Tencent Music (NYSE:TME) finally went public last week, following a slight delay due to market volatility. Dominant paid music-streaming platform Spotify (NYSE:SPOT) conducted an equity swap with Tencent Music about a year ago, and now holds roughly 9% of the Chinese music entertainment platform. In fact, Spotify's surprise profit last quarter was attributable to Tencent Music filing its IPO paperwork, as the Swedish company had to make a mark-to-market adjustment for its Tencent Music stake based on some of the information that was disclosed.
With Tencent Music shares currently trading around $12, down from the offering price of $13, Spotify stands to post a significant gain.
Spotify was carrying Tencent Music shares at $6.52
When the two music-streaming companies did their equity swap in December 2017, Spotify received over 8.5 million shares valued at around 910 million euros, or about $1 billion based on current exchange rates.
Tencent Music announced its plans to go public over the summer, and Spotify noted in its second-quarter shareholder letter that an IPO would trigger a fair market value adjustment, and that the resulting "gain could be significant." While Tencent Music did not go public in the third quarter, the aforementioned F-1 Registration Statement did trigger a fair market value adjustment. The total value of Spotify's long-term investments ballooned to nearly 1.6 billion euros ($1.8 billion).
Specifically, that F-1 Registration Statement pegged the fair value of Tencent Music shares at $6.52, and Spotify said in its third-quarter shareholder letter that it had marked up the value of its investment to that per-share price accordingly. That means that the value of Spotify's investment had nearly doubled based on the IPO price of $13, even if shares have traded down a bit since the debut.
Remember that Spotify uses International Financial Reporting Standards (IFRS), which treats accounting for financial instruments slightly differently than under U.S. GAAP. Spotify has opted to account for its Tencent Music investment within other comprehensive income, with changes in fair value being recognized there.
A massive gain is in store, but Spotify will continue losing money after that
While Spotify had already recognized some of the gain at the end of the third quarter, another one-time gain is in store based on Tencent Music successfully completing its IPO. Back when Tencent Music was targeting an earlier IPO, Spotify had said:
The accounting treatment for such a gain could trigger a tax benefit large enough to generate positive Net Income for us in the quarter of the IPO. If such an outcome were to occur, it would be a one-time, non-recurring event. The following quarters we would expect the business to once again generate a Net Loss.
Accordingly, Spotify will post a significant gain and tax benefit in the fourth quarter, before reverting to net losses. The company in November raised its fourth-quarter outlook and expects an operating loss of 35 million euros ($39.7 million) to an operating profit of 15 million euros ($17 million).