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Is This the Next Twitter?

By Alex Dumortier, CFA – Feb 17, 2014 at 3:00PM

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Spotify takes a step toward an initial public offering.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

U.S. stocks are coming off a good week, with the benchmark S&P 500 gaining 2.3%, which puts it almost back at breakeven for the year. The narrower Dow Jones Industrial Average (DJINDICES: ^DJI) also gained 2.3%. Those aren't the sort of numbers to get growth investors' pulses racing, however. At the beginning of 2014, nine of my Foolish colleagues and I cited 10 companies that could be this year's Twitter (TWTR) -- growth companies that could emulate the microblogger's stock market success. Today, Reuters reported that Spotify -- which didn't appear on our list, but certainly could have been a contender -- is signaling that it is preparing to join the public market.

The Swedish online streaming music service is seeking to hire an executive who will bring its financial reporting up to U.S. Securities and Exchange Commission standards. Companies must obtain SEC approval before they can go public.

Like its closest publicly traded peer, Pandora Media (P), Spotify operates on a freemium model, wherein the company provides a basic service for free to anyone who will sign up, in the hope that some percentage of those users will eventually opt to upgrade to a paying package with additional features.

The problem for Spotify is that the side-by-side reviews with Pandora that I have seen suggest the the latter is more clever about the playlists it develops based on a single artist's name or a single song submitted by the user. The problem for both companies is that the newcomer to the field, iTunes Radio from Apple, has also gotten good at this and has a huge trove of data from iTunes purchases with which to perfect its algorithms. Add to that the fact that iTunes is part of Apple's broader entertainment ecosystem and you can see why I think Apple is a very credible threat to Pandora and Spotify.

That isn't stopping investors from valuing Pandora at a nosebleed-inducing 218 times next 12 months' earnings-per-share estimate. Not to mention that this multiple is calculated on adjusted earnings – on the basis of "as reported" earnings, analysts don't expect the company to turn an annual profit until 2015. Even using the $0.47 adjusted earnings-per-share estimate for 2014, that would still put the share price multiple at 77 times.

With those sort of multiples being bandied about as a comparable valuation, it would hardly be surprising if Spotify executives and investors want to take the company public. Still, I would recommend they do so sooner rather than later, as some air has yet to come out the social networking bubble.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Pandora Media and Twitter. 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.

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