As predicted as much as a year ago, music-streaming leader Spotify's eventual IPO was only a matter of time. More to the point, the comically onerous terms of its most recent round of financing give Spotify a strong incentive to go public as quickly as possible.
So it should come as no surprise that multiple reports over the past several months have claimed that Spotify's IPO could be only months away, though the company may choose an unconventional way of listing its shares.
But based on info from a recent leak of Spotify's 2016 financial data, the company seems to be sitting in a sea of red. What do the numbers say about the long-term prospects of the company's business model?
Spotify: Still seeing red
Last week, the music industry site Music Business Worldwide published Spotify's updated financial statements for 2016. As with past reports, the financial statements included a number of interesting takeaways.
In short, the good news is that Spotify's revenue and user growth continue to climb at impressive rates. The bad news? The streaming service's operating losses continue to widen. Here's a quick snapshot of how Spotify's sales and operating profits have trended over the past six years.
Spotify's revenues increased an impressive 52% in 2016 to roughly 2.9 billion euros, which equates to $3.2 billion at the current exchange rate. Unfortunately, the company's net losses more than doubled to 539 million euros ($603 million at current rates).
This doesn't necessarily mean that Spotify cannot eventually become a profitable stand-alone company. However, it does highlight a critical risk to the company's business model, namely its extremely-low-gross-margin structure.
Spotify's fundamental problem
Spotify's gross margin has hovered between 14% and 16% over the past three years, which compares rather unfavorably to most publicly traded companies. In fact, average gross margin among S&P 500 components has recently been between 41% and 49%, according to data from CSIMarket. Unfortunately, low margin is likely a permanent fact of life for Spotify, since the record labels from which Spotify licenses its songs have the majority of the say when it comes to setting royalty rates; Spotify's business falls apart without music licenses.
As a matter of basic accounting, Spotify will be able to turn a profit if it can ever reach a point where its gross profits exceed its operating expenses. However, the company continues to scale operating expenses, a trend that seems likely to endure to some degree as the company grows. It will need to continue to market its service to acquire consumers who are adopting on-demand streaming services -- or risk losing them to a rival service like Apple Music, Pandora (NYSE: P), or any of the myriad of streaming alternatives.
Paradoxically, continuing to spend money to acquire new users is likely the only hope Spotify has of ever growing large enough to gain the leverage to negotiate more favorable royalty rates with record labels. Even then, it's unclear whether this will ever work at scale. Critically, though, the company's spend-money-to-make-money strategy may also create a problem for its forthcoming IPO.
What this means for Spotify's IPO
While Spotify might be able to grow into its business model -- might being the operative word -- it's almost certain it won't be able to do so before its coming IPO.
According to many reports, Spotify should conduct what will be the most high-profile IPO since Snap as soon as this fall. The company is also reportedly considering bucking the traditional IPO practice of hiring an investment bank to price and sell its shares, instead favoring what's called "direct listing."
In such a process, holders of Spotify stock will be able to sell shares directly into the market, rather than via a traditional agent like a bank. This can save companies millions in underwriting fees, but lack of an experienced bank working to set the prices on its behalf means that Spotify's share price will be determined entirely by the supply-and-demand dynamics of the market. This may sound appealing in the abstract, but it carries some significant risks for Spotify in particular, especially given the company's most recent private market valuation.
Spotify most recently raised $1 billion in private capital at a $8.5 billion valuation in mid-2015. However, since it's a profitless growth company with a structural business-model problem it has yet to solve, it seems completely reasonable that public-market investors could give it a much lower valuation.
Here, Pandora is a useful, if not cautionary, example. After riding high from 2012 to 2014, it was caught by the same margin-structure issues that plague Spotify today. In fact, Pandora's share price has plummeted from around $37 per share to its current price of $6.85, which equates to a market capitalization of $1.5 billion.
Admittedly, Spotify has done some things better than Pandora, notably focusing on on-demand streaming rather than radio. However, Pandora's stock-price implosion should absolutely loom large in the minds of Spotify's executive team -- and anyone considering purchasing its stock during, or shortly after, its forthcoming IPO.