Spotify, Uber, and Lyft are three of the biggest unicorns out there, and there's been buzz about them possibly going public for years. But all three companies have some pretty serious red flags that investors should know about.

In this week's episode of Industry Focus: Tech, analyst Dylan Lewis and contributor Evan Niu, CFA, examine all three companies and explain the biggest issues they're facing. Find out why Spotify is losing money even as its subscriber base grows exponentially, why Uber's growth strategy is unsustainable, how Lyft and Uber might someday work up to profitability, and more.

A full transcript follows the video.

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This video was recorded on Dec. 8, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, December 8th, and we're taking a break from stocks to talk unicorns. I'm your host, Dylan Lewis, and I'm joined on Skype by tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: Not much. Ready for the weekend, as usual.

Lewis: As usual. You always have quite a bit on your hands, writing for the site, managing your kids. You're a busy man.

Niu: That's true.

Lewis: One of the things we're going to talk about today was brought on by something you've written recently that I've seen on We're going to do something unusual on today's show, we're going to talk about private companies, some high-flying unicorns, that have been the subject of IPO speculation for quite some time, and talk about whether we're even interested in them as investments should they go public in 2018. It's tempting to look forward and see if that might be happening. The piece of yours on the site that I saw that got me thinking along this line was some comments that were made by Jimmy Iovine, the Apple (AAPL 0.86%) Music chief, about the music streaming space, specifically Spotify.

Niu: Yeah, he was more or less suggesting that they're in trouble because the streaming music business is not really a great stand-alone business. I've stressed this in articles before, there's lots of industries that just aren't great businesses, and sometimes they can be better off served by larger companies that have this as a side business that they don't need to rely on for profits. Spotify is a stand-alone pure play on music streaming, and the economics of music streaming just aren't great. It's really hard to build a stand-alone business on this, even though Spotify is huge and by far the most popular paid streaming service in the world. So, they're definitely doing very well at executing, but if the financials don't look great, there's not much you can do if the economics just aren't there.

Lewis: And we're going to talk about the numbers there. You look at the user growth that they've shown and some of the top line growth that they've shown, it's very tempting. This is one of those companies that has been the subject of rampant speculation, I think going back even to 2015, about when they will go public. Hopefully, on this show, we might ease investors' gumption or enthusiasm about this company, because I think you and I both see a business that's going to struggle long-term. For folks who aren't super familiar with Spotify, it's a music streaming platform. They offer both an ad-supported and premium account model. The premium accounts cost $9.99-14.99 a month. That catalog that they offered gives you access to tens of millions of songs. If you have a premium account, you can download them and listen to them offline on your device as well. Recent insider private trades have valued the company around $16 billion. I've seen that, were they to go public at some point in 2018, which seems pretty likely, they would be going public at some valuation around $20 billion or so. Looking at the financials that we have for them, we were lucky enough to get something, looking back at 2016, they put up about $3 billion in revenue. Looking at some of the price to sales figures that we've seen in the past year or so for some of these companies going public, not crazy at that valuation, but certainly a little bit rich, Evan.

Niu: Right. I think one thing that's also important to consider is, all of the reports that we're seeing about Spotify's potential IPO suggests that they're looking at doing a direct listing, which is very different than the way that most companies go public. Most companies, when they go public, there's an IPO, they raise a bunch of capital, they issue a bunch of shares, they work with investment bankers. A direct listing basically bypasses all of that, and they just take their shares and list them on the New York Stock Exchange or the NASDAQ or wherever they choose to list. Then, the shares start trading. 

So, there's a couple of pros and cons to this approach. It's simpler, it's more direct, and they basically get to avoid all these fees that companies typically have to pay investment bankers. There's no roadshow, there's no dilution to existing shareholders. But the risk is, without the guidance of these bankers that typically crunch these valuation numbers for you, the market is kind of on its own to figure out what this company is worth. Obviously, when you talk about IPOs, we always talk about valuation, right? But if you're doing a direct listing, there's no set valuation, the shares are just there, and what is the market going to do with them? So, so far as that $16 billion number that you just mentioned, that was the most recent private transaction. But if they go public through this direct listening, that number doesn't really mean as much because it's really all just up to the market at that point, of what the market is willing to pay. So, there's a lot of risk of a lot more volatility, because there's a lot more uncertainty. So, there's pros and cons, but not many companies go this route. But it's an interesting approach. I do think it's interesting, because they're not raising capital, but Spotify probably needs capital. They did a $1 billion convertible note offering in early 2016. You have to think it's probably about time to run another capital raise at some point. It's interesting that they're not looking to raise capital, even as they might go public soon.

Lewis: Yeah. One of the things that has led a lot of people to think that they will be going public soon is some of the debt that they raised recently, I think about a year or a year and a half ago, where it basically had this escalating interest rate on convertible debt notes the longer the company stayed private, so a lot of people looked at that as a shot clock for the company's public issuance, thinking that, not only are they probably going to go public anyway, but now they have a financial incentive to go public, because the longer they hold out, the more they're going to be paying back to some of these people for access to that capital.

Niu: Right. And as you mentioned, they're losing a bunch of money, so you would think they would need more at this point. Or soon, at least.

Lewis: To circle back on that financial breakdown, they lost just over $500 million in 2016 on $3 billion in revenue, and that was a widening lost off of 2015, where they lost just under $250 million off of $2 billion on the top line. We talked about the economics of the music industry. It's probably worth diving into that now, and why they aren't really great, because those financials seem to illustrate it pretty well. It's not a space where the numbers are going to work out for a lot of these players.

Niu: Going back to Iovine's comments, he basically just argued that there's no margins in music streaming. He mentioned some examples of other companies that have bigger businesses. Apple obviously has a humongous business with all the other stuff it sells, and it makes the money there, so it doesn't really need to make money on streaming. Same thing for Amazon or Google, most of these companies that participate in music streaming have huge other businesses. The only pure plays that are really out there are Spotify and Pandora. Pandora is obviously the only public pure play comparable, I think. Pandora has a completely different model, and they've also been a pretty disappointing investment over the years. But, yeah, there's just not a lot of money to be made. One of my big questions about Spotify in particular is, why are there costs so high that they're losing this much money? Certainly, royalties are the biggest part of their costs, and that makes sense, but as far as other operating expenses, what is it that they're spending this money on? As a private company, we have no way to tell, because we don't have any real insight beyond the occasional leaks. But the occasional leaks only give you the top and bottom line, they don't give you any granular detail of the cost structure, specifically their operating expenses. What are they spending all this money on?

Lewis: I have to imagine that some of that is supporting the really rapid user growth that the platform has seen. They've really had exponential growth. You go back to 2014, they had 10 million users on the paid side. 2015, 20 million. 2016, 40 million. So, they've had several years in a row of 100% user growth. And now, most recently in 2017, they're around 60 million paid users. If you back that out and look at the folks that are using it on the ad supported side, that's the free accounts, they're north of 140 million active users at this point. So, they do --

Niu: That's total. Total is 140, paid is 60, so the free is 80.

Lewis: Oh, sorry, thank you for that clarification there. But, that's a lot of people using the service that they need to provide the tech support for and the hosting costs for.

Niu: Right. I would really want to see what they're spending money on. Beyond the royalty aspect, which would be the gross margin side of it, are they making enough on the gross profit to actually cover operating expenses? Certainly, we need to get an actual look at what their income statement looks like before we can make real strong calls on it. But generally speaking, take Iovine's word for it. This guy has been in the music industry for 30 or 40 years. If he says there's no margin, I believe it.

Lewis: And because they don't have another part of their business, and I think Iovine went on to say, Amazon can decide to bundle this into Prime at an even cheaper cost. I think right now, there's a certain part of the music catalog that is free on Prime, and if you want access to even more music, you can get Amazon Music Unlimited and pay for that on a monthly basis. But Iovine's point was, if Jeff Bezos decides, we're just going to drop it to $7.99 a month, what does that do to Spotify?

Niu: It's completely reasonable. You could totally see Bezos doing that, because that's how he rolls. [laughs] 

Lewis: And there really isn't all that much differentiating these services. It would be easy to liken Spotify to a Netflix for music streaming, but I think the difference is, Netflix has built up this really amazing catalog of Netflix Originals, and that's content that you can't get anywhere else. You don't really see that exclusivity in the music streaming space.

Niu: Right. It's a completely different sector, even though music and video, people tend to think of them similarly. But the businesses and the industries are totally different. Like you mentioned, all of the songs are basically everywhere, give or take maybe small discrepancies in the timing based on exclusivity or whatever these different companies score from time to time. But those exclusivity windows are generally limited for a few months or weeks or whatever. But one of Iovine's points was, music is everywhere these days. You can go on YouTube and find songs for free, and that's an example he specifically mentioned. There's just so many places where you can get this content for free, and it's all the same and it's all everywhere. So, that presents some really unique challenges to the music industry that the movie, TV and video industry doesn't necessarily have to deal with. Of course, there's a lot of licensed content out there too, but a lot of it is much more differentiated, it's much more exclusive to certain platforms or certain networks. It's just a very different beast. 

Lewis: To borrow a term from the Thursday's Energy show, I think in some ways, digital music has been commoditized. And when you're working in that space, you need something that sets you apart from other players, otherwise you don't have any pricing power. And I think that's one of the big things, when I look at Spotify, that I see for them as a long-term struggle. If they can't make the numbers work now, it's not like they're going to be able to Netflix it and raise prices $1 every year or every eight months or something like that to eventually hit the point where they're making margins on their content. They'll hit a certain point where people are going to be like, I'll just switch over to Apple Music because it's still $9.99 a month and I'm getting access to all of the same stuff.

Niu: Right. It's a race to bottom on the price. It's interesting, because what could Spotify do? There's not a whole lot they could do. I guess another question, relating back to wanting to get more detail on the cost structure is, can they scale it? Is this really scalable? Because this should be something that's really scalable. There should be some point where they might be able to make money if they can get large enough. But they're already so huge and they're still losing money. So that undermines the idea of scalability, if they're already at 60 million paid users and still losing quite a bit of money, where's the operating leverage?

Lewis: I think "losing money" is probably going to be the theme of today's show. We're also going to talk about Uber and Lyft in the second half the show.

Evan, for the second half of the show, we're talking about the biggest unicorn out there, the biggest start-up with over a $1 billion valuation, and that is none other than Uber. They've been head of the pack for quite some time.

Niu: Yeah, Uber is just insane. It's so expensive. I honestly sometimes wish I could short them. Uber, in my opinion, is one of the most unethical companies in recent memory. It's just so ruthless and they seem to have no scruples and they'll do whatever it takes. I just don't think it's a sustainable approach. Even before you get to the numbers, the financials, culturally speaking, they're just such a terrible company.

Lewis: They have had a really rough 2017. Why don't we give a couple of bullet points on exactly what happened for the company? You have these series of reports of the workplace culture of sexual harassment. You have issues with the company skirting local law enforcement in some app features that were available to drivers. You have a lawsuit from Google's self-driving car project, Waymo, about intellectual property. All of that led to founder Travis Kalanick stepping down as CEO due to this flurry, basically an avalanche, of really bad PR for the company.

Niu: I'm actually kind of surprised all this stuff didn't culminate until this year. This stuff has been going on for many years at Uber. They've always been ridden by scandals. There was a scandal a couple of years ago that you and I were talking about earlier where they were said to create a $1 million smear campaign against a journalist for writing negative things about them. I mean, what company does that? [laughs] And that was a couple of years ago. Even still, Uber has continued to march higher and higher in valuation, continue to grow their position in market share because they're so aggressive. These scandals haven't really taken a toll until this year, which in my mind is kind of late.

Lewis: These scandals have done two things that you don't see all that often for an industry-leading company. One is, given they're private, they actually had a revision down in their valuation. They're currently around a valuation of around $60 billion or so. At times, it seems like they were slightly above that based on some insider trades. Given a recent interest in investment from SoftBank, which is this Japanese telecom conglomerate, they're looking to buy $7-10 billion in shares from the company, and they're going to be doing so from early investors that are taking a 30% haircut on their shares. You don't very often see a private, growing, big-time company like this have people get access at a reduced rate. Typically, you see up rounds of valuations and up rounds of valuations. So, that's point No. 1 there. And point No. 2 that you don't see all that often is, you had a major exodus of people who saw this bad press, saw what a toxic environment there was at this company, and decided, we're going to go over to their competitor, Lyft. We're going to abandon Uber. That was another big PR thing that they had to overcome this year.

Niu: Yeah, they're in the process of potentially having this down round. Generally, there have been a lot more down rounds where valuations come down in the private market over the past two years or so, because this unicorn market has gotten a little overheated. And Uber is certainly the biggest example. SoftBank, as you mentioned, is doing this tender offer, where they're trying to buy shares, I think the valuation is around $50 billion vs. the prior valuation of $60-70 billion. So, that doesn't really inspire a lot of confidence. But, they are trying to accumulate a position. I think they're shooting for a 15-20% stake. But, it's also important to note that, through a tender offer, they're buying their shares off of the existing shareholders, so Uber itself won't get any of that money. They're not raising capital through this. So, it's this private negotiation where SoftBank is trying to get investors to tender shares.

Lewis: Yeah. You hear, these down rounds, it's not something that we see all that often. Looking at the financials for this company, in spite of all these crazy things that have hit them this year, they're still growing, and they're still growing very well. In 2016, we saw net bookings of $20 billion, revenue of $6.5 billion on that. And net bookings is basically what was booked as rides on the app itself. On all of that income, losses of $2.8 billion. You go to this most recent quarter that we have access to, Q3 2017, they posted net bookings of $9.7 billion, which is up 12% year-over-year, and you compare that, that's basically half of what they did in 2016 in one quarter there. Revenue of $2 billion. Again, losses of $1.5 billion. So, you show massive top line growth here, and, it seems, widening losses as well.

Niu: Right. They just burn so much cash at this incredible rate. I see Uber as, they're subsidizing rides using venture capital money in an effort to be super aggressive on pricing in order to grow their market share and take down all their rivals. But I view it as unsustainable because they're losing so much money. There's this good quote that's relevant here. We were talking about Sarah Lacy, she said in an interview lately, "The thing that's going to kill Uber has nothing to do with who's at the company, and it's not going to do with the scandals, it's not going to do with any of these. The thing that's going to kill Uber is when Uber finally has to charge what it costs to get a car to you." And that kind of speaks to the underlying economics of how Uber operates. They're pricing below cost, it's essentially a loss leader, where they're losing incredible amounts of money. They're growing market share and growing their top line, but they're on a really unsustainable path.

Lewis: And early on, that narrative made sense for Uber, because they were selling investors on this idea that, we're going to price very competitively, and sometimes even take some losses on rides, so that we can build out our driver network, build out our services, and create this massively disruptive transportation system. And that worked really well. It got them all these drivers in all these different cities, it helped with their international expansion. But what then happened was, they had competitor Lyft basically do the same thing. And once you have a network of drivers built out, there's no exclusivity with those drivers. I've gotten into so many Ubers where they have the Uber sticker, but they also have a Lyft sticker, and maybe they have a Via sticker -- that's a big service here in D.C. They can drive for any of them, and the drivers themselves are going to push toward whichever platform is giving them the best deal. That makes it really tough for them to ever hike prices back up to where they should be so that they can actually start making margins on all those rides.

Niu: Right. I think that's the sad thing about this whole situation. Uber has single-handedly created this perception in people's minds that rides should cost less than they actually do. And because of their aggression and their size, they force their rivals like Lyft, but also this whole industry, to cut their prices just to compete, and it sets the entire industry on this unsustainable path. If people think rides should cost $X, but that's way below what it should cost, it's really hard to reverse course on that value perception from the consumer. If I'm used to paying $20 for a ride, but if the ride should cost $30... it's really hard, how do you go back from that?

Lewis: It's tough to raise prices once you set certain expectations for what something should cost. The impact, when you look at Lyft's financials, too, we have access to those, you go to 2016, they booked $700 million in revenue and lost $600 million on that. So, clearly the economics aren't looking all that great for them. The company has said that they are looking to be profitable by 2018, which seems kind of crazy to me, given the pricing environment that these two guys are in, and what they've created for themselves as a market.

Niu: I think the one thing that really has the potential to change everything, quite literally everything, and this is obviously what everyone is talking about, autonomous driving, which has the potential to dramatically shift the cost structure for these companies, because you're no longer relying on these contractor drivers, which is a huge part of the cost structure. And if you can shift to this first party corporate-owned fleet of autonomous cars, then everything turns. The entire economics of the industry completely change. Of course, that's many years off, and there's so much uncertainty about who's going to get there first, if people get there what technology they're going to use, it's really too early to call. But, just to acknowledge that that has the potential to dramatically shift economics in favor of sustainability for these companies.

Lewis: Yeah. Both of these companies as they currently exist, I don't think, can continue running for the next 15 years. I just don't think the money is going to be there for it to happen. Were they to basically be able to create a car and pay $X to create that car and then know that that car is going to have a useful life that earns it 3-4X in fares, that's where the network of transportation becomes really compelling. I think something else with these businesses to keep an eye on is, what are they able to leverage this network to do outside of just getting people from A to B? If they can use this as last mile logistics, I'm sure they're also working on other alternatives that aren't as clear to you and me. But, I think, kind of like Spotify, these two companies as they currently are don't look like great long-term businesses. A lot of things have to change for the economics to look better.

Niu: I would not touch Uber at all. If they went public at these levels, I would have zero interest in them, not only because of the financials, but again, from all this corporate culture stuff. You have to really think sustainably in terms of ethics, [laughs] just basic ethics, and Uber has a horrendous record when it comes to ethics and being a good person, being a good company.

Lewis: On the note of autonomy, too, Lyft is partnered up with GM (GM -1.73%) for some of their autonomous efforts. Is that right?

Niu: Right, GM has a big stake, they invested in Lyft a few years ago, so they have an ongoing relationship there. GM is obviously developing a lot of self-driving autonomous technology as well. Then, you also have to talk about Tesla (TSLA -2.03%), because Tesla is in there trying to create their own thing, I'll tell him it's cars, and theirs will be more like a network where the car's original owner, assuming that they can get their cars to full autonomy, then you have a whole network of private owners that allow their cars to go out there autonomously and provide transportation at no real cost of the driver, and you can generate some revenue there. So, that would be a decentralized network, but owned and operated by Tesla where the owners get a cut or something. It's not clear yet, but that's the general thinking. Then, of course, you have Waymo, who's suing Uber for stealing trade secrets. Waymo is a pretty mature subsidiary at this point of Alphabet. They've been around for 10 years or so. It goes back to this culture thing. It just came out that Uber has this corporate espionage team that was specifically trying to steal trade secrets from other companies. So, Waymo is in there too trying to get there first. It's really a race to see who gets to autonomy first and who can actually put together the operations like the network, and actually get that part going, as well as the economics down.

Lewis: I will put it to you before we wrap up, Evan -- if you had to buy one of these companies and hold them for five years, if they go public, Uber, Lyft, Spotify, which one do you like the most?

Niu: [groans] I don't know. I don't really like any of them, but if I had to, I would probably pick Spotify, just because I at least understand where they're going with more visibility there compared to Uber and Lyft. I just don't see any end in sight to the bleeding. I don't know how they're going to get profitable without losing all this venture capital money. Yeah, I don't like any of them, but the least bad one is probably Spotify.

Lewis: I think for my hypothetical money, I go with Lyft, and it's just because Spotify's business, there's a great consumer utility for it, I worry about them ever really being able to make the money work, and they're very limited and what they do. I think the same goes for Uber and Lyft. But I like Lyft's partnership with GM, I like their company ethics a lot more, and I think there is some optionality. If things ever turn over to autonomous driving, that they can maybe make the numbers work, but also take that technology, take that network, and do some other amazing things with it, maybe on the delivery side or something like that. So, that's a big-time hypothetical, but that's why they're my pick. Anything else before I let you go today, Evan?

Niu: No. I think 2018 will be an interesting year to see what happens with these companies.

Lewis: Yeah, we've been kind of treated with some really interesting IPOs in 2017. I'm hoping 2018 is the same way. Listeners, that'll do it for this episode of Industry Focus. If you have any questions or you just want to reach out and say hey, you can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!