Tale of Two Aspirations

Spotify and Dropbox: Love Us, We'll Change

The companies are asking investors to look past their flaws to their unlimited potential.
Corrected
Photographers: David Paul Morris/Bloomberg (Dropbox); Roy Rochlin/Getty Images for Spotify
SPOTIFY TECHNOLOGY SA
+2.01
At Closing, May 25th
156.60 USD
DROPBOX INC-CLASS A
-0.23
At Closing, May 25th
29.97 USD

It's inevitable to compare Spotify and Dropbox. Both are relatively well-known internet companies that are seeking to debut on the stock market about the same time. They're both unprofitable but also savvy about persuading freeloaders to pay for subscriptions.

And both Spotify and Dropbox have a similar aspirational pitch to potential stock buyers: Don't love us for what we are today. Instead, please focus on what we might be in the future. It's true that investors want companies to have a vision far beyond the present day, but Spotify and Dropbox are unusual in nudging investors to look past the somewhat awkward or flawed businesses they are now. 

At the tail end of a bombastic presentation last week by Spotify Technology SA for its not-IPO stock listing, the company gave a glimpse of its future. A company that has fought to become a not-terrible (although still not good) business set a long-term target of continued healthy revenue growth and -- this was a surprise -- gross margins of about 30 to 35 percent.

Listen Up

New contracts with the major record labels helped improve Spotify's gross margin, or the share of revenue remaining after paying music royalties and some other expenses

Source: Spotify disclosures

As a reminder, gross margin percentage is a company's revenue minus its basic costs to make and deliver its product, expressed as a percentage of sales. Typical internet company margins are high, and both Netflix Inc. and Pandora Media Inc. have gross margins of about 35 percent. By contrast, Spotify needed a big break from the music industry powers to get its gross margin up to 24.5 percent in the fourth quarter of 2017, and even then the company posted an operating loss. Pushing up its gross margins into Netflix territory would give Spotify a better shot at being a viable company.

But to get there, Spotify said it would need to become a fundamentally different company. The chief financial officer mentioned briefly that Spotify's long-term gross margin target is predicated on Spotify expanding its businesses in areas other than subscription music streaming, which now generates 90 percent of the company's revenue.

Presumably that includes sales of advertising, concert ticketing, promotions for musicians and other revenue opportunities that are either relatively small or nonexistent for Spotify today. For investors to believe that Spotify's financial health will improve significantly, they need to bet on a material diversification beyond the subscription music model that has been Spotify's focus for 10 years.

Cue the Music

Spotify generates 90 percent of its revenue from digital music subscriptions, but the long-term profit potential of that business is unclear

Source: Spotify disclosures

Dropbox Inc., too, has the audacity of hope. About 70 percent of Dropbox's paying users are individuals who buy the software on their own. Those people might be using Dropbox for their jobs and persuading their co-workers to do the same, but they have decided to pay for Dropbox as individuals. 

Now look at Dropbox's video presentation to potential IPO investors. All of the Dropbox customers featured in the video are businesses -- tiny, medium and large -- not the individuals who make up the vast majority of Dropbox's paying customers. Businesses also were the featured customers in Dropbox's financial prospectus to potential investors. 

To be fair to Dropbox, business subscriptions are the fastest growing part of the company, and it is Dropbox's strategy to start with a handful of workers as customers and then persuade the whole company to pay up. But by training its camera lens on businesses, it's clear Dropbox would rather be among the gaggle of relatively richly valued companies that sell software to businesses than the lonely category of consumer-paid software it occupies today. 1 Dropbox would like more subscribers like Expedia, featured in its video and prospectus, than like you and me.

Look, all stock market newcomers are coin-flip bets on potential rather than current circumstances. Facebook at the time it went public had almost no revenue from mobile advertisements, which now generate nearly all of its revenue.

But Spotify and Dropbox are different from many stock market debutantes that came before. They are not young up-and-comers. They are decade-old companies with relatively long track records in their core businesses. They are valued at far-from-newborn valuations of $10 billion (Dropbox) and perhaps more than $15 billion (Spotify). And yet both companies want investors to look past their current condition and imagine a beautiful metamorphosis into different kinds of businesses entirely.

Those bets on a magical future may pay off. But it's not a great idea to enter into marriage hoping your spouse will change fundamentally. That's what Spotify and Dropbox are asking their investors to do. 

(Corrects the percentage of paying users of Dropbox who are individuals in the seventh paragraph.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. The Securities and Exchange Commission does have to approve these video presentations and prospectuses to ensure the accuracy of information and to make sure the customer examples are representative. 

To contact the author of this story:
Shira Ovide in New York at sovide@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net

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