As we've seen definitively over the past two years, streaming is the unequivocal future of the music industry. While great for consumers, it isn't so black-and-white whether or not this is a positive development for investors.
On-demand streaming leader Spotify is reportedly targeting its IPO next year, a slight surprise for those of us who have followed the company for some time now. However, now that the timeline for Spotify's IPO is clear, the focus has shifted to an entirely different question: Is Spotify's valuation tenable as a public company?
Inside Spotify's 2017 IPO plans
A report from Bloomberg cites five different individuals with knowledge of the matter in suggesting that Spotify purportedly plans to conduct its long-awaited IPO some time late next year. This timing alone seems potentially concerning for Spotify, though not without its merits, either.
Given the grinding terms of the $1 billion in convertible debt that Spotify raised earlier this year -- terms that grow more onerous with the passage of time -- it only seemed reasonable that Spotify CEO Daniel Ek would push headlong toward an IPO, possibly as soon as this year. Clearly, that isn't the case, and Bloomberg's report offers some insight as to why that might be.
Spotify apparently remains locked in negotiations, attempting to lower the royalty rate it pays record labels. According to the Bloomberg piece, Spotify currently pays record labels -- led by music industry giants Universal Music Group, Sony Music Entertainment, and Warner Music Group -- roughly 55% of its revenue, though it also pays unspecified royalties to music publishers, as well.
Still, Spotify's royalty rates apparently sit below the industry average. Rival Apple (NASDAQ:AAPL) reportedly pays labels 57.5% of revenues from Apple Music as royalties, a figure that further underscores key differences between Apple and Spotify. However, in a likely (and understandable) pre-IPO push toward profitability, Ek hopes to lower Spotify's royalty rates to somewhere below 50%, despite the guarantee of objections from the labels. If Ek cannot reach an agreement with the major labels, it doesn't bode well for Spotify's future as a publicly traded company.
Will Spotify's $8 billion valuation stand?
The problem facing Spotify is that even if it successfully negotiates its royalty rate below 50%, it still gives the company very little wiggle room in the way of profits to support its $8 billion valuation.
Spotify's revenue is expected to grow 50% in 2016, which implies that the streaming giant will generate sales of roughly $3.18 billion. However, using leaked financials from the fantastic industry site Music Business Worldwide, Spotify doesn't even approach breaking even until its royalty rate dips below 49%. This calculation also assumes that other line items for Spotify remain stagnant as its revenue increases, which is rarely ever the case for any business. The analysis gets worse, unfortunately.
There's also the parable-esque corporate history of streaming music rival Pandora Music (NYSE:P). Pandora was founded in 2000, making it a veritable dinosaur in the digital music business. Since it transacted its own IPO in 2011, the entire financial record we have for the company shows little -- if any -- profits. Maybe there's something more systemic about the music industry (cough: its cost structure) that makes it inhospitable to consistent profitability.
Furthermore, Spotify, Pandora, and Apple Music don't appear to enjoy the same kind of hugely scalable market opportunities offered by other growth industries, like e-commerce or cloud computing, to list a few. According to the music industry body IFPI, the global music industry produced total sales of just $15 billion last year. In that context, Spotify will already have grown to represent more than 20% of the global music industry by this year, assuming everyone's numbers are indeed accurate.
As a final piece de resistance, the competition for users should likely intensify. Apple's redesigned Apple Music -- not to mention its potential purchase of exclusive content-laden Tidal -- figures to strengthen Apple's hand in streaming. Pandora is a virtual lock to roll out its own on-demand streaming service from the carcass of Rdio, which it purchased out of bankruptcy on the cheap last year. Amazon is also reportedly developing its own on-demand streaming service, and Alphabet hasn't really gotten its act together with its muddled streaming strategy. This mounting competition isn't likely to make life easier for Spotify.
So how does a company support an $8 billion valuation in an industry with scant history of profitability, with a relatively limited growth ceiling, and with mounting competition from companies like Apple and Amazon -- companies that can afford to lose money on their services? I'm not saying Spotify can't, but it's certainly a question for which I don't have a credible answer, either.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Andrew Tonner owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Apple, and Pandora Media. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.