Spotify’s bid to bring music to investors’ ears

Spotify SharesPost Column VC

By Rohit Kulkarni, SharesPost

Spotify is one of the global music industry’s only bright spots of the past decade. The question now is will it bring music to the ears of investors.

If the company continues on its growth path and executes on its anticipated IPO, this is one possible outcome. But there are no assurances given the titanic shift the industry has experienced.

When Daniel Ek and Martin Lorentzon founded Spotify in 2006, music sales from CD and MP3 formats were at their peak. Digital downloads were just picking up, and on-demand music streaming was almost nonexistent.

Now after 10-plus years of global music industry declines, music sales growth accelerated to 6 percent in 2016, the fastest pace in 15 years. Arguably, Spotify was the single largest driver of this growth.

Spotify has become the global leader in music streaming with an estimated 140 million monthly active listeners and 60 million paid subscribers. It has established licensing partnerships with the “Big Three” music labels in the industry and recently renewed contract agreements ahead of its planned public offering in the next six to 12 months.

Despite all these positives, investors have plenty of reasons to be cautious about Spotify, including its lack of profitability, its relations with the record labels, the growing competition from well-capitalized and entrenched tech stalwarts, such as Apple, Amazon and Google, and, most importantly, the company’s valuation. In our new 61-page report on Spotify, which included a nationwide online survey of 5,500 streaming music listeners, we raise three obvious questions:

Can Spotify ever turn a profit?

Spotify pays $0.70 in royalty payments for every $1 earned. Its average revenue per user (ARPU) has been decreasing over the past three years. Ad-based streaming is running at a negative gross margin. While we have been encouraged by Spotify’s recent gross margin improvements in 1H 2017, given the licensing, marketing, and R&D costs to compete in this competitive space, we don’t expect the company to be profitable in the short term.

But the good news is that its paid subscriber base has been growing strongly. We expect it to reach up to 80 million within the next couple of years. That will raise margins and provide the company with leverage to renegotiate the royalty structure with label owners. If all this materializes, we believe Spotify will be on the path to profitability in the long-term.

How will the public markets value Spotify?

One way to value Spotify is to use public company comparables. We believe investors would triangulate Spotify’s valuation multiples based on music radio services, such as Pandora, pure-play audio streaming subscription services, such as Sirius XM, and video streaming subscription services, such as Netflix.

However, Pandora, Sirius XM, and Netflix have traded at fundamentally different valuation ranges. Pandora’s EV/Revenue multiples have hovered around 1.0x to 1.5x, whereas Sirius XM is valued at an estimated 4.0x to 4.5x its 2018 revenues. Netflix clearly trades at a premium of about 6.0x to 7.0x its 2018 estimated revenues.

In our base-case scenario, if Spotify’s 2018 forecasted revenue growth exceeds 30 percent and its 2018 forecasted gross margin stays above 15 percent, we estimate potential public equity investors would assign a EV/revenue multiple in the range of 3.5x to 4.0x on its 2018 projections. This range is largely consistent with valuation multiples used by Spotify for stock options in its publicly available financial statements. Our base-case scenario leads us to believe that Spotify could go public with a valuation above its most recent private valuation — roughly $21.5 billion — in about 6 to 12 months.

Another way to value Spotify would be to compare its metrics with Sirius XM. Sirius XM has 32 million paid subscribers and over $5 billion in annual revenues growing at about 10 percent year-on-year. It also has a 50 percent gross margin. Sirius XM is valued at $30 billion. Spotify would have more than 60 million paid subscribers and would earn more than $4.5 billion in revenues in 2017 growing at more than 35 percent year-on-year with a gross margin approaching 20 percent. Simply put, there are a lot of parallels between Spotify and Sirius, and we would argue that Spotify’s valuation has further upside if it continues to improve its ratio of paid subscribers to ad-based users.

Where could we go wrong?

Spotify’s ability to grow significantly beyond its current private valuation still heavily depends on its execution over the next 18 to 24 months and investor sentiment. Both will govern the revenue or EBITDA multiples. Most crucially, a premium valuation rests on the assumption that Spotify will continue to grow its consumer adoption and monetization levels, while signing more direct deals with record labels. If Spotify is successful on these fronts, it will indirectly help the company with operating costs and pave the way to profitability.

However, the risk is that competition may lead to substantially higher marketing expenses or put pressure on pricing. Furthermore, Spotify has been an early adopter and vocal advocate of Google Cloud Services. In the case of Snapchat, cloud computing has had a negative effect on gross margins. Spotify’s ramp-up in usage and spend on Amazon Web Services will likely weigh on its near-term profitability.

The other unknown risk factor stems from Spotify’s planned public offering. Spotify plans to go public using direct listing rather the traditional IPO process. While this approach comes with a one-time saving in underwriter fees and likely avoids shareholder dilution, we believe it also risks near-term volatility and a potential investor discount on Spotify’s valuation.

Rohit Kulkarni is managing director and head of research of SharesPost.

Photo of earbuds and Spotify logo courtesy of Reuters/Christian Hartmann

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