April 3rd 2018 is a historic moment in the digitized music industry, when the Swedish music streaming company Spotify is listed at the New York Stock Exchange. Spotify’s stock exchange listing is not just a touchstone for the music streaming service’s business model, but for the entire recorded music industry that is back on a path of growth. Spotify is the darling of the big music industry players. It provides a legal business model that can be monetized by hefty advances and royalty payments. This allowed the music majors and the indie label licensing agency MERLIN to become Spotify’s shareholders in return for advance payments Spotiy could not afford. Sony Music Entertainment’s Spotify stake of 5.7 percent (Spotify 2018: 148) e.g. is worth US $500m to 1.3bn.[1] The following analysis highlights Spotify’s success story, but also outlines potential risks of going public. It also analysis who benefits from Spotify’s stock exchange listing and assesses the impact on the music streaming market.
Spotify goes public – an economic background analysis
An economic success story with dark spots
Spotify is the icon for the emerging music streaming economy. The streaming service went online when the Pirate Bay trial culminated in October 2008 and Spotify positioned itself as the legal alternative to file-sharing.[2] In June 2009, Spotify counted 170,000 registered user and a monthly adverting income of GBP 82,000.[3] Despite the modest start, Spotify was already valued at US $250m.[4] At the end of 2017, Spotify had 159 million monthly active user and 71 million premium subscribers worldwide (Spotify 2018: 1) and was valued at US $19bn[5] – an amazing success story.
Figure 1: Number of monthly active users (MAU) and premium subscribers, end of period 2012-2017
Source: Spotify annual reports 2014-2017.
The growth of the number of users is pivotal for Spotify to go public. It is the signal to investors that its business model is on the path to profitability. And there is lot of investment money in Spotify that has driven up the company’s valuation. Hence, Spotify has to go public yet. In January 2016 the company issued convertible bonds at an interest rate of 4 percent to raise US $500 million. This loan can be converted by the borrowers at a discount rate of 17.5 percent in Spotify shares, if the company goes public within a year. If the IPO is later than a year, the discount increases 2.5 percentage points every six months.[7] At the end of March 2016, Spotify entered into a similar debt financing deal with investment companies TPG Capital, Dragooner and further clients of Goldman Sachs. At an interest rate of 5 percent, the Swedish company agreed to convert the debt into shares at a 20 percent discount for an eventual IPO. If Spotify does not go public within the next year the discount increases by 2.5 percent every six months too.[8] Since Spotify failed to go public in 2017, the discount rates meanwhile increased to 22.5 and 25.0 percent, respectively. Spotify, thus, had a burden of EUR 974m finance costs in 2017 (Spotify 2018: 10) and cannot afford to wait longer with an IPO.
Spotify, however, decided for an unusual process of public listing instead of an official initial public offering (IPO). In a public listing no new shares are issued and no capital is raised, but investors can trade their shares on the stock exchange. Such a listing is less bureaucratic, less time consuming and of course less costly than an official IPO. It is also a compromise, since the time pressure to go public was high. This also explains the cooperation with Tencent Music, a subsidiary of the Chinese conglomerate Tencent Holdings Ldt. In December 2017, it was announced that Spotify Inc. and Tencent Music Entertainment were buying 10 percent stakes in each other’s businesses. This opens Spotify the rapidly growing Chinese streaming market and Tencent gets a foot into the European and US music markets. Beyond that, however, the equity swap is also a financial instrument for Spotify to get access to fresh money. Since Spotify was valued between US $16-20bn in December 2017, a 10 percent stake was worth US $1.6-2.0bn. Tencent Music, with its outlets Kuwo, KuGou and QQ Music, was worth US $10bn. Since Spotify’s stake in Tencent was worth just US $1bn, there is a gap of US $600m-1bn that Tencent had to pay in cash to Spotify.[9] Thus, the equity swap channelled a considerable amount of money to Spotify that the company desperately needed. With Tencent Holdings (valued at US $500bn), Spotify now has a strong strategic partner to challenge Apple, Amazon and Google and their streaming services.
Spotify’s financials
The cooperation with Tencent also helps Spotify to improve its profitability in the long run. In 2017, Spotify reported a loss before taxes of EUR 1.23bn due to heavy financial burdens. The pre-tax loss, thus, exploded by 1,388 percent from EUR 82.9m in 2012 to currently EUR 1.23bn. In the same period Spotify’s revenue increased by 851 percent from EUR 430.1m to EUR 4.09bn. Spotify, therefore, urgently has to decrease finance costs, since the operating loss was comparably modest with EUR 378m in 2017 (Spotify 2018: 10).
Figure 2: Spotify’s revenues, pre-tax losses and operating losses, 2012-2017
Source: Spotify annual reports 2013-2017.
Although the operative loss stabilized in 2017, Spotify’s cost structure is still unfavourable. The cost of revenue in 2017 was at 79.2 percent (Spotify 2018: 60). Cost of revenue consists mainly of royalty and distribution costs related to streaming. Royalty payments to major record labels and their publishing companies, to the indie labels’ rights agency MERLIN and other rights holders are the main cost position and it can be assumed that Spotify has to pay out 70 percent of its annual revenue in royalties.[10]
Figure 3: Spotify’s cost of revenue in percent of total revenue, 2010-2017
Source: Spotify annual reports 2011-2017.
In 2017, Spotify entered into renewed licensing agreements with Universal Music Group, Sony Music Entertainment, Warner Music Group and MERLIN that lowered the royalty burden, if certain subscriber and revenue targets are accomplished – this is another reason why Spotify has to increase the number of active users and premium subscribers. In addition, Spotiy had to make concessions windowing new releases by the majors from its freemium service. [10]
There is need for Spotify to improve cost structure, since growth will be limited in the future as Spotify also pointed out in its latest prospectus for the direct stock exchange listing: “We have incurred significant operating losses in the past, and we may not be able to generate sufficient revenue to be profitable, or to generate positive cash flow on a sustained basis. In addition, our revenue growth rate may decline.” (Spotify 2018: 17).
In the short run Spotify is optimistic to meet the growth targets. In additional SEC filings, the Swedish streaming company forecasts a further increase of premium subscribers by 30-36 percent to 92-96m and a 26-32 percent growth of monthly active users to 198-206m at the end of 2018. The company expects a total revenue somewhere between EUR 4.9-5.3bn, up 20-30 percent year-on-year and a decreasing operating loss between EUR 230-330m.[11] The forecast should convince potential investors to buy Spotify shares and to avoid the scenario of Pandora. The US music streaming company went public in 2011 and was initially welcomed by the investors. Due to a lack of profitability, Pandora’s stock lost 62 percent of its value until 2017 and needed a US $480 million cash infusion by US online and satellite broadcasting giant SiriusXM in return for a 19 percent stake and three seats in Pandora’s board of directors.[12] We will see if Spotify has more fortune than its main US competitor.
Outlook – who benefis from Spotify’s “IPO”?
Who are the beneficiaries of Spotify’s “IPO”? First and foremost, the investors in the convertible bonds benefit from Spotify being listed at the New York Stock Exchange on April 3, 2018. They are offered a 22.5-25 percent discount for Spotify’s ordinary shares, which is a pretty good deal. The recorded music majors and MERLIN also benefit from the “IPO”. They own minority stakes of Spotify and if the issue price of Spotify shares will be in the expected range from US $50-130, Sony Music Entertainment e.g. will have an asset worth of US $500m-1bn in its books. We can assume that Warner, Universal and the indie label agency MERLIN will similarly profit from Spotify’s stock exchange listing. The artists contracted to the major labels are in a less comfortable situation. Usually no stipulations are included in their contracts what will happen if a record company sells a stake of Spotify. Nevertheless Sony and Warner made a public guarantee that their artists will share in at least some of the proceeds if Spotify’s stock exchange listing will be a success. The payments will be based on existing breakage clauses in the artists’ contracts. Universal also committed to share any money from a sale of Spotify shares with its artists if it is consistent with Universal’s artist compensation guidelines,[13] whatever this means. The independent label umbrella organization WIN (Wordwide Independent Network) goes a step further and issued a “Fair Digital Deals Declaration” stating in article 2 that they “account to artists a good-faith pro-rata share of any revenues and other compensation from digital services that stem from the monetization of recordings but are not attributed to specific recordings or performances.” (see www.winformusic.org).
And what about Spotify? Does it also benefit from the stock exchange listing? As said before, Spotify has to go public now if the company wants to avoid a further increase of its finance costs. The current financial climate seems to be advantageous and the public opinion on Spotify is largely positive. A negative impact could be the six pending lawsuits alleging unlawful reproduction and distribution of musical compositions that have been filed against Spotify since July 2017 (Spotify 2018: F-60).[14] Wixen Publishing e.g. claims that Spotify is hosting tens of thousands of its songs – among them works by The Doors, The Black Keys and Rage Against The Machine, Tom Petty and Neil Young – without a sufficient mechanical copyright license. Wixen’s songwriters are systematically under-paid resulting in total statutory damages of US $1.6bn. Even if the case will be settled out of court, the lawsuits are a dark shadow over Spotify stock exchange listing and could be a significant financial burden. In the long run Spotify has to prove that its business model is profitable and sustainable. April 3rd, therefore, is just the starting point.
References
Spotify, 2018, Amendment No. 2 to form F-1 registration statement to the US Securities and Exchange Commission (SEC). New York City.
Endnotes
[1] The calculation is based on Spotify’s latest information in the offering prospectus that the low and high sales price per ordinary share for private transactions of Spotify shares was US $48.93 and US $132.50, respectively during the period from January 1 to March 14, 2018 (Spotify 2018).
[2] “We’ve only just begun!”, Spotify News, October 7, 2008 (accessed March 29, 2018).
[3] “Fifty Quid Bloke, meet Spotify’s 14p man”, The Register, June 25, 2009 (accessed March 29, 2018).
[4] “Behind the music: The real reason why the major labels love Spotify”, The Guardian, August 15, 2009 (accessed March 29, 2018).
[5] “If Spotify’s worth $19bn … what’s the value of Daniel Ek’s stake?”, Music Business Worldwide, December 18, 2017 (accessed March 30, 2018).
[6] “With 70 Million Subscribers and a Risky IPO Strategy, Is Spotify Too Big to Fail?”, Variety, January 23, 2018 (accessed March 29, 2018).
[7] “Spotify Is Raising Another $500M In Convertible Notes With Discounts On IPO Shares”, TechCrunch, January 27, 2016 (accessed March 30, 2018).
[8] “Spotify raises $1 billion in debt with devilish terms to fight Apple Music”, TechCrunch, March 30, 2016 (accessed March 30, 2018).
[9] “Spotify’s mini-merger with Tencent Music isn’t just about power – it’s about getting rich quick”, Music Business Worldwide, December 12, 2017 (accessed March 30, 2018).
[10] “With 70 Million Subscribers and a Risky IPO Strategy, Is Spotify Too Big to Fail?”, Variety, January 23, 2018 (accessed March 29, 2018).
[11] “Spotify expects to have close to 100m paying subscribers by the end of 2018”, Music Business Worldwide, March 26, 2018 (accessed March 30, 2018).
[12] “Spotify Is Said to Be Going Public in Early 2018”, New York Times, January 3, 2018 (accessed March 30, 2018).
[13] “The major labels have committed to sharing Spotify equity money with artists. But what will they pay their indie label partners?”, Music Business Worldwide, March 6, 2018 (accessed March 30, 2018).
[14] The plaintiffs are the Bluewater Music Services Corporation; Gaudio et al.; Robertson et al.; A4V Digital, Inc. et al.; Watson Music Group, LLC and Wixen Music Publishing Inc.
Music Business Research 
Thank you or this Peter! As usual, a clear and thorough analysis of a historic event.
Great analysis on this. I think its safe to say Spotify would be a great investment being the music industry giant. I think it will stay that way.
good analysis overall, though I am not sure the “Cost of revenue” is a reliable metric given the cost can be divided into a license fee to access the catalogue (fixed) and a variable fee for the royalty per stream.