August 3, 2020

Dear Partners,

Coho Capital returned 46.6% during the first half of the year compared to a loss of 3.1% in the S&P
500. Many of our holdings, such as Netflix, Amazon, and Spotify, were perceived beneficiaries of the
Coronavirus pandemic aiding our results in the short-term. We suspect some of the
outperformance gained from pandemic-driven demand will reverse in ensuing months as
momentum traders abandon the stocks. While the pandemic pulled forward digital demand, the
more important takeaway for us is the notion that a good business model provides the ultimate
margin of safety.

While strong performance from our portfolio stalwarts stabilized performance, portfolio insurance
in the form of long volatility options and put options on cruise ship operators further bolstered
results.

While we are not top-down investors, we believe macro factors are an important component of
portfolio risk-control. When COVID-19 began spreading in China, markets were unperturbed with
most looking toward past viral outbreaks for guidance. Most of the hot takes proffered in the
business news media were pedaled by often wrong, but never in doubt, equity analysts. While
history is illustrative it often leads to sloppy past as prologue analysis, especially on Wall Street. As
Coronavirus (not yet COVID-19) jumped borders to South Korea it became clear that the first global
pandemic in our lifetime was unfolding.

Without a virologist background, we knew we could not predict the scope of the virus, but given the
fallout in other countries it was evident that outcomes were highly skewed and the ability to price
risk was quickly evaporating. Given the potential for asymmetric downside, we thought it made
sense to err on the side of caution. Lucky for us, after eleven years of economic expansion, ^VIX call
pricing implied muted volatility allowing us to pick up insurance on the cheap.

SPOT On

“If you focus on near-term growth above all else, you miss the most important question you should
be asking: will this business still be around a decade from now? Numbers alone won’t tell you the
answer; instead, you must thing critically about the qualitative characteristics of your business.” –
Peter Thiel
One of the most important considerations in consumer-facing technology investing is asking
whether the product alleviates pain points, reduces friction or enhances convenience. Whether it is
Amazon, Netflix or Peloton, all winning consumer platforms exhibit these attributes. With its best-
in-class user experience (UX), along with class-leading music discovery and curation, so too does
Spotify. It has all the makings of a company on its ways to platform dominance.

Spotify is the category leader in music streaming with 299 million subscribers across 92 countries.
With 35% of the global music streaming market, the company has nearly twice the market share of
Apple Music, at 19%. Spotify has compounded its leading position in recent years adding premium
subscribers at twice the rate of Apple. While Spotify’s growth has been impressive we think the
adoption of music streaming is still in early innings.

“Earshare is the new mindshare” – Andreessen Horowitz

Music streaming has already produced an epochal shift in how people listen to music with most of
the adoption taking place through mobile phones. While historically mobile phones have provided
the onramp to music streaming consumption, the next phase of growth will be driven by a plethora
of emerging platforms including connected cars, gaming devices, workout equipment and smart
speakers (owned by 53 million Americans). Music streaming is tailor-made for the emerging music
everywhere lifestyle. The surfeit of products designed for music streaming enables one to listen to
the same podcast or playlist while doing a morning workout, commuting to the office (headphones
or connected car), working on your office PC and upon returning to home relaxing with a smart
speaker. The transition across devices and activities is seamless allowing one to pick up where they
left off no matter their activity. The integration of music everywhere into our lives exponentially
increases the value of music streaming, moving it from a nice-to-have to a must-have service.

As device proliferation accelerates, Spotify’s position as the category leader makes it most likely to
be designed into device presets. Just as Google Maps is pre-loaded on car dashboard screens so too
is Spotify. This creates a virtuous feedback loop with scale leading to design integration, which in
turn drives scale higher through new consumer trials. This is similar to what we have seen with
Sirius’ dominance of satellite radio. Spotify is already available on 300 devices across 80 hardware
brands. With that kind of hardware footprint, it becomes very difficult to dislodge incumbency.

While the market tends to categorize music streaming customers on a like per like basis, Spotify
users are more passionate. Spotify listeners are twice as engaged as Apple Music users and three
times as engaged as Amazon Music Unlimited users. Other than an operating system (which is
perhaps the right way to think of Spotify – audio OS), there are few software programs or apps that
generate the daily usage of Spotify. The average Spotify user spends 25 hours a month on the
service, topping even Facebook at 19 hours a month and Instagram at 14 hours per month.
With each music streaming service offering up largely identical music libraries, conventional wisdom
suggests there is little in the way of competitive differentiation making the music streaming
platforms commodity businesses. This would be true if one did not care about user experience,
search functionality or social integration. The very fact that the average Spotify user is on the
platform an entire day a month suggests that ease of use and value of discovery are paramount.
There is no doubt that Spotify’s platform is sticky with 70% of churned users returning within 45
days. This is indicative of its competitive differentiation, something we believe the market has not
caught on to yet. Ultimately, we think the economic spoils from music subscription will be greater
than video platforms as most users will only subscriber to one platform.

Spotify has rerated materially this year rising 70% due to excitement surrounding its podcasting
strategy. While shares have recently caught a bid, they had languished for two years prior after
going public at $169 per share in April of 2018. Much of the enthusiasm gap during this period can
be traced to misunderstandings regarding Spotify’s business model and its future prospects. We will
address these misgivings below and outline why we think Spotify is one of the best market
opportunities over the next decade.

Labels – “You Can’t Always Get What You Want.” – Rolling Stones

“Aggregators consolidate demand to gain power of supply.” – Ben Thompson, Stratechery

The primary bear case on Spotify is that they will forever be in the music label’s clutches with 80% of
current streaming hours supplied by four labels. Not only that, but at present Spotify benefits little
from operating leverage with variable costs rising in tandem with streaming. Not surprisingly, it is
much more lucrative to collect royalties (labels) then it is to pay royalties (Spotify).

To know where we are going, it is helpful to know where we’ve been. Prior to streaming, the music
industry endured fifteen years of stagnation and decline with recorded music revenues dropping
from $14.6 billion in 1999 to $6.7 billion in 2015 (a 68% drop in inflation adjusted terms). It was only
once music streaming gained traction that the industry was able to return to growth. Last year,
music streaming represented 80% of the music industry’s revenue.

Before music streaming, it made sense for music labels to collect the lion’s share of profits. After all,
labels funded the retail network, oversaw the capital-intensive business of producing and
distributing physical media and discovered and promoted stars. Many of those tasks have been
rendered obsolete by music streaming. The retail network no longer exists and instead it is Spotify
that is funding the build-out of music streaming. Streaming has all but eradicated physical media
optimizing label cost structures and promotion is aided considerably by Spotify’s data tools. Despite
the seismic shift in industry structure, industry profit pool participation is little changed. In fact,
with labels capturing 65% of music publishing profits, one could rightfully accuse the labels of
economic plundering.

“But if you try sometimes, well, you just might find, you get what you need.” – Rolling Stones

Current music streaming profit dynamics are unsustainable. It makes no sense for Spotify to
continue to finance the build out of global music streaming while the music labels reap all the spoils.
Ultimately, we think a sort of détente will prevail with label economic participation curtailed to
better reflect their contemporary contribution to the eco-system. With streaming responsible for
the resurgence of the music industry, the labels need Spotify for maximum distribution. While in
theory the labels could pull their catalogues from Spotify to extract leverage, such a move would
sabotage their relationships with music artists who would see their earnings drop precipitously.
Rather than play hardball with Spotify, it makes more sense to give up a few points of margin in
exchange for a thriving global music industry with double digit growth rates as far as the eye can
see. Over time, we expect Spotify to capture the economics of the music industry value chain
commensurate with its importance to the eco-system.

Apart from shifts in industry value creation, music streaming is upending how consumers discover
new artists. With exploratory music streamers broadening their horizons, the music industry may
well be less star-driven in the future. A digital distribution model has fewer gatekeepers than
terrestrial radio and retail networks. This allows for an organic discovery process rather than a
prescribed feting of the next big thing by label hype machines. While bandwagon effects can be
amplified in digital environments, there is growing evidence that the enhanced discoverability of
Spotify’s platform is making music listening more diffuse. To wit, “a couple of years ago…the top
90% of listening was about 16,000 artists, that’s now grown to 32,000 artists.” (now 43,000) –
Spotify CFO Paul Aaron Vogel in 2019. The net effect should be broader market participation by
independent artists, which would weaken label’s power over time. In addition, we expect enhanced
discoverability to increase the globalization of music resulting in an erosion of US-centric labels’
market power and increased supply from non-domestic labels where supply tends to be more
fragmented. In summary, the importance of search in surfacing music content is bound to diminish
the music label’s hoarding of industry profits.

A David Among Goliaths

Apart from supplier power, the other mark against Spotify concerns its ability to ward off the
competitive advances of tech behemoths Amazon and Apple. These concerns are not misguided as
Apple has demonstrated its ability to take significant share, growing from a standing start in 2015 to
19% market share last year. A large active base of over one billion connected iPhones gives Apple a
head-start in establishing a connection with non-music streaming customers and a significant
advantage in Customer Acquisition Cost (CAC).
Amazon has also had success (13% market share) with a cut rate offering of $8.00 for Amazon Prime
members. Like Apple, Amazon enjoys device advantages due to its Alexa smart speakers as well as
Alexa design integration on non-Amazon hardware. Native design in smart speakers is a critical
onramp for music subscribers as a request to play music defaults to Amazon Music.

Last, there is YouTube (5% market share), which benefits from its ubiquity on our screens.

As a competitive slate, this is a murderers’ row. All three dominate globally, possess deep pockets
and enjoy low CAC. Moreover, each is happy to utilize music as a loss-leader to sell more phones
(Apple), serve more ads (Google), or in Amazon’s case, deepen its commitment to its ecosystem. It
would seem that Spotify’s die is cast.

Despite their advantages, each of Spotify’s competitors’ ability to scale globally is constrained. In
Amazon’s case, it is a market issue. Amazon is in 45 markets relative to the 92 markets in which
Spotify has planted its flag. Further, Spotify has done a better job of localizing music offerings than
its American counterparts. For Apple, gains have been constrained by the company’s inability to
gain significant traction outside of its iOS operating system, which currently hovers around 25% on a
global basis. Last, while YouTube is everywhere, its model will always be subpar due to an artist
payout ratio per stream only 1/6th that of Spotify – Digital Music News put it thusly, “once again,
please don’t ever make a career out of your earnings on the popular video platform. Trust us, you’ll
regret it.”

We want to focus our energies on what Spotify brings to the table and why we think it controls its
destiny. It is worth nothing, that despite competitor inroads, Spotify remains the undisputed
category leader. For observers it is difficult to digest, for in this case the market leader is a David
rather than a Goliath.

Data Flywheel Compounds Advantages - “I’m just sitting here watching the wheels go round and
round, I really love to watch them roll.” - John Lennon

In our 2016 annual letter we wrote about our attraction to self-reinforcing business models --the
rare business where each transaction on its platform makes the business structurally stronger.
Spotify is such a business. With more and more businesses harvesting data through AI, scale
supremacy is critical. With digital platform businesses, the quantity of data fed to algorithms
determines their efficacy. The data spun off by scaled platforms, particularly those with frequent
consumer engagement (Facebook, Google, Instagram, Zillow) generate superior insights due to data
sets which are an order of magnitude larger than competitor data sets. In Spotify’s case, it uses data
insights gleaned from its users’ listening habits to improve its recommendations for daily and weekly
playlists. With data training the algorithms, scaled businesses’ advantages compound at ever
quickening rates. For example, at two times the size of Apple and twice the engagement, Spotify is
collecting four times as much data as Apple. This enables the company to feed its recommendation
engines more data compounding its advantages. Further, since Spotify has the most global reach, it
is best able to cross-pollinate songs across borders leading to increased listening utility and
enhanced discoverability.

While superior data collection provides Spotify a competitive advantage within music streaming, it
also enables the company to sit astride emerging audio categories outside of music. Such categories
include books, courses, meditations, sports, news, talk radio, podcasts, concerts and live events.
Due to the variety of platforms, apps and exclusives, searching for many of these categories is
unruly. By aggregating content and serving as a central depository of all things audio, Spotify can
remove frictional search costs and become a one-stop-shop for audio content, a sort of Google for
audio search. Given its scale and data flywheel there is a more than outside chance this becomes
reality. The resulting total addressable market would be multiples larger than currently envisioned
in a music streaming scenario. Spotify CEO Daniel Ek has been consistently clear that Spotify’s
market is audio and he is going after earshare not music streaming share:

“The market we’re going after is audio. That adds up to two to three billion people around the
world who want to consume some type of audio content on a daily or weekly basis. If we’re going
to win that market, we’d have to be at least a third of it. We have somewhere between 10-15x of
where we are now of opportunity left.” – Daniel Ek on Invest Like the Best podcast

Discovery and Curation – You Get Me Spotify, You Really Get Me

“We are in the discovery business…If discovery drives delight, and delight drives engagement, and
engagement drives discovery, we believe Spotify wins and so do our users.” – Spotify F-1

“At the end of the day, margin flows to whoever owns demand creation. So demand creation is
everything, both in terms of driving a virtuous cycle of engagement, conversion, retention, and
lifetime value.” – Former Spotify CFO Barry McCarthy

Many have complained about the challenge of finding something to watch on Netflix, a platform
which clearly fails in curation and algorithmic matching. With music, the challenge can be even
more daunting. For example, Spotify has over 50 million songs on its platform, making a robust
discovery and curation system even more important.

Discovery is Spotify’s superpower. As elucidated in its IPO filing documents (F-1), Spotify has always
understood that its primary mission is to serve as a portal to music discovery. Playlists are the
backbone of Spotify’s discovery focused UX with over four billion playlists on its platform. By
providing best-in-class discovery and personalization tools, Spotify creates a virtuous flywheel of
demand -- with discovery driving engagement and engagement feeding data algorithms further
improving personalization. The success of playlists in keeping listeners engaged is reflected in
listener data with a third of listening time spent on Spotify generated playlists and a third of
listening time spent on user generated playlists.

Spotify offers a playlist for every genre and every occasion with its editorial team constantly refining
over 4,500 global playlists. The company’s most important playlist is Discovery Weekly, a new
playlist delivered each week made just for you premised on your taste (or lack thereof). The
product has been a monster hit generating 5.3 billion hours in listening since launching in 2015. By
rearranging commoditized content in new ways with continual updating, Spotify is in its own way
creating a form of original content. This should ultimately enable Spotify to better aggregate
demand increasing its leverage over music suppliers.

The more Spotify users tailor their listening experience to their preferences the less likely they are to
leave. Importantly, playlists cannot be shared across music platforms increasing customer
retention. Switching costs typically denote a learning curve, but in Spotify’s case it’s premised on a
personalization curve.

We all know the best entrée to music is often through an audiophile friend. With the largest base of
users, coupled with the best integration in social media, Spotify offers the easiest way to find your
friend’s playlist. With social at the center of playlist sharing, playlists are inherently scalable,
building a stealth layer of network effects. Spotify already has the largest userbase and most
engaged users naturally amplifying existing network effects.

Of course, Spotify’s competitors can produce playlists and curate content as well, but they are
technology companies first whereas Spotify has passion for music in its cultural DNA. That spirit is
embodied by Spotify’s RapCaviar, the most influential playlist in music. With over 13 million
followers, RapCaviar breaks new stars, runs concert tours and moves culture. Just like New York’s
Hot 97 used to confer star status on emerging hip hop artists so too does RapCaviar serve as a star
maker for aspiring rappers of today.

Two-Sided Marketplace, Now with B Sides

“The problem is Spotify has data that we don’t have. They can see data before our labels can see it,
so they have an opportunity to jump and make an investment on an artist that’s not a guess or
based on gut, the way everywhere here in this room has to work – it’s based on hard knowledge and
facts.” – Richard Burgess, CEO of the American Association of Independent Music

While the future balance of power between labels and Spotify will have outsized influence on
Spotify’s future margin structure, we expect to see short-term initiatives provide margin relief as
well. Chief among these are Spotify’s Two-Sided-Marketplace platform. As the nexus of global
music distribution, Spotify collects a treasure trove of data. As such, it is uniquely positioned to
deliver value to artists and record companies through richly featured data analytics. For artists,
Spotify data can illustrate demand and preferences by geography and demographics. With
behavioral data on 300 million users, artists can see which playlists are driving consumption and
learn about their fans. For labels, Spotify can serve as a talent scout, dissecting listening data and
offering insights into how to position and market artists.

The opportunity for record labels to utilize Spotify’s data is enormous. Music labels spend roughly
$4 billion a year in artist advances, logistics and marketing costs. Historically, much of this spending
has been spent on Led Zeppelin tour parties. The opportunity to revamp marketing dollars is vast
and Spotify’s data is the key change agent toward optimizing label spend. There is a lot of soft
middle ground here for the labels and Spotify to divvy up. Spotify’s Two-Sided Marketplace should
allow a wholesale transfer of many of these marketing dollars to its coffers while simultaneously
having a material impact on music label’s ROI. The distribution agreement reached between UMG
and Spotify this month suggests closer cooperation between the two companies on the utilization of
Spotify’s data – UMG commits to “deepen its leading role as an early adoption of future (marketing)
products and provide valuable feedback to Spotify’s development team.”

Spotify also plans to utilize its Two-Sided Marketplace to allow for sponsored listings. Sponsored
listings are a form of advertising in which labels or musicians can advertise a song to a user matched
by Spotify’s algorithms. There are almost no incremental costs for Spotify as songs are merely
inserted into existing playlists. Perhaps this is why Ek has stated that sponsored listings will have
“software-like margins.”

On the artist side of the marketplace, Spotify has made a number of advances to burgeoning stars to
trial direct relationships. According to media reports, Spotify has offered musicians that sign direct a
50% revenue share of music streams, higher than the 30% share offered by labels. While such
efforts are a signal to labels of the disintermediation risk poised by music streaming platforms, we
expect them to remain a small component of Spotify’s business. At present, Spotify does not have
the resources to match the marketing firepower labels spend on roster stars. Nonetheless, it is an
important arrow to have in its quiver as the industry evolves and is a signal for labels to play nice.

With the ability to license and promote artists, musicians may choose to increasingly go direct.
Chance the Rapper is perhaps most famous for eschewing labels to go direct and yet his star has not
dimmed without label promotion. As far back as 2012, Metallica realized its label, Warner Music
Group, was not critical for reaching its fans or the buying public. As a result, the band ended its
contract with the label and licensed its entire music catalogue to Spotify.

Podcasts, The New Talk Radio

Podcasting is a small market but growing rapidly. From its humble beginnings as a platform for
audio bloggers to shout into the void, podcasting is now a $1.3 billion market growing at a 22%
compound annual growth rate (CAGR). According to an annual survey commissioned by Edison
Research and Triton Digital, one third of Americans listen to podcasts monthly with one quarter
listening on a weekly basis. Podcast listeners are a deeply engaged bunch consuming six hours per
week. Podcast listeners tend to be upwardly mobile with roughly half making over $75 thousand in
annual income and one third having a graduate degree. On Spotify’s platform, engagement with
podcasts rose 100% over year-over-year with an additional 20 million monthly average users
listening to podcasts over the last six months.

In recent months, Spotify has accelerated its push into podcasting, announcing deals with Michelle
Obama, DC Comics, Kim Kardashian and the Joe Rogan Experience. The increase in deal activity
builds off the $600 million Spotify spent over the past year to acquire four podcasting companies
including Gimlet (original content), The Ringer (pop culture and sports – potentially the ESPN of
podcasting), Parcast (original content) and Anchor (distribution and monetizing of podcast content).
Spotify is clearly angling for vertical integration to both publish and distribute content and has a real
chance of becoming the preferred platform for podcast discovery.

Spotify’s exclusive with the Joe Rogan Experience podcast could be a game changer. In many ways,
the Joe Rogan deal is akin to Sirius’ $500 million deal with Howard Stern in 2004. That deal
completely changed the trajectory of satellite radio enabling Sirius to scale and drive operating
leverage. It is worth noting that Sirius’ deal with Stern leveraged a base of 35 million US subscribers.
In Spotify’s case, its deal with Rogan will be spread across 300 million existing Spotify users, not to
mention Joe Rogan’s audience of 190 million monthly downloads, suggesting its potential for
transformational impact could be even greater. Relative to consumption hours, podcasts are
woefully under-monetized with radio generating four times as much revenue per hour.

Spotify’s embrace of podcasts is significant for two reasons; first, the flurry of activity underscores
Spotify’s commitment to an audio first (inclusive of audio outside music such as courses, podcasts,
meditations and books) market posture. The audio first mentality offers the potential to turn
Spotify into the Google of audio search – where one begins their search for all things audio. Second,
Spotify’s increasing investments in podcasts should lead to a shift in its cost structure with fixed
costs replacing the variable costs paid to music labels. This is similar to Netflix’s shift from licensed
content to original content. Like Netflix, Spotify’s move toward greater in-house content should
drive operating leverage.

Aside from improved unit economics, podcasts also provide a point of competitive differentiation
and thus improve conversion from free to paid while also increasing retention. Increased
engagement with podcasts should ultimately result in increased pricing power.

It makes sense to spend heavily now as this is a business where scale begets more scale. As we have
seen with Netflix, scale players can pay more for content due to their ability to spread content
spend across a broader base of subscribers. On a global basis, this is a significant advantage and one
Spotify should pursue aggressively. The more spent up front, the faster Spotify can make the
flywheel spin – as long as engagement and new subscribers are rising in tandem. In Spotify’s case,
there is the added benefit of lower cost supply due to fixed cost operating leverage on non-music
content.

Management – Thinking Fast and Slow

We are big fans of management teams that ignore Wall Street. The first rule of winning is knowing
what game you’re playing. For Spotify CEO Daniel Ek, it’s the long game. Since inception, Spotify
has never wavered in its mission to be the best audio platform in the world and the best partner to
artists and record labels. How a small Nordic-based upstart realigned the global music industry
around its vision for music as a service while vanquishing the world’s most profitable company
(Apple), the most widely used website service in the world (Google), and the world’s most powerful
company (Amazon), all while being at the mercy of consolidated suppliers with money to burn will
someday be a master class taught at the world’s best business schools. It is too soon to say Spotify
has vanquished its competitors but thus far it has pressed its advantage and widened its lead.

“Music is everything we do all day, all night, and that clarity is the difference between the average
and the really, really good.” – Daniel Ek

Mr. Ek has imbued Spotify with several cultural attributes that leave it well equipped to win the
prize. First, and probably most important, has been focus. Ek understood early that music is a
business about passion and creating a healthy ecosystem would require an artist’s mindset rather
than that of a software engineer. That singularity of purpose informs its software. Apple Music is
an add-on thrown in to drive revenues whereas Spotify feels like the music geek at your local record
store guiding your browsing.

Second, Spotify has put the customer at the center of everything it does. Like Amazon, Netflix, and
Costco, investment spend is geared toward elevating the user experience above all else. This is not
done in the spirit of charity but in the recognition that customers have choice and scaled Internet
platforms win the spoils. Daniel Ek put it best, “engagement drives usage, usage drives data
insights, data insights drive a better user experience. A better user experience drives longer lifetime
value.”

Mr. Ek has taken a patient approach in building out Spotify’s moat, realizing that he can better
fortify the company with a long-term view. Just like Bezos with Amazon, Ek is happy to defer
profitability in the pursuit of growth. Ek knows once Spotify achieves the scale he envisions there
will be nothing anyone can do to dislodge its dominant perch. In the meantime, however, it appears
foolish, just as Amazon’s 20-year march to profitability did.
It takes a unique mix of urgency and strategic planning to both focus on the long-term but
relentlessly innovate in the short-term. Long-term thinking invites a plodding approach and an
innovate or die approach often leads to sloppy decision making and capital allocation. Given the
cognitive dissonance at the center of these two approaches it takes a master tactician to play along
the continuum. Daniel Ek seems uniquely capable of playing at both ends. Spotify has continually
out-innovated its peers while maintaining long-term discipline and a cost-conscious posture. Yet, it
moves more quickly than anybody in the space. Mr. Ek understands scaled players win – “Success
for us will be determined by our ability to move faster than everyone else in this space.”

We also like a CEO who puts his money where is mouth is. Late last year, Ek spent $16 million
dollars to purchase 800 thousand Spotify warrants expiring in July of 2022. The warrants break even
at $211, 56% higher than at Ek’s time of purchase. I can’t recall a CEO spending $16 million of their
own money to buy warrants more than 50% out of the money. It’s a strong statement on Spotify’s
future.

It is rare to find a CEO who can move fast and out-innovate competitors while at the same time
remaining focused on the long game. Amazon CEO Jeff Bezos is one such example. By not playing
to the whims of Wall Street, deferring profitability in the pursuit of widening its moat, and treating
every day as day one, Amazon has built the most successful and enduring business the world as ever
seen. It will be a long time before the world sees another Jeff Bezos but in looking at Daniel Ek’s
track record thus far it is clear that he is cut from the same cloth.

Pricing Power – Through the Looking Glass

Unlimited on-demand streaming of a catalog of 50 million songs across devices and without
commercials for $9.99 a month is one of the best deals around. Especially when you consider that
Spotify has not changed its pricing since its US launch in 2011. Adjusting for inflation alone would
equate to a price of $11.45 in today’s dollars.

Subscription services with increased engagement offer substantial consumer utility. While the price
remains the same, increased engagement means lower costs for each unit of content consumed
(songs for a service such as Spotify and shows or movies for a service like Netflix), a sort of personal
operating leverage for consumers. This means marginal costs for extra music consumption is zero.
In economics, this is known as a “consumer surplus,” which reflects the difference between the
price consumers are paying for a service and the price they are willing to pay. Given the steadily
growing engagement of Spotify consumers, it is our contention that the company benefits from a
substantial consumer surplus which will be monetized in the future.

Many look at Spotify’s stagnant pricing and view it as proof of a commodity business. This is a
dangerous assumption to make. Like Netflix, we believe Spotify has one of the longest pricing
power runways in all of business. The decision to not flex pricing now is a conscious decision to
hoover up as much market share as possible. As Spotify’s churn statistics indicate, it is difficult for
Spotify customers to leave. Playlists, social integration, curation and user experience create
enduring habits. The degree of personalization over time makes Spotify very sticky and positions it
well to commoditize suppliers rather than the other way around. Given the winner take most
nature of globally scaled internet businesses it makes sense to optimize for consumer lock-in now
while consumer habits are still being formed. As long as engagement continues to inflect higher,
monetization will come.

Valuation

“The best decisions are the ones that are really instinctive and the most simple. You can use
enormous amounts of data and find all kinds of clever ways of slicing and dissecting things. But at
the end of the day, the simple decision tends to be the best…One of the simplest decisions you can
make is to buy the category winner and wish that the whole category does well. Because if it does,
so long as the category winner stays on top of the category, they will get the disproportionate
amount of the gains. And that’s been completely true in markets since time immemorial.” –
Chamath Palihapitiya

After lying dormant for two years (Spotify IPOed at $169 in April 2018), Spotify’s shares have finally
caught a bid. The material rerating in shares was no doubt spurned by excitement surrounding
recent podcast announcements and new label negotiations. Despite this year’s robust returns, we
continue to believe that Spotify offers one of the best return profiles over the next decade.

To value Spotify, you must ask what this business looks like at scale. Both Goldman Sachs and
Morgan Stanley assume the market for paid music streaming subscribers will grow to 1.2 billion by
2030. This seems more than reasonable given the world already has more than 2.7 billion global
smart phones in use outside of China, so we will stick with it. We expect Spotify to continue to take
market share and net out at 50% of the market. In terms of pricing, we assume Spotify will be able
to grow its average revenue per user (ARPU) from $5 to $10. This may sound aggressive, but once
Spotify migrates beyond the landgrab stage it will not hesitate to press on the pricing lever. Given
the massive consumer surplus enjoyed by customers there is enough pricing runway to more than
make up for lower ARPUs in developing markets. Further, ARPU will benefit from extra platform
fees generated from Spotify’s Two-Sided Marketplace, ancillary revenue streams and increased
share of podcasting in listening consumption. In aggregate, Spotify’s revenue jumps to $72 billion a
year. At Spotify’s gross margin guidance of 35% (we assume 40% or higher due to business
evolution and favorable label negotiations), the company would generate $25.2 billion in gross
profits. Put another way, Spotify trades for roughly two times where we expect gross profits to net
out in a decade. This is not inclusive of advertising profits, which given the emerging podcast
platform could be significant. Nor does it consider call options on music streaming supplanting radio
or Spotify becoming the destination for audio search.

Ten years is a long-time to underwrite an investment, but we strive for a punch card mentality in
deploying capital. In Spotify’s case, if we are even directionally correct, we will make multiples of
our investment.

Conclusion

Value investors talk a lot about patience, but typically it is about waiting for the market to rerate a
company’s multiple after digesting an excisable problem. Better yet is the patience required for a
company achieving global scale in a winner take most market – Facebook, Netflix, Google. The
economics of these businesses are rarely apparent when in reinvestment mode, but the dominant
strains of their business model often are. Spotify’s competitive advantages, while self-evident to us,
are poorly understood by the market due to a focus on existing industry margin structure. As
elucidated earlier, we think industry profit pool dynamics are poised to shift in Spotify’s favor.
Further, there are multiple untapped monetization options through ancillary revenue streams, data
products, pricing power and platform extension. There are only a handful of companies in the world
capable of achieving global scale in a winner take most market, very few of them are available for
less than $50 billion. If music is the soundtrack to our lives, then control of the most widely used
global platform for serving up audio will surely be worth many multiples of its current market cap.

Respectfully yours,

Jake Rosser
Managing Partner
Coho Capital Management