Spotify Technology SA (NYSE:SPOT) has offered investors one of the most interesting IPOs of 2018. The company itself is exciting. It already is reaching $5 billion/year in revenues. That’s a gigantic sum for a new IPO. And it dominates its industry — closest rival Apple Inc.‘s (NASDAQ:AAPL) Apple Music badly trails Spotify in subscribers in most non-United States markets.
In addition to having a great product and large market size, Spotify’s public offering is interesting for another reason. The company chose to forgo the usual IPO route. Instead, it sold pre-existing stock directly to the public without the usual IPO underwriting and roadshow. This most nontraditional form of an IPO raises both opportunity and concerns for investors.
Spotify has great service, but will SPOT stock deliver?
Spotify: The Music Industry’s Savior
Between 2001 and 2010, the global music industry’s revenues plummeted from $24 billion to $15 billion. That’s even worse than it sounds after accounting for inflation. Spotify launched in the United States, and I’d argue, not coincidentally, the music industry bottomed that year. After years of flat results, music revenues are now rising again for the first time since the 1990s. Spotify is almost single-handedly responsible for this. Digital accounted for more than half of the music industry’s revenues in 2016, and that’s rapidly moving to streaming and away from iTunes sales.
And the runway is still long. Spotify is still at just at 71 million paid subscribers — triple that (still under 5% of the world’s population) at $10/month, and you have $2.1 billion a month for Spotify and the music labels to split — should be enough to make both sides happy.
Spotify has a crushing lead over its competition. It has double the subscribers of Apple Music, has four times the subscribers of Amazon.com, Inc’s (NASDAQ:AMZN) Amazon Music, and more than 10 times the subscribers of also-ran Pandora Media Inc (NYSE:P). Thus, Spotify seems perfectly positioned to be the Netflix, Inc. (NASDAQ:NFLX) of music. Spotify has a great platform, and its only real competition is coming from a more niche service (Apple Music) that is unlikely to ever achieve widespread global penetration.
In one way, Spotify’s position is even better than Netflix’s. Both have large leads over the nearest streaming rivals. However, unlike Netflix, Spotify doesn’t really have to compete on content. All the major labels distribute to the major streaming players and, if you’re an independent, you basically don’t exist in today’s music environment if you aren’t on Spotify. In other words, Spotify doesn’t have to compete — as Netflix does — for the best content library. Spotify only has to have the best apps and user experience. And as long as they’re up against a company that doesn’t treat non-Apple hardware users well (Apple Music on Android is a deeply disappointing user experience), Spotify has the natural edge there as well.
Loved By Many, But Not Rewarded Financially
Over the past three years, Spotify has grown revenues at a rapid rate. The company brought in $2.2 billion in 2015, $3.3 billion in 2016, and $4.6 billion last year. That’s all healthy. However, the company’s operating losses also surged, moving from $300 million in 2015 to more than $1 billion last year.
The fundamental problem here is simple. With Spotify paying an estimated 70% of its revenues to the labels as licensing costs, that leaves just 30% of the $4.6 billion pie to Spotify to cover all its costs and try to make a profit. When 70% of your revenues go out the door just to deliver your product, it’s hard to make a profit. In the long-run, Spotify needs to get the record labels to give them a better deal, or the business proposition doesn’t work.
Why Not Start Their Own Label?
Fundamentally, Spotify has a serious problem. Unlike Netflix, it has to pay a (large) royalty every time we listen to a song (Netflix would pay once for a film and be allowed to stream it as many times as it wanted). And even with that in place, Netflix couldn’t make money solely paying for content. As Netflix grew, the content producers would demand ever-higher contracts for new content, wiping out Netflix’s potential profit.
Netflix’s solution? It started making its own content. A ton of it, in fact. It’s essentially betting the company on generating enough content to make the subscription worthwhile, even if the likes of Walt Disney Co (NYSE:DIS) and others pull their content. It’s a risky, though probably correct, play.
Spotify may not have this option. It doesn’t own any of the underlying content on its platform. And it would be difficult for Spotify to become its own record label — a la Netflix — since the remaining major labels already own a decent chunk of Spotify’s equity and are unlikely to accept it launching competition against them. Even if Spotify tried to launch a label of its own, the overhead would be immense.
Spotify: Short-Term Pain, Long-Term Winner
Ultimately, I do see SPOT stock working out. The music labels need streaming to succeed — there’s no other option at this point. As long as Spotify doesn’t allow a challenger such as Apple Music to overtake it, it will be too-big-too-fail as far as the music industry goes. Given that only 1% of the world pays for streaming music, there’s plenty of growth left. The pie can expand enough to make both sides happy.
In the short-run though, expect SPOT stock to flounder. Since this wasn’t a traditional IPO, there is no lockup on SPOT stock. Insiders can sell at will. Combine that with a business that is currently losing large sums of money, and you get a recipe for a sinking stock price.
The time to buy SPOT stock will be once it has hit the cusp of turning profitable. If you avoided Twitter Inc‘s (NYSE:TWTR) IPO and waited until the company finally became profitable, you saved yourself a lot of anguish and opportunity cost. I expect a similar run for SPOT stock, where it underperforms until reaching the positive EPS inflection point.
Unfortunately, that could still be a couple of years off.
At the time of this writing, the author held no positions in any of the aformentioned securities. You can reach him on Twitter at @irbezek.
