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Spotify vs. Drake: The Drama

🎶 Get the inside scoop on the music industry clash between UMG, Spotify, and Drake.

December 09, 2024

Silver banana goes to…

In this issue of the peel:

  • 📊 Wall Street solidified a 3-week win streak, with the market getting a boost from Friday’s economic data.

  • 💼 Non-Farm Payrolls report highlights a strong rebound in job growth and a low unemployment rate.

  • 🎶 Get the inside scoop on the music industry clash between UMG, Spotify, and Drake.

Market Snapshot

Banana Bits

There’s a lot to learn from lower middle-market deals.

They continue to represent a large chunk of private-target M&A activity, and—as a result—they offer unique insight into the M&A market overall. You just need to know where to look.

This report is where to look.

It analyzes key aspects of lower middle-market transactions and compares them with the broader M&A landscape to help you hone your negotiation approaches, whether you’re working on a $50 million deal or a $5 billion deal.

Deal structures, PPAs, earnouts, escrows, and more—it’s all covered. Download the report now to see how small deals can be a big deal when it comes to informing your M&A work.

Macro Monkey Says

A Pricey Bite: The Economics of Fast Food

I remember walking into the Chipotle near my University’s campus 10 years ago and paying $7.50 for a nice, thick burrito. Since then, it seems like portions have consistently gotten smaller while prices have consistently increased. 

This is understandably frustrating for consumers, but taking a deeper dive into the economics of quick-service restaurants might give you a little more empathy.

What Happened?

Chipotle and Cava recently announced nationwide price hikes, with Chipotle raising prices by 2% and Cava by 3%. 

While customers were wailing and gnashing their teeth, investors were celebrating the stock surge that followed this news. Why? Because it should help both companies fight higher prices that have impacted profitability. 

Quick-service restaurants across the board have been struggling to keep up with rising inflation, which has impacted prices for avocado, beef, dairy, and a swathe of other key products used in food production. This, in turn, has weakened operating margins and bottom-line profit.

The Numbers

Despite all of our collective frustration with skimpier portion sizes and rising prices, the data says that we haven’t done anything about it. When our stomachs growl, we go for what’s familiar. 

For example, when Cava instituted a price increase earlier this year, in-store foot traffic dipped slightly in Q1 before rebounding to grow by 9.5% in Q2 and 12.9% in Q3. 

Chipotle’s last price hike came in October 2023. Traffic never dipped but, in fact, grew 7.4% that quarter. Simply put, it’s really hard to bet against these companies. 

Take a look below at Chipotle’s resilient revenue growth over the past 20+ years, even when facing rising production costs, E. Coli outbreaks, and a litany of negative news reports.

While on the surface, it could appear that corporate greed is fueling these price increases, you may be surprised to see a breakdown of the expenses involved just to keep the lights on. 

Between packaging, rental/leases, labor, and other general & administrative items, the costs pile up. 

Rising beef and avocado prices, in particular, have made it challenging for places like Chipotle to generate enough revenue to outpace costs. 

Chipotle has a 17.7% margin, which means that for every $1 in sales they generate, they keep $0.17. 

While it seems low, this is amazing for quick-service restaurants, which generate 5-8% margins on average. In part, their scale enables them to do this as they can spread costs over a larger number of stores. 

However, when the input costs required to run the business keep increasing, companies are left with no other choice but to raise prices accordingly. Cava, on the other hand, is 1/10th of Chipotle's size, with about 352 locations compared to Chipotle’s 3,500. This makes it even tougher to achieve economies of scale and manage costs. 

The Takeaway

As much as we might grumble about paying a few extra bucks for our favorite burrito or grain bowl, the reality is that these price hikes aren’t arbitrary. 

They’re a reflection of the immense pressures that quick-service restaurants face in balancing rising costs with maintaining profitability. 

For Chipotle and Cava, it’s not just about keeping shareholders happy—it’s about staying competitive in an industry where margins are razor-thin, and one bad quarter can spell trouble. 

So, the next time you’re biting into a pricier burrito, consider this: those few extra dollars are keeping the guac on the table and the lights on behind the counter.

Career Corner

Question

I was recently asked this question and would love to get some input on how I should answer it: "What are some line items that might be included in the COGS section of the income statement of a tech and/or biotech company?"

Answer

Look up the public financials of a tech company and a biotech company, and you'll see what they include in COGS (directly below revenue, above gross profit). You want to make sure these line items are directly tied to the production of revenue.

Then, research each of the line items and learn about what they are

Head Mentor, WSO Academy

What's Ripe

Asana, Inc. (ASAN) 43.53% 

  • With the Q3 earnings season largely behind us, Asana decided to end it with a bang. Strong revenue and operating profit boosted the work management company by 43% on Friday. Other key metrics for software, including billings, RPO, and customer additions, also came in hot.

  • The results are particularly encouraging, given the macroeconomic context we’re in. Asana’s growth rate took a nosedive after a hot start. They’ve been faced with a tough sales environment in the first half of 2024, but new CFO Sonalee Parekh has been kicking ass with her financial turnaround plan.

  • Management also highlighted the launch of its own artificial intelligence product, AI Studio. The product is helping customers manage their workflows more effectively and efficiently, which investors see as another lever being pulled to bring the company’s growth rate back on track.

Hewlett Packard (HPE) 10.62% 

  • Hewlett Packard pleased investors in more ways than one (no pun intended) with solid earnings results and positive updates regarding its ongoing merger with Juniper. This led to price upgrades across Wall Street.

  • Revenue, Profit Margin, and EPS all beat expectations, a pure trifecta! Things are looking up for the foreseeable future as they are set to benefit from recovering demand in mainstream servers and enterprise networking, which should help HPE catch up to competitors.

  • AI, in particular, represents a major opportunity. Orders from enterprise customers and sovereigns boded well for earnings moving forward. Additionally, the company confirmed that its acquisition of AI firm Juniper Networks is on track to close in 2025.

What's Rotten

Guidewire Software, Inc. (GWRE) 14.04%

  • Don’t you hate when a company’s stock crashes despite a good earnings report? Even the most fervent anti-capitalist has to feel bad for management teams when that happens.

  • GWRE’s EPS came in 43% above analysts’ expectations, driven by rising international demand and Guidewire Cloud deals. But even that wasn’t enough for investors, who are more worried about long-term profitability, sustainability, and cash flow challenges. Sure, I guess those things are pretty important.

  • While ARR has consistently outperformed for several quarters in a row, the methods used by GWRE raise some eyebrows. The company had a negative free cash flow of $67mn, primarily because of bonuses and commissions paid out to employees. One has to worry about the long-term sustainability of that strategy and whether revenue increases will outpace employee incentives.

National Beverage Corp (FIZZ) 6.54%

  • The beverage maker behind LaCroix saw its stock fizzle out after posting 2Q earnings. The verdict: Americans might be moving away from the healthy trend and going back to the good stuff (Coca-Cola and Pepsi).

  • In the long term, investors are worried about shifting consumer habits toward healthy beverage options and high inflation, which reduces customers' purchasing power. FIZZ is overhauling marketing efforts, expanding in-store merchandising in new cities, and teaming up with influencers and professional sports teams to increase brand awareness via digital marketing campaigns.

  • Apart from that, there were record-breaking storms that hit large areas in the Southeastern US. This caused major supply-chain disruptions and store closures among their key customers. Despite these headwinds, FIZZ reported increased earnings and margin improvement, which should give investors some sort of relief.

Thought Banana

Certified Lawyer Boy

Drizzy, if you’re reading this, it’s too late. Just when we thought the dust settled on the Drake-Kendrick beef and all went back to our boring lives, more drama emerged. 

This time in the form of a lawsuit. Well, it’s not actually a lawsuit but a pre-action petition filed by Drake against his own label, Universal Music Group. 

This petition serves as a precursor to a lawsuit and is meant to force the hand of the counterparty to provide evidence or data pertinent to the case. 

It’s basically saying to someone, “Hey, I might sue you, and I need you to provide me with the data to help build my case and determine if I want to go through with it.” I’m no genius, but playing that game with a multi-billion-dollar music monopoly sounds fruitless to me. 

What Happened?

We here at the Peel are not rap beef judges, so we won’t be discussing our opinions on that. But this is a great opportunity to parse through some of Drake’s complaints against UMG in order to have a broader conversation about the economics of music.

His primary complaint is that UMG and Spotify colluded to pump up his opponent’s songs, utilizing bot services to inflate streaming numbers and create the facade of popularity artificially.

In the context of business, think of the record label as a giant loan company. They identify raw talent in the hopes that they can develop into a successful artist. They provide the artist with an advance or an upfront sum of money to sign with them. 

They then work to develop the artist along with producing, distributing, and promoting their music. Remember, this advance is really just a loan. The label needs to make back the initial capital they invested in the artist and then some. 

If an artist gets a $1mn dollar advance to put out an album, the label receives all the proceeds from that album until they recoup the initial investment. They also take a significant share (typically 80%) of an artist’s masters or the revenue they make from streams, sales, and licensing. 

Similar to a hedge fund manager selecting a portfolio of stocks, a record label exec takes many bets on many different artists. 

Some stocks will rise in value, and others will crash, just like some artists will become the next Drake while others will remain in obscurity. As a result, the record labels have every reason to promote their own artists. 

Spotify enters the chat. With over 600mn users, Spotify is by far the dominant player in the streaming game and essentially runs a monopoly on streaming. 

As you learned in Economics 101 freshman year, that essentially means they can split the profits however they want. Indeed, on average, Spotify pays $0.005 per stream, which means a million streams would generate a whopping $5,000. 

From our earlier example, the artist would need to generate 200mn streams just to break even on the $1mn advance. The chart below clearly highlights the issue within the music industry. Only about 11,000 artists earn at least $100k on Spotify, and less than 1,500 artists earn $1mn.

A huge part of gaining streams comes through Spotify’s curated playlists like RapCaviar or Today’s Top Hits. Getting a song placed on these playlists can dramatically boost an artist’s visibility. 

So, bringing everything back full circle, it is well within reason to hypothesize that record labels like UMG would use their leverage and relationships with Spotify, Apple Music, and others to boost their artists' streaming numbers. 

This is just basic promotion, and there is nothing illegal about it. The real damming accusation is using fake bots to run up streaming numbers.

But what would Spotify stand to gain from doing that? Don’t they make money either way, regardless of which artist gets higher streaming numbers? That's a bit more complicated. 

Playlists keep users engaged on the platform, and promoting trending or hyped songs could encourage subscribers to remain. Higher overall engagement translates to higher ad revenue for Spotify. 

Lastly, a big part of Spotify’s success is perception. If music consumers feel that they are the go-to platform for discovering hot artists or trendy songs, this serves as its own form of marketing.

Again, all of these are accusations and major ones. There is no evidence to prove that UMG and Spotify engaged in anything other than the typical promotion and marketing that occurs as a normal part of the music business. We’ve seen major artists try to buck up against the industry, but none have been successful.

The Takeaway

In the end, Drake’s battle with UMG and Spotify highlights the growing tensions between artists and the music industry machine. 

Whether it’s about bots, playlist placements, or revenue splits, this saga sheds light on the opaque systems that drive music economics. While Drake might not bring the industry to its knees, his actions spark critical conversations about fairness, transparency, and the power dynamics that govern music today. 

As fans and consumers, we’re left to wonder: how much of what we stream is truly organic, and how much is orchestrated behind the scenes?

Banana Brain Teaser

Previous

The price of gasoline at a service station increased from $1.65 per gallon last week to $1.82 per gallon this week. Sally paid $26.40 for gasoline last week at the station. How much more will Sally pay this week at the station for the same amount of gasoline?

Answer:

Today

Send your guesses to [email protected]

❝

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas

Paul Samuelson

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Happy Investing,
David, Vyom, Ankit & Patrick