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In the last few weeks, we have seen two high profile unicorns file for initial public
offerings. The first out of the gate was Dropbox, a storage solution for a world where
gigabyte files are the rule rather than the exception, with a filing on February 23.
Following close after, on February 28, Spotify, positioning itself as the music streaming
analog to Netflix, filed its prospectus. With it's larger potential market capitalization and
unusual IPO structure, Spotify has attracted more attention than Dropbox, and I would
like to focus this post on it.
Source: IFPI
Note that not only has the move towards streaming, in proportional terms, been
dramatic, but disruption has come with pain for the music business, with a drop in
aggregate revenues from $24 billion in 1999 to about $16 billion in 2016. In a bright
spot, revenues have started rising again in 2016 and 2017, and it is possible that the
business will rediscover itself, with a new digital model. Spotify was not the first one in
the business, being preceded by both Pandora and Soundcloud, but its success is
testimonial to the proposition that the spoils seldom go to the first movers in any
business disruption.
The Spotify business model is a simple one. Listeners can subscribe to a free version,
with limited customization features (playlists, stations etc.) and online ads.
Alternatively, they can subscribe to a premium version of the service, paying a monthly
fee, in return for a plethora of customization options, and no ads. The company's
standard service cost $9.99/month in the United States in 2018, with a family
membership, where up to six family members living at the same address, can share a
family service for $14.99/month, while preserving individualized playlists and stations.
Prices vary globally, ranging from a high of $16.94 in the UK (for standard service) to
much lower prices in Eastern Europe and Latin America. (You can check out the
variations in this fascinating link that reports the prices across the world for Spotify, in
dollar terms.) Spotify pays for its music content, based upon how often a song is
streamed, but the rates vary depending on whether it is on the free or premium service
and where in the world, creating some complexity in how it is computed. To get a
sense of where Spotify stands right now and how it got there, I looked the prospectus,
with the intent of catching broad trend lines. I came up with the following:
3. Content Costs are coming down: While Spotify insists that it is not
scaling back payouts to music labels and artists, the company has been able
to lower its content costs as a percent of revenues each year from 88.7% of
revenues in 2015 to 79.2% of revenues in 2017. In fact, Spotify has conveyed
to investors that its intent is to earn gross margins of 30%-35%, implying that it
sees content costs dropping to 65%-70% of revenues. There is an inherent
tension here between what Spotify has to convince its investors it can do and
what it tells the music industry it is doing and the tension will only intensify,
after the company goes public.
4. Other costs are trending up: There are three other buckets of cost at
Spotify -R&D, Selling & Marketing and G&A- and these costs are not only
growing but eating up larger proportion of revenues. If there are economies of
scale, as you would expect in most businesses, they are not manifesting
themselves in the numbers yet. The collective load of these expenses are
creating operating losses, and while margins have become less negative, it is
primarily through the content cost controls.
At this stage of its story, Spotify is a growth company with lots of potential (no irony
intended) but lots of rough spots to work out.
My Spotify Valuation
In keeping with my view that you need a story to provide a framework for you valuation
inputs, and especially so for young companies, I constructed a story for Spotify with
the following elements:
Download spreadsheet
It goes without saying, but I will say it anyway, that I made lots of assumptions to get
to my value and that you may (and should) disagree with me or some or even all of
these assumptions. You are welcome to download the spreadsheet that contains my
valuation of Spotify and make it your own.
Bottom Line
There are three elements missing in this post. First, I have argued in my prior IPO
posts that what happens after initial public offerings is more of a pricing game than a
value game. To those of you who want to play that game, I don't think that this post is
going to be very helpful. In my next post, I will look at how best to price Spotify, why
you will hear pessimists about the company talk a lot about Pandora and optimists
about Netflix. Second, there is the argument that top down valuations, like the one in
this post, are ill equipped to value user or subscriber based companies. I will also use
the user-based model that I introduced last year to value an Uber rider and an Amazon
Prime member to value a Spotify subscriber. Finally, there is the lurking question of
what Spotify is learning about its subscriber music tastes and how that data can be
used to not only modify its offerings but perhaps create content that is more closely
tailored to these tastes. That too has to wait for the next post.