaddressed.
  • Consequently, I think the company will run out of money in Q4 17, as predicted, and be forcibly acquired for just enough to pay down the debt ($70m) leaving the assets unencumbered.
  • Of all the potential suitors, I think Google makes the most sense.
  • This is because SoundCloud is most like YouTube as a repository of user generated content and in that regard, Google will probably be most able to monetise what SoundCloud cannot.
  • I can see it being slotted into the YouTube infrastructure and being rebranded YouTube Audio or something similar.
  • The future is very bleak for SoundCloud but I think that management has only itself to blame for spending too much time feathering its nest and not enough time on grinding out hard cold cash.

 

Snap – Valuation snaps pt. II.

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Twitter remains by far the better choice

  • Reality is beginning to set in for Snap Inc. but I think that the shares still have some distance to go before there is an opportunity to snap up a bargain.
  • A major downgrade by one of its underwriters taking the target price from $28 to just $16 caused the shares to dip to $15.44 which combined with the possibility that Snap Spectacles are not selling that well and savage competition does not bode well.
  • A very informal survey found that the target group (millennials) were not that interested in Snap Spectacles, have not seen them in public and do not know anyone else who is interested in the product.
  • However, there was some interest in Snap’s new functions such as Snap Maps and World Lenses but this is where the competition problem comes to the fore.
  • The minute Snap hits on an innovation that resonates with its user base, Facebook will copy it and offer it to its 1.2bn Messenger users or 600m Instagram users which, in my opinion, pretty much neuters the appeal of Snap.
  • This is because both of these companies are network based businesses where Facebook’s network is orders of magnitude larger and therefore offers its users exponentially more utility.
  • Consequently, I really struggle to see how Snap is going to increase its user base as its differentiation is flagging and the same services on Facebook are more useful.
  • It is on this basis that I value the company.
  • The peer group of Facebook, Twitter and LINE Corp is trading on a forward EV/Sales multiple of 6.6x for 2017E and 5.5x for 2018E.
  • Given, Snap Inc.’s current growth rate and its medium-term potential (see here), I think that the company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E.
  • Being generous to Snap Inc. and because it is growing faster than the peer group I can give it a 200% premium to its peers giving an EV valuation of $10.5bn based on 2017E and $13.2bn based on 2018E.
  • The average of these two is $11.9bn with which I can be comfortable assuming flawless execution, continued rapid growth and a move into generating profits.
  • This translates into $12.40 per share which is still some 20% below where the share price is today despite recent falls.
  • Hence, I think that unless Snap Inc. can get its user base really growing again, it is going to have difficulty in justifying it’s still lofty valuation and I see further downside.
  • If Snap were to go below $10 per share ($9.6bn), there could be significant acquisition interest.
  • Until then, I would stay away.
  • Twitter (see here) remains in a much better position than Snap Inc. and if I was forced to choose between the two, I would have Twitter any day of the week.

LeEco – Bleeding out

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LeEco could be acquired by one of the BATmen.

  • Despite closing the vast majority of its US operations, LeEco’s troubles are far from over as its cash problems have intensified which I think could lead to its eventual acquisition.
  • Leishi Internet Information & Technology (listed parent of LeEco) held its AGM last week and admitted that the cash crunch that first appeared towards the end of 2016, is now far worse than expected.
  • LeEco raised $2.2bn in January from Sunac (see here) but instead of using the money to fix its financial problems and invest in its fledgling businesses, Leishi used it to pay down debt.
  • Some of the debt was in the founder’s (Yueting Jia) name which may explain why debt was paid down rather than being used to keep its subsidiaries going.
  • The result was that all of the operations (especially USA and Faraday Future (see here)) appear to have received no cash injections at all, leaving them in dire straits.
  • This is why the company has had to exit its acquisition of Vizio, sell the land in Silicon Valley it bought from Yahoo, close most of the US business and the founder has also been forced to sell his stake in electric car company Lucid Motors.
  • Yueting Jia also admitted at the AGM what I have long suspected which is that the real problems have been caused by LeEco’s automotive ambitions, Faraday Future (see here).
  • The company is now seeking funding for this venture but given that many participants in the automotive industry and the state of Nevada (where the factory is being built) have grave doubts with regard to its viability, raising money will be extremely difficult.
  • Consequently, I see two outcomes for LeEco.
    • First: It sells or closes all of its automotive operations and pours everything into its core business as a provider of Chinese media over the Internet.
    • This would mean a return to its more humble origins and not something that I think its founder has seriously considered.
    • Second: It continues trying to create an ecosystem around televisions, mobile phones and cars for which it is very unlikely to see any success.
    • I do not think that Leishi has the capital, management depth or credibility to bring this ambition to fruition meaning that I see an intensification of the cash crunch if this option is chosen.
  • Given management’s commentary at its AGM, I suspect that it is going to go for option 2 which I believe will end in failure.
  • This is likely to cause the real value of the shares (currently suspended since April 2017) to continue their free fall.
  • This would make the Internet media asset a good tuck in acquisition for Baidu, Alibaba or Tencent (BATmen) all of whom are aggressively vying to become the leader in the Digital Life segment of Media Consumption in China.
  • In the absence of real fiscal discipline, I fear that this will be the ignominious fate of a once great ambition.

Snap Inc. – Snap in the box.

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Facebook keeps Snap Inc. in its box.

  • Despite launching in August 2016, Instagram Stories has been extremely successful in mitigating the threat from Snap Inc. as it already has 50% more users than Snapchat.
  • In a blog detailing some feature updates, Facebook has disclosed that Instagram Stories now has over 250m daily active users (DaU) all of whom have been added in the last 10 months.
  • By comparison Snap Inc reported 166m DaU at its Q1 results in May and a far more pedestrian level of user growth.
  • This is a strong indication that Facebook has been very successful in preventing its users from going outside its fledgling ecosystem of apps by replicating new services in house.
  • It is also a sign of how critical the network effect is as Facebook’s 2bn users can all be directed to the Instagram app, use the same credentials and get going with a minimum amount of fuss.
  • By contrast, Snapchat is a completely different system to which users have to be separately recruited.
  • It is this ease of transition and the fact that it is quite simple to cross promote Instagram Stories that has allowed Facebook to imitate an innovation and quickly dwarf the original creator.
  • This is extremely concerning because I suspect that Facebook has more than 90% penetration of the smartphone users that matter from a marketing perspective.
  • If this avenue in increasingly closed off to Snap Inc., then very real questions need to be asked about its medium-term growth prospects.
  • Snap’s narrow focus on Instant Messaging begs the comparison to Twitter, but I do not think that this comparison goes far enough.
  • Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering (see here).
  • This means that its outlook for growth remains very bleak.
  • However, in the Digital Life Pie segment of microblogging and related messaging, where Twitter is present it is dominant with no opposition.
  • This means that once it stops spending money in trying to grow, it should make good, but static returns from monetising that niche.
  • Snap Inc on the other hand still has some growth ahead of it but Facebook is doing a very good job of keeping it out of its core user base.
  • I still think that the company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E as it is quite far from fully monetising the users and traffic that it already has.
  • However, this is not enough to justify the current valuation.
  • Assuming that all goes well for the next 18 months, I can still be comfortable with a valuation of $14.4bn (see here).
  • While the current valuation is now closer to this figure than it was a few months ago, at $17 a share Snap Inc is still 13% above what I would consider to be fair value.
  • Consequently, I still see no reason to get involved especially as Facebook is showing every sign of very successfully keeping Snap in its box.
  • Twitter, for all of its faults, still has better prospects.

Facebook – Soft target

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Facebook chasing broadcast rather than Netflix or YouTube.

  • Facebook’s move into Media Consumption is well underway but it looks to me to be going after broadcast rather than premium or user-generated content.
  • Facebook has closed a deal for a reality TV show called Last State Standing and is close to doing a deal to shoot and air a second season of Loosely Exactly Nicole which originally aired on MTV.
  • It is also commissioning shorter shows from the likes of Vox Media and Buzzfeed.
  • This is in no way a move to compete with the high-end shows on Netflix or the user generated content on YouTube but instead looks like it is aiming at broadcast.
  • Despite the atmosphere of cord cutting, broadcast TV is still an advertising market that is worth $70bn a year and it is the younger end of this market that Facebook is targeting.
  • This looks to be somewhat experimental as Facebook is not really targeting expensive, high quality content as one of the shows it is looking at was cancelled after one season on MTV and has an IMDB rating of just 5.1.
  • These shows will air first on Facebook via a video tab called Spotlight that will be present at the side of the screen and will be funded by advertising.
  • The broadcast market represents a much softer target in my opinion as Facebook can add all sorts of interactive and social functionality on top to make the experience much more engaging than just watching TV.
  • The level of investment being made at the moment is small with a few hundred thousand dollars being spent per episode on its big shows as well as a few tens of thousands being spent for shorter segments from producers like Vox Media.
  • I see this as a sign of Facebook’s media consumption strategy reaching the point where it can be considered to be properly present in this segment of Digital Life.
  • This will bring its coverage of Digital Life to 46% up from 36% where it is today.
  • For me, this represents a 28% increase in its addressable market which should allow revenue growth to re-accelerate after the slowdown I have been long expecting this year.
  • Given that Spotlight is not yet available in the app and that Facebook is just closing the deals to produce this content now, I do not expect these shows to hit Facebook until 2018.
  • Consequently, for 2017, I see Facebook’s growth potential remaining hampered by the fact that it has already fully monetised the segments of Digital Life where it is already present.
  • The result is likely to be a much slower growth profile, which I think is something that the market has still not fully anticipated.
  • Hence, I can see disappointments coming in the Q2 17 and Q3 17 results as the market adjusts to this more sanguine short-term outlook.
  • It is at the point I would be looking to go back into Facebook as 2018 could see an uplift in financial performance driven by monetisation coming from Media Consumption.
  • This should be followed up by Facebook’s expansion into Gaming and Search which would bring its coverage up to 78% and global market leadership, pipping Tencent which is currently on 77%.
  • This is what underpins my long term positive view on Facebook, although I am expecting weakness in the short-term as it will be sometime before the new business lines can pick up the mantle of growth.
  • In the meantime, I prefer Tencent, Microsoft or Baidu.

Snap Inc. – Price of opposition.

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Twitter is in a better position.

  • A poor set of maiden results highlights that Twitter is actually in a better position because although it is stuck in a niche, it remains unopposed in that niche.
  • Management even had the temerity to laugh off the threat from its much larger and far more powerful rival, Facebook, which is successfully replicating Snap’s innovations to great effect.
  • Q1 17A revenues and adj-EBITDA were $149.6m / LOSS$188.2m slightly below consensus at $158m / LOSS$180m.
  • User numbers also disappointed with 166m daily active users (DaU) compared to consensus at $168m.
  • This is not nearly good enough for a company valued at 31x 2017 EV/Sales which triggered a 23% decline in after-hours trading.
  • The company also burned $155m in cash from operations.
  • Commentators are already drawing the comparison to Twitter, but I do not think that this comparison goes far enough.
  • Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering (see here).
  • This means that its outlook for growth remains very bleak.
  • However, in the Digital Life Pie segment of microblogging and related messaging, there is no opposition.
  • This means that once it stops spending money in trying to grow, it should make good but static returns from monetising that niche.
  • Snap Inc on the other hand still has plenty of growth ahead of it but its core business competes head to head with Facebook’s dominant properties of Messenger, WhatsApp and Instagram.
  • This is where the problems begin as Facebook can easily afford to outspend Snap in every instance and has 7.8x more DaUs than Snap does.
  • Both of these businesses are network based where there is an exponential relationship between the value that can be created and the number of connections that the network has.
  • Furthermore, to continue its growth, Snap has to monetise outside of USA as its US ARPU already looks full at $1.81.
  • Outside of the US the relative strength between Facebook and Snap Inc. is even more in Facebook’s favour making Snap Inc.’s task all the more difficult.
  • These results were bad because the company has a very high valuation and then missed expectations rather than anything in particular going wrong.
  • However, Facebook’s announcements and the intentions that it made clear at F8 (see here) are a concern.
  • Consequently, I see no reason to change my position on Snap Inc.’s fundamental outlook or my valuation of $15.4bn or $16 per share in a blue-sky scenario (see here).
  • Given the increasing risks involved, I would not consider buying until the shares were meaningfully below this value.
  • Between the two, Twitter is the better long term investment but given the choice, I would not have either.

Facebook Q1 17 – Sleeping policeman

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Facebook’s growth story hits a temporary bump for 2017.

  • Facebook reported good results but once again tried to temper enthusiasm with reality by saying that overall growth this year would slow materially.
  • Q1 17A revenues / EPS were $8.03bn / $1.04 nicely beating consensus at $7.8bn / $0.86.
  • Advertising revenue was $7.9bn of which mobile was $6.7bn making up 85% of total advertising revenues.
  • The user count has now hit 1.9bn MaU (1.3bn visiting every day) with the vast majority coming from mobile.
  • Video and Instagram remain the biggest drivers of growth but Facebook has reached a limit in terms of the amount of advertisements that it can stuff into its apps.
  • Further increases could improve revenues in the short term but would probably lead to a fall in engagement which would negatively impact revenues anyway.
  • Hence, Facebook is turning to other avenues to find growth.
  • With its existing mature apps, Facebook has 36% of the Digital Life Pie and this is now fully monetised.
  • This is why, I have long been of the opinion that to become a $40bn revenue company, Facebook needs to increase its coverage of Digital Life.
  • The good news is that the signs of this continue to strengthen and at its developer conference, Gaming and Media Consumption were in sharp focus.
  • The issue is that I don’t think that Facebook’s Media Consumption offering or its Gaming strategy are mature enough to really start generating revenues which is why revenues will really start to slow down this year.
  • The street is expecting a 40% YoY improvement in revenues this year which I think is unattainable.
  • However, once those new services hit maturity, I think that Facebook will once again, be in a position to beating expectations.
  • Consequently, as the disappointment sets in for lower growth in 2017, I expect the valuation of the stock to moderate.
  • This will be driven by straight-line-loving (of which I am equally guilty) analysts bringing down their long-term forecasts in response to short-term issues.
  • It is at the point that the greatest opportunity exists to invest in Facebook for the next leg of its development.
  • In the meantime, I continue to prefer Microsoft, Baidu and Tencent.

Spotify – Crown jewels

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Spotify keeps the crown jewels to itself.

  • In striking a deal with Universal, Spotify has traded much better than I thought it would giving the label two concessions that I think will end up being pretty worthless.
  • Spotify has signed a licence with Universal that has three main aspects:
    • First: Universal artists will have the option to release their music to premium users only for two weeks before it is available to all users.
    • Second: It looks like Spotify will cut the share that pays to Universal from 55% to 52%.
    • Third: Spotify will provide Universal with the data that its music generates thereby enabling the label and its artists to gain better insights into how its music is being consumed.
  • On the surface, it looks like two of these points benefit the labels but when I take into consideration how the music industry is evolving, I think the winner from this deal is Spotify.
  • This is because Spotify has managed to increase its gross margins on Universal music by 300bp and has cleared one major hurdle towards its road to an IPO.
  • Sony and Warner are the two remaining hurdles which, now that a precedent has been set, may be easier to overcome.
  • That is what Spotify has gained from this deal but what has it given up in return?
  • Not much in my opinion.
    • First: I do not think that delaying releases to the free tier for two weeks will have much, if any, impact on the appeal of the free tier.
    • I have long believed that the free tier is far more valuable to Spotify than anyone thinks that it is (see here) and I think that its desire to protect the user experience of this segment has been a major sticking point in striking a new deal with the labels.
    • Time shifting media releases is how music and films have been released for years but I think that this is changing.
    • Spotify knows what it users listen to and what they like and I think that in the future, users will be increasingly made aware of new music when the streaming services recommend them rather than when the artist or label releases them.
    • Hence, many users might not even notice a two-week delay meaning that Spotify has received something for nothing.
    • Second: Spotify is giving Universal access to its fire hose of data but I have doubts whether it will be able to make much sense of it.
    • This is because it will only have access to the data which is just a raw material.
    • To make something useful out of it, trained algorithms are required to parse that data and draw meaningful conclusions from it.
    • These algorithms are Spotify’s crown jewels and I am pretty sure that they will be staying safely under lock and key.
    • After all, they are the reason why Spotify’s service is better than Apple’s and are the key to its ability to eventually replace the labels entirely (see here).
    • Furthermore, Universal will only have access to its own data which compared to the entire catalog that Spotify has, is a small subset.
    • Hence, even if it could make sense of the data, it wont be able to draw many meaningful conclusions from it as it will be looking at an incomplete picture of user activity.
  • The net result is that I think Spotify has dealt much better than I thought it would as I was concerned that the pressure to make it to IPO in 2017 would force it to give too much away to the labels (see here).
  • In fact, I think that the reverse has happened putting Spotify in a good position to IPO without having to give much, if anything, away.

 

Twitter – End of days

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The loss of the NFL is a disaster.

  • Twitter has lost its deal to stream certain NFL games which I think punches a potentially fatal hole in its strategy to break out of its niche of microblogging.
  • Amazon has reportedly paid $50m for the rights to stream 10 Thursday night NFL games for the coming season.
  • This is 5x what Twitter paid in 2016 but I do not think that this is a case of the little guy being priced out of the market.
  • Instead, I think that Twitter got a very good price from the NFL because of its promises to be able to leverage its social interest graph to generate meaningful advertising revenues as well as insights that could be shared back to the NFL.
  • Clearly, Twitter has not been able to live up those promises which is why the rights have been sold to a more conventional bidder who I think is simply paying a more regular price for the rights.
  • In my opinion this is nothing short of a complete disaster because expanding into media consumption was Twitter’s one hope to break out of its niche and resume subscriber and revenue growth.
  • The loss of the NFL is an indication that this strategy is failing and that despite its efforts, it is nothing more than a broadcaster of short text messages and a second-rate instant messaging platform.
  • Blogging and Instant Messaging make up a total of 16% of the Digital Life pie which I have long believed that Twitter has already fully monetised.
  • I remain convinced that this is the reason for its growth grinding to a halt (see here).
  • If Twitter can entice its 300m users to do more with Twitter beyond these activities, then there is scope for revenues to begin growing again as it will have more traffic to monetise.
  • This is why the video strategy was so important.
  • Media Consumption makes up another 10% of the Digital Life pie and had Twitter been able generate significant traction from it, there would have been significant upside from current revenue levels.
  • Without this growth, I still fear that Twitter’s shares will fall below $10 because even at $14.5, with no growth, the shares are still expensive.
  • This loss makes it even more likely that 2017 is going to be a stagnant year where the realities of the company’s predicament really begin to become apparent.
  • I think that this could drive the shares to $10 or below.
  • I continue to see Twitter as a potential acquisition target but would expect to see the shares touch $10 before real interest is triggered.
  • I see no reason whatsoever to go bargain hunting as there is no bargain to be had.