The curious case of the Spotify direct listing

Spotify Logo

Once in a while, unusual and fascinating things happen in the financial markets. Spotify, a popular music streaming company, filing for a direct listing (instead of a traditional IPO) of its shares on the NYSE certainly qualifies. Given the uniqueness of this listing, I shall disregard my usual “An Unbalanced View” format for IPOs in favour of a more deep dive analysis of this listing.

The Basics

Spotify is a music streaming service founded in Sweden by CEO Daniel Ek and Martin Lorentzon in 2008. It is currently the world’s largest music streaming service with 159 million monthly active users (MAUs), which Spotify believes to be double their closest competitor, Apple Music.

Spotify filed a prospectus with the SEC to begin the following road map to list on the NYSE under ticker symbol SPOT:

Timeline.JPG

Direct listing vs Traditional IPO

The direct listing path is very different from that of a traditional IPO. Here’s a summary of the key differences:

Direct Listing vs IPO.JPG

A direct listing involves the company simply listing all of its existing shares on an exchange, without a need to issue new shares to new investors. As a result, there are no bankers involved and you do not have the usual army of dealers and bankers conducting roadshows and presentations to market the company’s shares to its network of investors. As such, it is a more democratic process as all investors are only given access to purchase shares on the listing day, other than early investors. It is also cheaper as you do not have to pay expensive investment banking fees on this process.

The downside is potential volatility of price after your listing due to the following factors:

  1. No underwriters in place to stabilise the market and prop up the share price
  2. No lock up on pre listing investors, resulting in nothing preventing cornerstone investors from selling on day one.
  3. No IPO price is set, as such there is no price anchoring in the minds of investors.

Some of the reasons given by CEO Daniel Ek for doing a direct listing instead of an IPO  was that:

  1. They had 1.5 billion in cash and short term investments, no debt and thus did not need the money.
  2. They believe in being transparent and not favouring 1 investor over another.
  3. They have been allowing investors and employees to freely buy and sell their shares in the private market and didn’t want to lock up any investors as part of a IPO.

The CEO even committed to not ringing the bell, taking interviews or even being in the exchange when his company’s stock lists, which is undoubtedly a breath of fresh air.

Spotify’s Business Model

Spotify operates on a “Freemium” model, with a free product and a premium upgrade.

Spotify Pricing

Source: Spotify

The free service is basically a shuffle playlist sprinkled with ads. The premium service gives you freedom to play any track and other premium features. The premium service costs $9.90 for a single user, $4.99 for a student and $14.98 for up to 5 users at the same address for the family package. (Take note of the family package pricing)

The company’s only other significant revenue stream is from advertising within the free service. The main cost of the company is royalty fees payable for each play of a song.

Financial Highlights

1. Revenue and Gross Margins

Revenue and cost analysis

Source: Spotify Prospectus

Revenue ratios.JPG

The revenue of the company has been experiencing explosive growth since 2015. Although the revenue growth rate has been slowing, it still grew revenues at 38.55% in 2017. Management issued 2018 guidance of 4.9-5.3 billion which represents a 20-30% year on year growth.

The upside is that gross margins have been improving, mainly due to new licensing agreements with the record labels that have lower royalty rates. The company has also guided for 23-25% margins in 2018, which is a further improvement on 2017.

That itself  is a interesting dynamic though, as by lowering royalty rates, you are essentially squeezing your content providers who can someday decide that enough is enough and pull their content from the platform. We’ve seen that happen with some high profile absentees from Spotify’s platform like Taylor Swift and Jay-Z. Whether Spotify can continue threading that fine line remains to be seen.

2. R&D, SG&A and Other Expenses

R&D Ratios

Other expenses are have been slightly outpacing revenue growth. For a very scale-able business like Spotify, it is pretty surprising as it should benefit from economies of scale. The only reason I can think of possibly costs associated with 2-sided platform development (to be elaborated later) and marketing into new markets. One to watch out for.

3. Cashflows

Cashflows.JPG

Source: Spotify Prospectus

The business as turned cashflow positive in 2016 and continues to improve into 2017. This is a good sign as the continuing operations is able to fund itself.

4. Key Performance Indicators

KPIs

Monthly active users (MAUs) and premium subscribers has been growing steadily over the past 3 years. Management has guided for further growth to 198-208 million MAUs while premium subscribers are expected to grow to 92-96 million. This represents further declining growth rates perhaps due to the law of large numbers and competition.

Interestingly, Premium average revenue per user (ARPU) has been declining, in a large part due to the Family Package deal earlier mentioned. This means that each premium user signed up has been worth less in incremental revenue as the years go by. Another thing to watch out for going forward.

The Positives

1) Financials paint a mostly rosy picture

The company is experiencing double digit percentage growth in revenue and subscriber growth, which are fantastic numbers. Gross margins are also improving and the company is already operating cashflow positive. With many markets still to unlock like India and South-east Asia, there is still a clear pathway to growth those numbers.

Blemishes include operating expenses outpacing revenue slightly and declining ARPUs.

2) Recovery in Music Industry Revenues

Global music revenue trend.JPG

Source: IFPI

Global music industry revenues have stabilised and slowly recovered since 2014, with it largely driven by growth in Digital music revenues and music streaming. If Spotify continues to maintain their market leading position, they will be able to ride this wave.

3) The Big Data value driver

The unique advantage Spotify has is the ability to identify each user’s listening preferences and suggest music and playlists to try and discover. On the flipside, they are able to use this data to build tools to help artistes to better engage and target their fans. This creates a “2 sided platform” mentioned earlier that allows you to sell services to both the artiste and the listener.

With the recent focus on data privacy arising from the Cambridge Analytica scandal with Facebook, Big data software firms are experiencing a re-rating in valuation. As such, this aspect may be a drag on the company. I would argue that there is a smaller scope of use for knowing my music preferences than if they knew my age, race and job. I mean, is Putin going to conclude that because I love Jay Chou music, I would be in favour of Taiwanese independence and target me as a result?

The Risks

1) Competition

The giant elephant in the room is of course Apple Music. With Apple Music on track to surpass Spotify’s US subscriber base, Apple has proven to be significant competitor to Spotify. With cash to burn and a ready database of iOS users to sell their services to, Apple could rain on Spotify’s parade.

That being said, given the closed ecosystem nature of Apple’s strategy, I see potential for both services to thrive with Spotify filling in the non-Apple gaps of the market.

2) Reliance on Artistes and content providers

Spotify is very much reliant on the artistes and content providers to stay interested in the platform. This is very much why Netflix pursued an original content strategy, to not be beholden to their content providers. As such, Spotify has to continue to drive value to their content providers while also balancing the licensing fee reductions. We’ve already had Taylor Swift and Jay-Z leave the platform, it’ll be crucial if they can retain and provide a greater value proposition to their artistes and maybe one day bring back these A-list artistes back on board.

3) Ownership structure

Principal Shareholders.JPG

Source: Spotify Prospectus

As is the case with founder driven tech unicorns, although founders Daniel Ek and Martin Lorentzon own a combined 38.9% of the company, they hold a combined 80.4% of all the voting rights in the company by virtue of the Beneficiary Certificates issued to them pre-listing. As such, you are essentially entrusting your money to them to hopefully do the right thing with the company.

4) Potentially unstable market prices

As mentioned above, the direct listing path results in no share lock-ups or market stabilisation facility. Plus the current market climate being highly volatile, much care has to be taken if you choose to invest on day 1.

What price to buy?

As there is no IPO price, retail investors especially do not have a price anchor to target and fix to.

Thankfully, the prospectus provides some guidance:

Share Price History.JPG

Source: Spotify Prospectus

The prospectus shows the private market share transaction price and volume since 2017. Based on this, it is likely that the share price will trade at least between $95 – $132.50, implying a $16.8 – 23.4 billion valuation.

Renown business valuation professor Aswath Damodaran at NYU also did a Discounted Cash Flow (DCF) valuation of Spotify and arrived at a valuation of $115.31 based on his own set of assumptions. He also has done up a excel file for his DCF if you wish play around with it. His blog and his workings can be found here.

Conclusion:

In a world where tech unicorns going public are becoming increasingly rare, Spotify seems to have chosen the right time in their growth story to list – a good enough story to garner interest but with enough execution risk to allow people to speculate and participate in the upside. How it will trade and at what price on day 1 intrigues me and I will definitely allocate some capital to buy if it hits my personal price target.

Happy Hunting,
KK

References:
Direct listing prospectus
Spotify Investor Day presentations
Spotify 2018 guidance

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