I cop flack for a few things in life and deservedly so. At the moment, though, I am getting an outsized amount of heat for something rather strange: my choice of music streaming service.

These three things have all happened in the past few weeks:

  • One friend tried to share a Spotify playlist with me and recoiled in disgust when I had to politely decline on account of being an Apple Music user.

  • Another friend called my subscription “povo” and teased me for not having a Spotify Wrapped like everybody else.

  • Another friend called my subscription “a massive ick” and said that she had “genuinely never met another Apple Music user in her life”.

Well actually, there are over 90 million of us - but thank you for the article idea. Today I hope to explore to what extent social shame and social product features might contribute to Spotify’s moat. And if not those things, what?

Let’s start with a quick overview of Spotify’s business.

Spotify is the world’s leading music streaming service. Over 250 million people worldwide pay a monthly fee for unlimited listening to pretty much every song ever made and the ability to download songs for offline listening and make custom playlists. Another 400 million use it for free, supported by ads.

Spotify was music streaming’s first big mover and is still the undisputed category queen.

Unwrapping the moat

Spotify has been awarded a Narrow Moat rating by our analysts. Let’s see if any of the social features we’ve touched on have a role to play in that, starting with Wrapped.

Spotify Wrapped comes out in December every year. It gives Spotify users a data-driven look at their year in music, showing their most listened-to songs and artists and comparing their devotion to other users worldwide. Apparently, my partner is in Taylor Swift’s top 2% of fans by listening time.

From a business point of view, Wrapped is cool in a few ways.

Based on what I have seen, a high percentage of people screenshot their wrap and share it with their friends in group chats. Millions more post their wrap on their social media account every year. This is viral and essentially free marketing. And something that leaves users of other platforms feeling left out.

Features like this can be copied quite easily, in principle. But - Spotify’s costs of developing features like this, and copying innovations from elsewhere, are spread over a far bigger number of paying and ad-supported users. I also doubt a smaller platform could get Taylor Swift to film a thank you message.

Wrapped is still more of cool product feature than a moat source, though. Even if the free marketing does help Spotify cement its place as the quintessential streaming brand. The next feature we are going to look at, however, might have more traces of moatiness.

Social playlists

As I said earlier, a big (but by no means unique) perk of Spotify is the ability to mould the world’s entire music catalogue into your own playlists. Where things gets interesting and potentially more unique is that you don’t just have access to the playlists made by you, but to those made by other users.

If I was a Spotify user, I could have copied my friend’s playlist above into my library and had access to it. I can also find playlists compiled by users I’ve never met but may have good taste. Spotify’s CEO recently said the platform is home to eight billion user-generated playlists.

This feature, and the magnitude of it in Spotify’s case, have traces of a network effect, a situation where each new user makes a product more valuable for all other users. More users mean more playlists to copy and more people to share them with.

A new streaming upstart would not be able to replicate this huge bank of human-made playlists. Nor would their users be able to share playlists with as many of their friends, unless they all happened to be on this new service too.

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The other side of playlists

Switching costs are when something (a financial outlay, extra effort, or added risk) makes it unattractive for a customer to leave their existing product or service provider for another one.

I don’t want to know how long Jonny spent creating his “Coffee and cleaning” playlist, but I imagine he has better things to do than recreating it, and all of his other playlists, on a new platform.

This effort-based switching cost has the potential to be especially effective in Spotify’s case.
Why? Because the two main ways a competitor would usually try to overcome this switching cost seem to be off the table.

In a previous article inspired by the middle aisle of Aldi, I wrote the following:

“The moat rarely comes from the product or service itself. It comes from whatever stops other people from copying the product or business model successfully.”

Building a streaming service today from scratch today wouldn’t be easy -  for one, you would need to secure deals with different music labels to get all of the songs on your platform. But it wouldn’t be ridiculously hard. It would just take time and money.

Building a successful streaming upstart today, though, would be extremely hard.

Both major routes to market share gains are blocked

Circling back to the first question, upstarts in most industries will usually try to tempt the incumbents’ customers by innovating on either product offering or price. First, let’s consider the scope for innovating on product offering.

Spotify and Apple Music give users immediate access to essentially every song ever recorded and every major feature you could want: the ability to play songs at your leisure, save them to your device and make playlists. What more is there to do?

Then you have the pricing aspect. Content costs are standardised in the streaming industry as follows:

  • The music labels get 50-55% of streaming subscription revenues

  • Music publishers get another 15%

  • The streaming firm gets the remaning 30-35% and tries to make a profit after covering its labour, marketing and other costs

As our Spotify analyst Matthew Dolgin notes in his analysis on Spotify, this structure doesn’t leave much room for a price war.

In fact, the ultimate gatekeepers – the music labels that own the music rights and have unrivaled negotiating power – would be unlikely to want competition on price because it would reduce their slice of the pie.

Worth the pain?

Given the pricing structure and weak negotiating position outlined above, you might wonder why anybody would start a streaming business.

Spotify knows this better than most. Despite its long leadership position in one of the world’s biggest emerging industries, it has only just reached profitability after many, many years of losses. Nowadays, though, it seems the pain might have been worth it.

In Dolgin’s view, the very characteristics that make it so difficult for a streaming platform to gain an advantage – lack of pricing flexibility, limited scope for product innovation, and the dominant negotiating power of music labels – are now good things for Spotify’s competitive position.

“Assuming a new competitor could secure the same music rights that Spotify and other major DSPs hold, it would face a long uphill battle to attract customers and reach adequate scale to generate profits.” As a result, Dolgin does not see Spotify ceding its world leading market share any time soon.

Is Spotify stock cheap?

Dolgin is optimistic on the outlook for Spotify’s business, noting an “opportunity for the global music streaming market to expand and the moat we think the firm has to keep its edge over competitors.”

The shares, however, screen as overvalued versus Dolgin’s Fair Value estimate of USD 390 per share. This estimate bakes in his expectation that Spotify can grow sales at double-digits for each of the next years while growing profits and free cash flow at an even faster rate.

Spotify Technology (NYS: SPOT)

  • Economic moat: Narrow
  • Fair Value estimate: USD 390 per share
  • Share price on December 5: USD 502
  • Star rating:★★

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Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.