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Be wary of Spotify’s unusual IPO

Assif Shameen
Assif Shameen • 10 min read
Be wary of Spotify’s unusual IPO
SINGAPORE (Mar 26): On April 3, giant music streaming firm Spotify Technology will list on the New York Stock Exchange. Don’t look for CEO Daniel Ek ringing the bell that morning from the narrow balcony overlooking the trading floor or patiently waiting
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SINGAPORE (Mar 26): On April 3, giant music streaming firm Spotify Technology will list on the New York Stock Exchange. Don’t look for CEO Daniel Ek ringing the bell that morning from the narrow balcony overlooking the trading floor or patiently waiting for an hour before the trading of the IPO shares actually begins once the mass of buy and sell orders have been carefully matched. Spotify executives will not be handing out souvenir baseball caps on the floor of the exchange or uncorking champagne bottles as Wall Street underwriters help the stock spike upwards. Indeed, Spotify will not even be offering any new shares to investors. Only the shares of existing shareholders, who by the way will not be constrained by a traditional “lock-up” period, will trade on listing day.

The Stockholm-based music streaming behemoth is going public through an unusual form of IPO called “direct public listing”. There is no IPO price or underwriter paid to “stabilise” the stock on the first day of listing. Gobal investment banks typically take 7% of the proceeds in fees of large tech IPOs. Spotify is saving on those expenses, although it will pay a small fee to Morgan Stanley for helping it in the listing process. Just as it helped revolutionise the music industry, Spotify, in its own way, is transforming mega tech IPOs, which might prompt tech unicorns to be more innovative in their approach to listing, bypassing Wall Street’s traditional ways.

Co-founded by Ek, now 35, and Martin Lorentzon, 49, in 2006, Spotify was launched in 2008 as a commercial music streaming service. It has 71 million paid subscribers and another 92 million free users in its ads-supported service. Apple, which eschews advertising, has 38 million paid subscribers for its Apple Music service (in addition to eight million on free trials) compared with Amazon Music Unlimited’s 16 million paid subscribers, Pandora Media’s 5.4 million and Google Play Music, which has less than five million. Apple, Spotify and Google charge US$9.99 ($13.14) a month for streaming music, while Amazon.com charges its Prime members US$7.99 monthly for music.

Music streaming boom

Spotify is riding the wave in a booming music streaming market. After nearly two decades of plummeting revenues, the global music market is turning around, owing partly to the rapid growth in streaming subscriptions. Streaming revenue grew 47% in 2015 and 60% in 2016, according to the International Federation of the Phonographic Industry (IFPI), the industry body. Although IFPI has not published 2017 data, streaming revenues grew an estimated 50% last year and are forecast to grow over 40% this year. Indeed, because of the boom in streaming, the global music industry is on the mend. Worldwide record-business revenues peaked at US$23.8 billion in 1999 at the height of the CD boom, then plummeted to US$16.9 billion in 2008 when iTunes downloads were all the rage. The global recorded music market grew 5.9% in 2016 to US$15.7 billion. It is estimated to have grown 9% last year and forecast to grow 8% this year. Digital music now accounts for more than half of the market.

More people are spending more time listening to music. Americans listened to 21% more music, or 32 hours on average per week, last year than they did in 2016, according to Nielsen. Because the world’s music catalogue is now available on demand, consumption habits have dramatically changed, says ARK Investment Management, a tech-focused asset management firm in New York, in a recent note. Knowledge workers, for example, often listen to music throughout the workday. Unlike TV or movies, which require much more attention, music consumption can overlap with other activities such as walking, commuting, running, working or training at the gym.

A key secret sauce in Spotify’s popularity is its ability to personalise our music. Nearly a third of all listening on Spotify comes from its curated playlists, including popular ones such as RapCaviar and personalised playlists such as Discover Weekly or Daily Mix. Spotify not only predicts what you might want to listen to next, every 24 hours it also pushes a new playlist of music you might want to listen to.

Yet, the Spotify IPO is likely to struggle, not because it is an unusual listing with no underwriter propping up the shares on the first day, but because the streaming giant does not make any money and is unlikely to be profitable for the next several years. “We will continue to invest in growth and won’t focus on profit initially,” Ek was quoted as saying recently. Spotify raked in US$5 billion in revenues from subscription and advertising last year, but incurred a US$1.5 billion loss because it pays 79% of its total revenues to music labels such as Sony Music, Universal Music Group and Warner Music Group as royalties. In 2015, it paid 88% of its revenues to music labels.

Since 2008, Spotify has paid out US$9.8 billion in royalties to music labels and publishers. It has hammered out a deal with the top three music labels to rewrite their contracts now that it is such a big revenue generator for them. Yet, many of the publishers argue that the streaming giant is shortchanging them. Spotify actually pays just under one US cent in royalties for every song it plays, and artistes get onetenth of that. Rihanna needs her songs to be streamed 10 times on Spotify before she earns a cent, or a thousand times before she earns a dollar. Wixen Music Publishing, which administers the copyrights to songs by Tom Petty, The Doors, Neil Young and other singers, sued Spotify for US$1.6 billion in December, claiming it uses compositions without licences and does not even properly pay royalties.

Royalties and margins

Mounting royalty payments are weighing on Spotify’s gross margins. Unlike video streaming giant Netflix, Spotify cannot pivot quickly to original content because music consumption depends heavily on catalogues and familiar tunes. Spotify’s gross margin rose to 22% in 2017 from 16% in 2016. It lags behind Netflix and Pandora, both of which had 34% gross margin last year. CEO Ek has talked about his long-term operating goal of 30%-to-35% gross margin, which he claims is achievable if Spotify can increase scale. The bigger Spotify grows, Ek argues, the more willing music labels would be to cut deals, which in turn would help its gross margin.

Although music streaming is a huge and growing market, until now, the only way for investors to play it was through Pandora, which was listed four years ago. Pandora, which runs an ad-supported streaming service, saw its stock surge more than threefold after its IPO in late 2013, then plummet 90%. The stock has been languishing close to a third of its IPO price. Ek is hoping investors will value his music streaming firm the way they have valued Netflix, whose stock is up 3,626% since July 2012.

Ek controls 37.3% of voting shares in Spotify, while Lorentzon, a former chairman, has 43.1% of voting shares. Chinese Internet giant Tencent Holdings has 7.5% of the total shares, or 2.4% of voting shares, following a share swap late last year that gave Spotify a 10% stake in the soon-to-be-listed Tencent Music.

So, if you love music and subscribe to Spotify, should you buy the stock on IPO day? Legendary investors such as Berkshire Hathaway’s Warren Buffett and Fidelity’s former star manager Peter Lynch have extolled the virtues of buying “what you know”. Moreover, getting on the tech bandwagon early has paid off well for investors. If you had bought Google, whose listed parent is now called Alphabet, at its IPO 14 years ago, your stock would be up at least 27 times. And investors who bought Facebook at its IPO six years ago are up more than fourfold, not to mention the humongous gains made by those who bought Amazon or Apple. Yet, for the handful of success stories, there are literally hundreds of equally spectacular failures. Investors looking to equate Spotify with huge gains in the stock of video streaming player Netflix (up 1,170% over five years) will be disappointed because not only does Netflix not pay 80% of its revenues in royalties, its real draw is its original programming.

Because of its unusual IPO, there will be no predetermined opening price for Spotify. Indeed, Spotify executives concede that the first few hours of trading could be fairly volatile. Based on recent private share sales, the stock could open anywhere between US$90 and US$132 and could immediately plunge or soar on opening day.

If Spotify’s IPO does well, the biggest winners will be the music labels such as Sony Music Entertainment, Universal Music Group and Warner Music Group, which control 20% of Spotify’s total outstanding shares. Sony Music Entertainment, the world’s largest music publisher, has a 5.7% stake. At the expected IPO valuation of US$24 billion, Sony stands to make US$1.37 billion. Music labels have said they will share some of the windfall from the IPO with recording artists. So, Drake, Kendrick Lamar and Ed Sheeran are all rooting for the IPO’s success, although Taylor Swift, who had a running battle with the streaming service until the end of last year, will probably miss out on big gains.

Competing with the big guys

Simply being a great streaming service will not save Spotify from being trampled by the big guys — Apple, Amazon and Alphabet — which see themselves as players in the music arena. To compete with them, Spotify needs to be in the voice-powered smart home speakers business. Forty million homes around the world already have a “smart speaker” such as Amazon’s Echo, Apple’s HomePod or Google Home, not just blasting out songs but also using artificial intelligence to listen in and carry out mundane tasks such as calling an Uber or ordering groceries online. Spotify already has partnerships to embed its streaming service in cars as well as devices such as TVs and Microsoft’s Xbox console. Yet, Snap’s foray into Spectacles two years ago is a cautionary tale of how difficult it can be for services and software companies to establish a beachhead in hardware.

What else could Spotify do? Think podcasts and music videos. Spotify has described podcasts as a “significant opportunity” and is investing in original shows aside from distributing popular programmes from other companies. According to Edison Research, 44% of Americans over 12 years of age have listened to a podcast, up from 40% last year. Podcast listening has gone up more than 70% over the past four years. Moreover, people who are listening to podcasts are listening to more shows, or an average of seven shows, up from five. Spotify is also teaming up with BuzzFeed to produce newscasts, which would help it compete more directly with terrestrial radio, which draws US$28 billion in advertising globally and US$14 billion in the US. It is also wooing more advertising because its free service helps lure listeners to its subscription platform. Advertising currently makes up just 10% of US$5 billion in revenues, with subscription accounting for the rest. As Apple Music and YouTube Music double down on music videos, Spotify is being forced to respond with a video strategy of its own.

Whether Spotify’s IPO is a roaring success or a huge disaster, the Swedish company has clearly changed the way we all listen to music. All the way, from its humble beginnings to its IPO early next month, it has been continuously innovating. The streaming industry’s subscription model is now being touted as the way forward for all forms of the media as the advertising-supported model for print media, TV and radio slowly crumbles. Spotify may not be a commercial success yet, but it has taught the media some interesting lessons about the need for innovation. But that’s no reason to pounce on its IPO. Investors might want to wait until a clearer pathway to profitability emerges.

Assif Shameen is a technology writer based in North America

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