Are Music Streaming Companies a Big Hit With Investors?

Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Neil Macker. He is a senior equity analyst with Morningstar U.S.

Hello.

Neil Macker: Hello, how are you today?

Black: I'm good. So, Neil, you've been looking at the music streaming industry, which is a pretty amazing growth story because of just a few years ago, it didn't even exist. Do you want to tell us some of the key findings from your research?

Macker: Some of the key findings are, as you said, the music industry has rebounded because of simply the streaming industry itself. Music streaming has exploded over the last few years, and because of that, record labels have moved from a declining business in terms of revenue to a growth business over the last five years.

Black: Something we hear about this industry is that there's fractions of pennies involved in each stream. How do these companies make profit?

Macker: From the recording label side of it, the way they make a profit is, they're basically taking that money and then splitting it with the artists themselves. From the streaming side, they do only give away a set percentage of their revenue here. Now, having said that, most of these companies are losing money on the streaming side from an operating income basis. And for companies like Apple and Google, that's fine because it's a way to sort of keep you in the ecosystem. For Spotify, that's something they're looking at and one of the reasons they're moving into areas like podcasting.

Black: And the other sort of controversy in this industry quite a lot we hear is between the artists themselves and the streaming companies because they don't think they're getting properly compensated. Is that a risk factor for these stocks?

Macker: For companies like Warner Music, which is one of the names that I cover, it's not that big of a risk factor. I do think that one of the problems right now in the pandemic is that a lot of these artists that make a ton of money touring are not having that income. So, the streaming is becoming a bigger part of their income, and they are looking more deeply into that. You could see some issues, especially in the U.K., where I know that the Culture Secretary there has looked into that. But I think in general for companies like Warner Music, as long as somebody is paying for the music, they'll be fine.

Black: We've seen user numbers of these sites grow at a really fast rate, and that's a particular success story of the year of COVID, I think. Do you think this growth can continue or are we going to reach a saturation point?

Macker: From our viewpoint, we've done analysis of the paid streaming market, and we expect that market to double in size over the next five years. Part of that is going to be increased penetration in Western in postindustrial markets but also in countries like India, Indonesia, and Africa in terms of the continent there, their mobile usage is continuing to grow in terms of data as well. So, we should expect to see increased paid subscription there as well.

Black: And I know one thing Morningstar analysts really like to see at a business is an economic moat, a barrier to competition. Is this a moaty type of industry?

Macker: From the record label side of the business, we do think it's a moaty business, specifically for Warner Music, which is the one stand-alone major record label, and that's based on intangibles of not only the library that they have but the know-how that they know how to create and develop new talent and get them on these streaming platforms as well.

From the streaming side of business, we don't view that as a moaty business for companies like Spotify. I think it's something they're trying to build and move forward with, but it's not something that they have currently.

Black: With all of that in mind, what are some of your top picks in this sector?

Macker: I think we see the sector is actually fairly valued to overvalued. A name that we recently started coverage on is Warner Music. Our fair value estimate there is $33. The stock has run into that right now. So, for right now, the stay-at-home trade across a lot of this industry has moved valuations up. So, we think investors should keep an eye on the space, but maybe wait for a pullback before investing.

Black: Neil, thank you so much for your time. For Morningstar, I'm Holly Black.