Spotify Makes Its Public Debut

After years of speculation, Spotify (SPOT 2.77%) finally went public last week -- and now that the market has had time to react, we're taking a closer look at the music streaming giant.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu share what we know about Spotify so far, how the market is treating the company, and what it all might mean for this exciting new tech offering. Find out what investors should expect from Spotify's share price for the next few quarters; what we do and don't know yet about the company's fiscal health; some important things to remember about fresh IPOs and direct public offerings; Spotify's biggest competitive risks, and a few of their greatest strengths; and more.

A full transcript follows the video.

This video was recorded on April 6, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 6th, and we're talking Spotify. I'm your host Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, we've talked about Spotify before. We're both users of the music streaming service. Do you have a go-to playlist on your Spotify account?

Evan Niu: I actually don't listen to as much music as I used to. For me, I actually lean very heavily on their algorithmically generated playlists, which are one of their most popular features, like the Discover Weekly and the daily mixes. So, I actually just lean heavily on those, listen to whatever it plays for me automatically, and it works out pretty well.

Lewis: I've recently been super into their Focus playlist. I kind of struggle to listen to music while I'm doing stuff, because the words from whatever I'm listening to wind up bleeding into whatever is in front of me on my computer screen, and their music that is focus-oriented, very instrumental, has been awesome.

Niu: Yeah, I agree, I use those a lot, and that's actually how it's tailored a lot to that, because I do the same thing when I'm working. 

Lewis: So, we have done a full rundown on Spotify somewhat recently, for listeners that may have not been following along, so we're going to skip over some of the core business details on this show and get into the news of the issuance. If anyone wants those details, the full discussion is in the March 9th Tech show, so we are not totally leaving you out to dry, but because we did it recently and the metrics haven't changed all that much, we're going to leave that there. Evan, the reason we're talking about Spotify today is, shares hit the market earlier this week, and frankly, Wall Street seemed pretty excited. 

Niu: Yeah, it was a pretty big day. Shares opened at around $165, kind of went up a little bit from there, I think close to $169-170, but have been falling. Ended the day much lower. Investors are still trying to figure out what this thing is worth.

Lewis: But, they ended lower, and yet still above this reference price that we saw, which is kind of a testament to the idea that -- this is something that I have to put in quotes, this "reference price" is something that we're not super familiar with, and a testament to the odd approach with the direct listing that we saw here. Maybe something people aren't as familiar with. Why don't we talk a little bit about what price discovery is, what the reference price was, all of these terms that came up in the coverage of this issuance that people may not normally be seeing?

Niu: Sure. In a traditional IPO, there's an offering price that comes out, and that's the official price at which the shares are sold through the offering to investors. But in this case, since it wasn't a traditional IPO, it was a direct listing, what they did is, the New York Stock Exchange put out a quote-unquote "reference price," like you mentioned. That was $132, which is basically the high at which it traded at in the first half of March. So, again, it's pretty self-explanatory, it's like, "Hey, for reference, this is what these shares were." It's not an offering price. The opening price was still primarily determined by supply and demand dynamics. 

It's also worth noting that the float that were actually sold was actually quite small. There are about 55 million shares that are registered in the offering, but those are just existing shareholders that have registered the shares, so they're able to sell the shares. But it's still entirely up to their discretion on what they do or don't want to sell. And in this case, it seems like, I was looking at the number yesterday, it was about five or six million shares that ended up being sold into the open market on the first day trading, which is only about 3% of total shares outstanding. So, the float was very small on the first day.

Lewis: And that's something that you have to keep in mind with IPOs, or direct listings, in this case -- when shares become available for the first time, a very small portion of the overall shares are available. And so, if there's any demand whatsoever, that's going to cause some craziness in share price. 

Looking at the market's reaction, I think there's probably a sigh of relief here for Spotify, because this was not exactly the warmest water to be jumping into for a tech issuance. There are so many big macro things that are causing uncertainty in the stock market right now. And then you look specifically at the tech sector, you've got like Amazon (AMZN -1.65%) being in Trump's crosshairs, you have all the data issues with Facebook, you have some self-driving car problems. The world does not love the tech space right now. So, I think anyone that owns Spotify shares or has been following this story is kind of relieved to see that there wasn't this massive sell-off.

Niu: Right, I mean, and the shares have been coming down since then. But I would certainly expect this to continue being quite volatile, just because the whole process was kind of unique, plus the whole short float thing, and all companies are very volatile when they go public, so I would expect it to continue being really volatile. 

Lewis: Now that shares are out there, Evan, we have a sense of the valuation of this business, and this is something that we didn't have before, because there was nothing out there, there was nothing really to anchor to, aside from going back to recent rounds and recent transactions on the private markets. What are we looking at in terms of valuation? 

Niu: When they opened, the total market cap was right about $30 billion. By the close of the first day, it was closer to $26 billion because the stock went down a little bit. Actually, really quick, just to mention, that compares to their most recent private funding round valuation of $8.4 billion, which was way back in 2015. That was just a funding round. That doesn't include all the activity that took place since 2015 in terms of private market activity. But, just another data point to compare it against. In terms of valuation, that put it at around 5X sales since on a trailing 12-month basis they've done about $5.3 billion in revenue. So, I mean, that's pretty expensive. 

Lewis: Yeah, we cannot look at P/E for this business because Spotify is not profitable. It's expensive. It's funny, though, because you look at some of the recent tech issuances, you go back to Dropbox, which recently hit the public market, Snap, and Twilio, those were extremely rich by comparison. Dropbox went public around 10X trailing sales. Snap went public at 25X trailing sales, and Twilio went public at 15X trailing sales. So, a lot of these businesses, by comparison, seem extremely rich. I think the important thing to look at here is, those are not perfect comps, though, for Spotify. Just because they're in the same tech space and they're these hot IPOs does not mean that it's a good apples to apples comparison.

Niu: Right. And that's going to be real challenge going forward. So much of valuation in general is really predicated upon comparable valuation, you compare it to the peers and what the rest of the industry looks like. And every industry is different. So, that's how all valuation works. In Spotify's case, there is no comparable pure-play. They are the largest music streaming company on Earth. And all the other companies that are pure-play streaming, like Pandora or whatever, they're tiny in comparison, and their business models are very, very different fundamentally. So, there's not really a good way to measure Spotify. There's no one to measure it against. I mean, Apple (AAPL 0.52%) is the next-closest competitor, and they have half the subscriber base as far as premium subscribers. But obviously, Apple is a humongous company that does many other things, so you can't really compare valuations there. 

So, I think that there is a possibility that Spotify ends up being one of those companies where you can't really rely on traditional valuation metrics very much because they don't have anyone to compare it against, and they're unrivaled in terms of scale and their position in the industry they operate in. They also have some opportunities to really reshape the whole music industry. There's a lot of value in those things, so I think it's going to be kind of tricky.

Lewis: And I was fighting for a company that I think could possibly be in that space and be something that you could stack them against, and the best thing I could come up with was Netflix. That's actually a company that has, at times, traded in that 5X multiple. It's been up a little bit more recently. But even there, there are major differences. Netflix pulls in a lot more on the gross margin side than Spotify does, and Netflix has original content, which is just a totally different business than what Spotify is in. Spotify does this undifferentiated kind of commodity business with the music streaming. Their biggest differentiator is these Discovery playlists that we were talking about before, and the music curation. So, I don't even know if that's a good parallel. 

Niu: Right, exactly. I don't think Spotify is going to get into the original content game any time soon, make their own music. 

Lewis: It's going to be hard for them to. We've talked in the past about how maybe the best option for them, or something that would be certainly very interesting, is getting more involved or disintermediating the music industry. There might be something there. But we have to look at current valuation and what they do, and right now, that's where we're at. It's going to be bits and pieces from a whole bunch of different businesses. 

I think something that might be helpful is also looking at, how does their valuation stack up looking at the number of MAUs they have. This is something that we do with social media companies sometimes. And you think, OK, they're in the neighborhood of about $25 billion, and they have about 160 million monthly actives. I think that puts them around $160 or so a member. And the problem is, not all of those people are paying for the service, and they're not going to derive the same value from all those people. So, even trying to do it that way, it's a difficult business to wrap your head around from a valuation perspective. 

Niu: Right, exactly. I definitely see a lot of potential in the platform and the company. But there's also a lot of challenges that I think prospective investors should look at, particularly around profitability and scalability. Because most of the time, investors like companies -- especially for companies that focus on software as services -- because they can usually scale very well. But Spotify will not have that benefit because their largest cost is royalties to the record labels, and the royalties are paid out on a per-stream basis, which means it's a variable cost. So, as hours streamed engagement goes up, so does the cost revenue associated with delivering that content. So, you're not going to really have very much operating leverage, if any. 

And as you mentioned before, we had talked about this idea of connecting listeners to artists directly and cutting out the role of the middleman, even though they'll always be there, to some extent. If you think about it like, because these costs are tied to the usage, there's a very good chance a lot of this engagement is very concentrated in these major artists and record labels, which means that those costs are still unlikely to come down even if they make a lot of success and progress with growing the other side of the business that's connecting artists directly. So, it's going to be pretty tough to really expand profitability.

Lewis: Yeah. This relationship with cost is actually something similar to what we've talked about in the past with Snap, where if you have a variable cost that rises with usage, that means that leverage is just going to be tough to come by. Evan, looking at the business for them, though, do you see anything that gives you some signs that there's a chance they could improve profitability down the road?

Niu: I mean, the biggest piece of it is really these record labels and the licensing deals with them. They did renegotiate them in 2017, which has been a huge help for them in terms of improving their gross margin. But that's really the only way that they can get any type of a really meaningful relief on these royalties. And with them just renegotiating these a year ago, it seems unlikely that they're going renegotiate them any time soon. They're probably good for another couple of years, in which case, is there some other catalyst in the near-term that can really help profitability? I don't know.

Lewis: I guess it would have to be something like a new business segment or a meaningful new operation that they get into that has some sort of dramatically different margin profile than what we're seeing on the streaming side. Looking forward into Spotify, we have a little bit more. This conversation, we're actually going to have the benefit of some guidance that we got. We did not have it last time we talked about the company. We're going to talk about that on the back half of the show.

Evan, to wrap up the show, we got some more data from Spotify about what 2018 might look like. What should investors expect?

Niu: Spotify did provide some guidance for how their first quarter closed out. They released some estimates right before the quarter closed, kind of ballpark numbers. Total monthly active users are about close to 170 million, plus or minus a couple of millions. Premium subscriptions are at about 75, again plus or minus a couple. And revenue was about $1.4 billion. That gives investors kind of a baseline of how the first quarter went. 

Spotify didn't provide guidance for the second quarter quite yet, but what they did also provide is full-year guidance, so, they gave a little bit more of a long-term forecast. And for a full-year 2018, they're expecting 198-208 million monthly active users, which represents growth of 30-36% or so, and 92-96 million Premium subscribers. So, a lot of really nice trajectory on the Premium side of the business, which is obviously where all the money comes from. Revenue for the full year should be $6-6.5 billion. Gross margin 23-25%, compared to 21% last year, which, as we talked about earlier, is really just because they've been able to get some concessions from record labels on their costs. So, we are seeing some nice expansion on gross margin. Every little bit's going to help there. 

Lewis: Yeah, every little bit's going to help. The growth that we've seen over the past couple of years I think will probably slow unless we see something dramatically change with their business. I think at points over the past couple of years, it's gone from somewhere in the 11% range all the way up to the low 20s now, and if they're targeting somewhere in the 23-25% range, I do wonder how much more they're going to be able to stretch that. The big lever for them -- again, going back to the idea of them being similar to Netflix -- is, maybe they hit a point where they can start raising prices without really annoying customers, because they're getting enough value there. I certainly think that I'd be willing to pay more than $10 a month for music streaming. The tricky part is, when you have an undifferentiated product like they do, and the switching costs aren't super high, people could just decide to go to Apple Music instead.

Niu: Right. And I think that, if you look back, like you mentioned earlier, there's a big premium that the market is assigning to each of these Premium subscriptions. And if you look over the past year, Spotify ended up disclosing their private market transactions in their filings. The stock has been soaring in the private market throughout 2017. There's a pretty strong correlation between the value of the stock in the private market and the Premium subscribers. So, with them forecasting a pretty nice uptick for the next year on Premium subscribers, and if the market continues to put a big premium on these subscribers, then that could be a case for why there might be more upside even though, as we've discussed, there are some other concerns that we have with the business.

Lewis: And what is maybe the most optimistic number for me with Spotify is that that 200 million monthly active user count. They are the largest player in the space. Apple is there, but it's really Spotify's space. That is a tiny, tiny, tiny portion of the overall number of consumers who want music. So, the market here is massive. The growth runway is really big. It's really just a matter of whether the economics for this business wind up turning into something that can be a profitable business. That's the sticking point for me.

Niu: Right. And as of right now, Spotify and Apple Music combined have about 110 million paid subscribers. Interestingly, today actually, Amazon announced -- in the way that Amazon does, very vague -- that Amazon Music Unlimited does actually have tens of millions of subscribers. So, who knows if that's 20 million or 90 million. [laughs] Your guess is as good as mine there. 

But, it's an interesting data point, because they've never disclosed that before. As a quick reminder, Amazon Music Unlimited is Amazon's separate streaming service that's very comparable. It's about $10 a month -- well, they have a couple different price points, but it's the same service, where it provides on demand access to a large catalog of music. It's different from the Amazon Music that is bundled into Prime itself, because that one has only two million songs or something. So, that's kind of like something that Amazon throws into Prime. Then, they separately offer this Music Unlimited subscription. 

So, the fact that they have tens of millions of subscribers also, apparently, is kind of good news for the whole industry. Because like you said, this is a big market, and lots of people are going after it. And it's a growing market. Paid streaming is really where the market is heading. So, yeah, it turns out that market is a little bit bigger than we thought.

Lewis: I don't want to take away from the very coherent point that you just made Evan, but Amazon saying that they have tens of millions can only remind me of Arrested Development and the dozens of Never Nudes that that Tobias Fünke claims to exist, and the dozens of listeners that we also claim to exist. So, that's where my head went when you made that point.

Niu: [laughs] I mean, it's also worth noting that Spotify has a really dominant position in the emerging markets because of its free tier. I mean, a lot of people in emerging markets can't afford $10 a month. Apple basically is not really willing to go there. They don't have a free version, they only have the paid version. So, in effect, Apple's not addressing very large swaths of the market that Spotify is willing to, particularly in these emerging markets. So, I think that they do have a lot of levers they can pull and some avenues to really pursue growth.

​Lewis: Yeah. And, the free side for them has not been a profitable one for a long time. That recently changed. I think, maybe in the late quarters of 2017 or in 2017 as a whole, they'd been losing money on that segment of users for a long time, recently switched it over. So, there's some optimism there. It's also a huge engine for paid growth. That's the on ramp that they see for a lot of their users. So, any user growth is good user growth for Spotify. They obviously want to see people paying, but they'll take what they can get. 

Niu: Right. I mean, I think as we go forward, as the overall market for paid streaming continues to grow, because that's where it's heading, if Spotify can just maintain and defend its position as the top dog -- which they're doing a really good job of right now. I mean, they've really maintained this very consistent proportion vs. Apple Music of, at almost any given time, keeping twice as many subscribers over the past two years. It's been a very steady correlation that at any given time, they have twice as many subscribers. If they can just keep that up, I think that they'll probably keep executing pretty well. 

Lewis: I think that's a good note to end on here. Anything else before I let you go, Evan?

Niu: Nope.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. And, our podcasts are actually available on Spotify as well. 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. Thanks to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!