Does Spotify Have a Moat?

In this podcast, Motley Fool senior analyst Asit Sharma discusses:

• Target's (TGT -0.36%) 2nd-quarter profit falling nearly 90% compared to last year.
• Silver linings within Target's results.
• Lowe's posting a quintessential "mixed" quarter.
• Lowe's CEO Marvin Ellison's steady leadership.

Does Spotify (SPOT 11.41%) have a moat against Apple? Motley Fool contributor Travis Hoium joins Motley Fool producer Ricky Mulvey for a "medium dive" on the streaming audio business.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Aug. 17, 2022.

Chris Hill: We've got more retail earnings and a closer look at Spotify, Motley Fool Money starts now.

I'm Chris Hill joining me today, Motley Fool Senior Analyst, Asit Sharma. Good to see you.

Asit Sharma: Chris, good to see you.

Chris Hill: It's been a little while.

Asit Sharma: Yeah. I took some time off. I think you did too, so it's good. We're both refreshed.

Chris Hill: Yes, batteries recharged. Let's continue with the theme of the week, which is retail. Anyone who claims to be surprised by Target's, second-quarter results probably hasn't been paying attention the last couple of months. Profit was down nearly 90 percent year over year as Target cleared out inventory. The inventory level is still pretty high, but the CEO, Brian Cornell says it's a much better mix of inventory. I don't know, we talk all the time about taking the long-term view. It seems like that is exactly what Cornell is doing when you see what they did with clearing out their inventory, taking the short-term hit. He's very clear-eyed about what they are trying to pull off here.

Asit Sharma: I agree, Chris. This was like a rip the band-aid off quarter. Let's go ahead and take the hit now. Although for those of you who have had very small dermatological procedures and ripped off a band-aid only to see this mole looks about the same as it did before. [laughs] They said they're going to take it out. That's what we saw in the balance sheet. The inventory balance didn't really change that much from the last three months. But as you mentioned, the company has shifting out of some of those goods we were buying during the pandemic like electronics. Instead, they are piling into food which is a great attractor for foot traffic, their costs are going up. Even as they were foregoing some future revenue and frankly, promotionally discounting some longer-term goods, they're paying more at the unit level for groceries and hey, we are too.

Chris Hill: We are, and shares of Target are down a little bit today not that much. I'm trying to get my head around like what a reasonable expectation is for shareholders because I agree with you and I'm one of those Target shareholders. I agree with you. I would have liked to see the inventory level come down a little bit more, but I feel like they made progress and this sets the stage for their third quarter earnings report, which we'll get in three months. We're hopefully they build on what they've done over the last three months. If you're looking for some silver linings, comps were still in positive territory. They weren't all that impressive, but up about two and a-half percent. Food and beverage was the strongest category and those Ulta Beauty shops seem to be doing well within the Target.

Asit Sharma: This is what you want to see as a shareholder, you want to see continued innovation. As you mentioned, they had some nice metrics in the report. I think digital sales, comp sales were up just over a percent. What you want to have out of your management team isn't ability to recognize reality. They're sending us a message that look back to basics is the best course that we can take. We have to just acknowledge that in an uncertain environment where most of the pandemic is in the rear view mirror. But the consumer still doesn't know how he or she is going to utilize that discretionary income in the face of inflation, maybe uncertainty on the wage level. Our best TAC as a Target is to pile into the categories that pre-pandemic were providing that constant store traffic. That's how you build on a comp base. After that, yes, the little nudges innovations certainly help and emerge as a stronger company out of this. Now, we just don't want to hear management flip-flop, let's say in a year and say hey, we're reversing gear, we're taking a hit on inventory. We've shifted back into bicycles, stereos, the soundbars, etc.

Chris Hill: Silver lining for us as consumers. Checkout your local Target. [laughs] I said this when Cornell came out a couple of months ago and the stock took that huge drop. At the time it was like, hey, if you're looking for patio furniture, if you're looking for large appliances, checkout your local Target and it seems like particularly in the season of back to school shopping, you're probably going to find some good deals there as well. Let's move on to Lowe's. Lowe's second-quarter was the quintessential definition of a mixed quarter. On the downside, revenue was lower than expected. Same store sales fell just a tiny bit. On the plus side their profits held up and just like we saw yesterday with Home Depot, the average ticket at Lowe's was up 6.5 percent again similar to Home Depot that was driven largely by inflation.

Asit Sharma: Yes, so a little boost on the top line, as you note from macro pressures. I really admired though, what CEO Marvin Ellison has been able to achieve in the fears since he's taken over the helm. They really are getting more productive on that operating margin line. They're watching their cost both in terms of cost of sales and their fixed overhead. Lowe's despite up pretty flattish, top line was able to eke out a very small improvement on its operating margins. That was pleasant to see. Of course they call that out and as well they should. The other thing which is really interesting is this mix of sales. In the do it yourself shoppers are dropping off, but the pro sales that the contractors who are builders that business increased by double-digits so it offset a little bit of that consumer weakness. I found it interesting. Management tried to explain to investors in the conference call that investors really shouldn't be worried too much about the fact that the housing market is slowing down. They called out the dynamics which push Lowe sales for chiefly. Almost quoting verbatim from transcript here at Lowe's, the three highest correlating factors of home improvement demand, are home price appreciation, the age of the housing stock, and disposable personal income. They went on to point out that more than half of the homes in the US are over 40 years old. I think mine's probably approaching that, maybe it's I don't 25-years old. Millions more at the peak of the housing boom are turning that magic 20 years old where you start to have to invest in your house. They also pointed out that consumer savings are about 2.6 trillion bucks higher than they were before the pandemic. The long-term factors which are good for shareholders of do-it-yourself businesses like Lowe's and Home Depot's those aren't changing despite the fact that you see this housing market really slowing down and prices starting to come off those searing high as we saw earlier this year.

Chris Hill: We've definitely seen data over the last few weeks out of housing, whether it's houses for sale, being on the market longer bidding wars starting to taper down, all that thing. You mentioned Marvin Ellison. He is as steady a hand on the wheel of this company as any CEO out there. It's just great to see. On yesterday's show, I said that you look at Walmart and Home Depot and what they did yesterday, fairly or unfairly, they raise the bar of expectations for Target and Lowe's. I think if you're a Target or Lowe shareholder there's nothing really to feel bad about. There's nothing to throw a party about either. But I think that in the case of Target, they showed improvement and it sets the stage for hopefully more improvement in the next three months. Cornell's being very transparent about what they're trying to do there. In the case of Lowe's the numbers weren't quite as good as Home Depot, but I feel like there was a lot to like there, including the fact that Ellison is very steady as she goes there. It's one of the things I like about them as a CEO. He doesn't get too high or too low no matter how good or how challenging the results are.

Asit Sharma: I think Ellison, speaking of home improvement is like that neighbor that you have who quietly goes about his or her business and gradually improves the exterior of their house and the lawn and you start to envy that at least people like me who are very bad with to yourself stuff too. I think this is a really nice point about both CEOs and both companies. These are disciplined businesses. They both shoot for very steady operating margin. The world has thrown a huge amount of crap into their business models, Chris, over the last 36 months. To be able to have fairly predictable results with the occasional big adjustment, as we saw in Target's inventory, this quarter is not a bad deal at all for long-term shareholders. I should point out both of these are highly generative cash businesses. They do right by shareholders with their capital allocation.

Chris Hill: Asit Sharma, always great talking to you. Thanks for being there.

Asit Sharma: Always fun to be here, Chris, thanks so much.

Chris Hill: Quick reminder about FoolFest, our annual investing conference in Washington DC. It's a two-day event August 29th and 30th. You've got breakout sessions on different investing strategies. We've got an awesome lineup of speakers, including Trex CEO Bryan Fairbanks, Venture Capitalists, Jenny Abramson, Motley Fool Co-Founder David Gardner, best-selling author Morgan Housel, just to name a few. It is free for Motley Fool members. If you're not yet a member to sign up for our Stock Advisor service and you get a complimentary digital pass to this two-day event. Go to fool.com/foolfest for more details. That's fool.com/foolfest. I will put the URL in the show notes. Up next Travis home and Ricky Mulvey go for a medium dive on Spotify, including whether or not Spotify has a mode against Apple.

Ricky Mulvey: You probably know Spotify, you might even be listening to the show on Spotify right now. Joining us now for a medium dive on the music streaming and digital media company is Motley Fool contributor Travis Hoium. Thanks for being here.

Travis Hoium: Thanks for having me here.

Ricky Mulvey: Easy question to start off, why is Spotify an interesting company to you as an investor?

Travis Hoium: It's the only company that's really focused on your ears as a business. It started with music but now they're really moving into podcasts, audio books. I think that could potentially be a really big market. Think of it as replacing radio if you will and pulling some of the successful business models that have been proven with advertising companies like [Meta's] Facebook and Alphabet or Google. I think that's a really compelling market and as an investor I think there's still a lot of upset.

Ricky Mulvey: They've got a premium model, they also sell ad space. A little bit into how the business model works.

Travis Hoium: Well, it really started with music. There are four major record labels that they have to deal with on the music side of things. That really limits what they can do in monetizing the music business. But like you said, they're able to offer subscriptions and then advertisements and they share that revenue with those record levels. Think about that as you have a small number of suppliers as a result, the suppliers have a lot of bargaining power that really squeezes their margins. That's why Spotify has been in this 20-30 percent margin range. But now they've moved into the non-music business, really trying to ramp up their advertising business. Think about this as like dynamic ads as you're listening to a podcast. Maybe you get some of those as you're listening to Spotify if you're listening to it right now. That has a lot more upside from an investment standpoint because it potentially has higher margins and also maybe even a bigger market.

Ricky Mulvey: Looking at the premium subscriber base, the company has about more than 400 million people on the platform. Something that caught my attention, that Spotify has about a 182 million premium subscribers and 240 million free users. I look at that and I had few questions because, A, it could mean they've been an incredibly high conversion rate. But also, B, the concern that I might have is that that might mean the company has hit a growth ceiling and that a lot of the leads have already become premium users.

Travis Hoium: To put that number into perspective, Facebook has about two billion users and Spotify has a huge international business. I'm not too concerned about them being in a saturation point in the market but definitely something to keep an eye on, this is something they report every quarter but the active monthly users were up 19 percent year-over-year last quarter. That's a pretty solid growth rate. Any company that's growing double-digits long term is really the kind of investment you want to be as a growth investor. I'm not worried about them hitting a wall at this point but obviously one of those numbers that you want to keep an eye on from a year-to-year basis.

Ricky Mulvey: Something that also [inaudible 00:14:02] brought this up is that the company doesn't seem to have a lot of pricing power so Spotify Premium and Apple Music are both set at $10 a month. Do you think they have more pricing power when it comes to the advertisements and owning that ear space and that's where investors should focus for growth.

Travis Hoium: Yeah, ultimately that's really where the upside is in the business. Think about this a little bit like being in the same business that Google is or that Facebook is where you don't have just a small number of suppliers like you have in the music business. Now you have potentially hundreds of thousands of podcasts who are coming to you to try to monetize their podcasts. You're able to match them with advertisers. Well, margins typically go up in that scenario. Margins of 60-80 percent long-term in the ad business is really where we see companies like this being. Long-term, that's really what I'm looking at for Spotify. Can they push not only growth on the revenue side but push up the gross margin number on the advertising business? That's where we could see profitability really jump. We're a long way from there. Spotify is relatively new in the advertising business. They only had $360 million in ad revenue last year but growing 31 percent,. If you keep a 31 percent growth rate, you double every 2.5 years so this could be a really big business by the end of the decade.

Ricky Mulvey: Spotify is also spending a ton of money on exclusive content. Thinking about Dax Shepherd, Joe Rogan, they have a partnership with DC Comics. What is their approach to exclusive content and how is that different from something like a Netflix?

Travis Hoium: There's some similarities with Netflix. They are doing licensing deals, they're also buying some companies like The Ringer. When you buy a company you own all of that content and so you're able to monetize it long term. There are obviously costs associated with ongoing podcasts so it's a little bit different business model from Netflix from that perspective. But the licensing side is very similar. Joe Rogan is a great example. They just write him a big check and then it's Spotify's responsibility to monetize that on the back end. Very similar there, what I think is unique with Spotify is this advertising side of the business where they have content coming to them that they don't have to pay for upfront and they're able to monetize that with their advertisers and match users who are paying for those ads. That's a little bit more like YouTube and that just gives a lot more potential upside because there's no limit to the amount of supply that there's available.

Ricky Mulvey: Companies led by founder leader Daniel Ek, sure he's made some expensive content plays but we also like some founder-led companies. What's your take on him as the CEO?

Travis Hoium: I really like what he's doing with this business and I don't know that anybody else could have the same vision and take a big swing at podcasting, at audio books the way that Daniel Ek is. He also sees that there's just a limit in how profitable on how big this company could be focusing on music. You got to expand that business if you're looking at owning the ear. The next place is podcasts and audio books. I think they have the right vision. Now, executing it is going to be a bit of a challenge because the ad space is very challenging naturally but if they can continue to scale the business I think there's a lot of upside for investors.

Ricky Mulvey: Exclusive podcasts also seem to be in my mind a challenging strategy because unlike the streaming wars, your competitors are offering free products with Apple and lets say even Pocket Casts, those sorts of things.

Travis Hoium: Yeah. The idea with exclusives is really to make Spotify a go-to location for podcasting. I think I'm a perfect example of this. I started using Apple podcasts and I continue going back to the Spotify app because they have podcasts that I listen to that are only available on Spotify. It is a draw, it is a way to build a marketplace and there is a huge upfront cost with that. Now, long-term, I don't think that having a lot of exclusives on this platform is really the way to go. If you think about this a little bit like YouTube, YouTube doesn't have many exclusive pieces of content. They just want to be the go-to place for both viewers and content producers and that's what Spotify is trying to do but instead of for video they're trying to do it for audio.

Ricky Mulvey: Before I ask you about their modes, anything stand out to you about Spotify's balance sheet? They've had some, let's call it wavering profitability particularly around the net income area.

Travis Hoium: Net income isn't something I'm super concerned about because they do have a lot of costs related to building out both the technology stack on the ad side but then also this exclusive content that we've talked about. One thing I am watching is free cash flow. They have been free cash-flow positive in 2022 so that is a positive thing to look at. As long as they can keep growing the business and stay positive on the free cash flow front I think the balance sheet isn't something I'm really worried about.

Ricky Mulvey: You've got competitors like Apple and Amazon. Those are mighty competitors at that. Do you think Spotify ultimately has a mode against them, and if Apple and Amazon are Spotify's biggest risk, what do you think is?

Travis Hoium: The great thing about having Apple and Amazon as competitors is they're trying to do a lot of things and Spotify is focused on the owning your ears. I think that's where they're really able to differentiate themselves. They're also able to distribute their content almost anywhere. They don't care if you listen on an iPhone or an Alexa speaker or in a car, whereas Apple and Amazon do care about those things. They're playing a little bit different game and I think that's what we need to focus on from a strategic standpoint, is that Amazon and Apple just aren't going to be able to compete in the same way that Spotify is. The biggest risk is simply that there isn't enough demand for advertising or for listening to podcasts and basically non-music content. Is there a cap on how much time we spend listening to podcasts long term? I don't know the answer to that. I'm very bullish but I've been listening to podcasts for over a decade at this point so maybe I'm not the right target market. I continue to look at what they report from listener numbers and then the amount of content that they're putting on the platform which is in their quarterly report and it continues to grow. It seems like the momentum is there, ad revenue is growing at a really rapid rate. So as long as the momentum continues and the flywheel effect keeps growing, I think they're in a really good position but that would be the limiting factor.

Ricky Mulvey: Full disclosure, I own shares and Spotify, Travis do you?

Travis Hoium: Yes, I do.

Ricky Mulvey: Last question, I know you're not into the Spotify playlist. What's your favorite podcast on there that is not the one-year currently on?

Travis Hoium: I listen to the Ringers basically full suite of podcasts but I keep going back to Bill Simmons podcasts. He is the OG in podcasting. I've been listening to him ever since I heard him. You had to listen on a web browser, so we go back long ways and I just can't quit that podcast.

Ricky Mulvey: Travis Hoium, thanks for your time.

Travis Hoium: Thanks for having me.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.