Spotify Was a Terrible Business. Then the Record Labels Stepped In.
Spotify may have saved the record labels. But the record labels saved Spotify, too.
Here at Gadfly, we've chronicled the music industry's long, slow, still-incomplete revenue rebound, in large part because Spotify (and others) convinced consumers and record executives that subscriptions for digital music were the industry's best way out of the darkness. The music industry isn't financially healthy yet, but Spotify has helped industry revenue grow again for the first time since the CD was king.
Documents that Spotify filed Wednesday to go public through a not-IPO prove that this relationship isn't a one-way street. Spotify took a victory lap in the filing for warding off music industry doom, but it needed a helping hand, too. The company's finances significantly improved last year, and that was largely because the three biggest music labels rewrote their contracts with Spotify in a way that helped the company go from wobbly to steady-ish.
It was clear the revamped contracts gave Spotify Technology S.A. a break, but it wasn't entirely clear how much until Spotify's disclosures on Wednesday. The filing shows that in 2015 the company paid about 88 cents of every dollar in revenue in fees to the record labels and a grab bag of other expenses. In 2017, those costs shrunk to 79 cents.
That still doesn't leave Spotify much wiggle room to post a profit. For comparison, Netflix's cost of revenue -- which includes the spread-out expenses for its streaming TV shows and movies, similar to Spotify's music royalty fees -- was 66 cents on each dollar of 2017 revenue. The bite from the music royalty fees was one big reason Spotify's operating loss was 378 million euros ($461 million) last year.
But in theory, a gross margin of 21 percent provides a path to turn a profit eventually. Already, Spotify has stopped burning cash. Its operating cash flow minus its capital spending and change in restricted cash was 109 million euros last year. That isn't exactly bathing in cash; it's a free cash-flow margin of a dinky 2.7 percent. Still, positive free cash flow shows Spotify can stand on its own feet financially. I wasn't sure it could ever do that.
To give a glass half-empty view: Given Spotify's contractual obligations with the music companies, it's not clear how much more the company's gross margins, and therefore its net income, might improve. And there are plenty of reasons to be cautious about Spotify's plans to list its stock for sale to public investors. For one thing, there is the very, very big unknown of Spotify's plans to list shares directly on a stock exchange and bypass the typical dog-and-pony IPO road show.
Disclosures in Spotify's not-an-IPO filing show the company was valued as low as about $6 billion and as high as $23 billion in private stock transactions since the start of 2017. In short, who the heck knows what Spotify is worth? The company itself said the plan to list its stock on the market without underwriters or the other trappings of an IPO is a "novel method" and warns that trading in its shares "may be more volatile" than a typical newly public company.
I also wonder if the company is making a mistake by not taking the opportunity to raise money from a conventional IPO. (Spotify itself doesn't appear to be selling any stock in the non-IPO. Only the company's existing stockholders will have the ability to sell their shares to public stockholders.) Given Spotify's skinny cash-flow margin and history of whopping losses, it seems a little odd that Spotify didn't choose to sell some stock itself to have a bigger cash cushion. The company did have about 1.5 billion euros in cash, cash equivalents and short-term investments as of Dec. 31.
Spotify for a long time was a great product and a terrible business. Now thanks to its friends and antagonists in the music industry, Spotify's business looks not-terrible enough to be a viable public company.
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