I analyzed Spotify’s F-1 last weekend. Below are my thoughts.
Summary
Spotify is the largest global music streaming subscription service. Spotify’s mission is to:
“Unlock the potential of human creativity — by giving a million creative artists the opportunity to live off their art and billions of fans the opportunity to enjoy and be inspired by these creators.”
In 2017, Spotify shares were sold for a vast range, placing the company’s valuation somewhere between $6.3 billion and $20.9 billion. However, per recent transactions, Spotify was valued by private investors at $23 billion.
The largest stakeholders are its two founders: CEO & co-founder Daniel Ek, who owns 25.7% of the company, and co-founder and director Martin Lorentzon, who owns 13%¹. The other shareholders are, Tencent (7.5%), Tiger Global (6.9%), Sony Music (5.7%) and Technology Crossover Ventures (5.4%).
With a presence in 61 countries and territories, Spotify includes 159 million MAUs and 71 million Premium Subscribers. Europe is the largest market, representing 37% of its total user base.
Spotify intends to list on the NYSE under the symbol “SPOT.”
Direct Public Offering
Spotify has opted for unconventional “direct listing” to go public. Below are my thoughts on Spotify’s unusual move.
Since it’s a direct listing, there are no roadshows to attract investors, no underwriters involved and no lock-up period for shareholders.
The primary reason behind Spotify’s direct listing approach is — they are not in desire to raise capital. Spotify’s business model is very cash efficient. They receive money via subscription fee on Day 1 of the month and they don’t pay to content owner till end of the month. So, it doesn’t make sense to go with traditional IPO route and spend money for underwriting fees.
However, there is also a risk associated with this cheaper route. As stated in F-1, there are no safeguards to protect volume and price of shares from volatility.
…the trading volume and price of our ordinary shares may be more volatile than if our ordinary shares were initially listed in connection with an underwritten initial public offering.
Since Spotify is not selling any new shares, there will be no price as the starting point for its debut trading. So, market makers at NYSE and Spotify’s financial advisors will work together to match buyers and sellers to settle on an opening price.
It’ll be interesting to see how Spotify’s direct listing goes as it could serve as a template for existing unicorns looking for a cheaper and more innovative approach to going public.
Glimpse of Financials
Spotify hasn’t been profitable yet. Spotify’s revenue is growing at a faster rate (~38% from 2016 to 2017). But, Spotify has a very high cost of revenue. It consists royalty costs primarily, which they pay to publishers, artists and music record labels. Due to this reason, unlike other tech companies, Spotify’s cost of revenue and operating losses are expected grow YOY and profitability doesn’t seem possible in short-term.
However, in 2017, Spotify entered into licensing agreements with a few record label companies and their cost of revenue and gross margins have improved due to new licensing agreements.
In 2017, we entered into licensing agreements with Universal Music Group, Sony Music Entertainment, Warner Music Group, and with Merlin, among others. Our cost of revenue and gross margins have benefited from the terms of the new licensing agreements.
Apart from that, Spotify seems very lean company operations-wise. Their S&M, R&D and G&A costs (~30% of revenue) are slim and controlled compared to their cost of revenue.
Business
Spotify’s major revenue streams are: Premium and Ad-Supported services. Premium service is Spotify’s largest revenue stream. It is interesting that Spotify earns 90% of its revenue from ~44% Premium users. So, it’s important for Spotify to keep growing its premium user base in future.
Moreover, Spotify’s user engagement is high and growing. Ratio of DAU and MAU² was ~ 44% in 2017. From a content perspective, on average 25 content hours per MAU were streamed in each month of the fourth quarter in 2017, up 13% from the fourth quarter in 2016.
Premium Service
Premium service provides Premium subscribers with commercial-free, unlimited online and offline streaming access to Spotify’s catalog through multiple channels such as computers, tablets, and mobile devices.
Spotify had 71 million Premium Subscribers in 2017 and it is growing at a faster rate (48% from 2016 to 2017). New Premium Subscribers primarily are sourced from the conversion of Ad-Supported users to Premium subscribers.
Spotify launched variety of pricing plans — Family Plan and Student Plan, which have decreased Premium ARPU by 14% due to the lower price points per Premium subscriber. However, it has helped company improve retention across the Premium service, and as result of that Premium Churn has declined 1.1% — from 6.6% in 2016 to 5.5% in 2017.
The trend toward lower Premium Churn has had a positive impact on the lifetime value of a Premium Subscriber (“LTV”). The ratio of LTV to the average cost of acquiring a Premium Subscriber (SAC), LTV/SAC³ was 3.6 in the fourth quarter of 2017.
Ad-Supported Service
Spotify’s Ad-Supported Service has no subscription fees and it provides Ad-Supported Users with limited on-demand online access to the catalog on their computers and tablets and shuffle only access on compatible mobile devices. Spotify generate revenue for Ad-Supported segment from the sale of display, audio, and video advertising delivered through advertising impressions.
Revenue for Ad-Supported segment is affected primarily by the number of Ad-Supported users, the total Content Hours Per MAU of Ad-Supported Users, and Spotify’s ability to provide innovative advertising products that are relevant to Ad-Supported users.
Product
Needless to say, Spotify has one of the most impressive and innovative products. Spotify leverages artificial intelligence and machine learning capabilities to create a personalized user experience on their platform.
Content Strategy — Personalization
Spotify’s platform leverages deep user engagement, rich data, and artificial intelligence to optimize the content matching process between artists on the platform and Users who are likely to be their fans and engage with their content.
Spotify’s majority of content is on a non-exclusive basis. Spotify believes that personalization, not exclusivity, is key to the continued success. Additionally, because Spotify provides artists with access to millions of Users around the world, many artists independently choose to release content on their Service, even if they initially provided this content exclusively on another Service.
One of our strengths and one of our challenges for consumers is that we have an overwhelming amount of content available on our Service for consumers to choose from. In order to better utilize that content, we need to be able to help individual Spotify Users find the content they will love, and we need to help the content find its target audience. We believe this is an important factor in maintaining our market leadership and competitive position.
Use of Data and AI
Spotify owns more than 200 petabytes data which provides them with significant insight into content consumption and user behavior, and approximately five petabytes of data is queried daily.
Since all the Users have to log in to access Service, this enables them to track behaviors such as playing songs, sharing, selecting recommended music, skipping, following, and active participation through the up-vote and down-vote buttons. More than 150 billions of these kinds of events are logged daily and Spotify analyzes this data in order to obtain useful insights with machine learning and artificial intelligence.
Spotify’s algorithms personalize and curate the content by measuring an individual User’s preferences against more than 40 different parameters such as demographics, past listening behavior. Furthermore, they can combine situational context, such as time of day and location, to make better recommendations for appropriate content to an individual User based on his or her current activity.
Spotify’s advanced algorithm help advertisers serve highly targeted specific users and audiences. Spotify serves relevant advertising to ad-supported users by understanding people through music, mood, mindset, activities and tastes.
New Content Offerings
As a part of Spotify’s growth strategy, they have diversified their content by introducing podcasts and short form of videos.
Podcasts: Spotify offers podcast on wide range of genre including musical content, sports, business, finance etc. Spotify had 484 million podcast listeners in 2017, representing 39% YOY growth. I believe podcast is great addition to content offering as that would further improve brand-stickiness.
Video: Spotify has expanded their content offerings by including videos. Video content includes interviews, freestyles, behind-the-scenes footage, and full-length music videos. Videos allows artist to promote their music further through graphics or photos on social media platforms while the song is playing.
March towards Profitability
Spotify has achieved network effect⁴, which would help them towards scalable revenue generation, however company doesn’t have control over its cost of revenue. Spotify pays $0.70 in royalty payments for every $1 earned. It’s vital for company to control the marginal costs, while improving operational costs and keeping its current growth intact.
In a short term, Spotify should continue renegotiating agreements and get into licensing agreement with record labels. In a long term, similar to Netflix, Spotify should start its own record label, along with a music publishing company. That would improve their marginal costs, and it would also create an additional revenue source assuming radio stations and other streaming services would be forced to pay licensing fees for Spotify-owned music.
Spotify has already taken steps to diversify their content offerings by introducing podcast and videos, however they should also consider diversifying revenue streams. Spotify can monetize their 200 petabytes data by providing data/insights to artists/labels.
Footnotes
¹ The duo also has “beneficiary certificates,” which entitle them to extra voting rights. Ek has 37.3% voting power while Lorentzon has 43.1%.
² DAU/MAU ratio is defined as average number of DAUs over the quarter divided by the average of the MAUs for each month in the quarter.
³ LTV is calculated by dividing one by the Premium Churn rate for the fourth quarter of 2017 multiplied by the Premium ARPU for the fourth quarter of 2017 and by gross margin for the Premium segment for the fourth quarter of 2017; and SAC is calculated by dividing sales and marketing expense for the Premium segment for the fourth quarter of 2017 by gross Premium Subscriber additions for the fourth quarter of 2017.
⁴ A product displays positive network effects when more usage of the product by any user increases the product’s value for other users (and sometimes all users).
