Irrational Exuberance? The Hype Is Real As Spotify Goes Public

Daniel Ek
Ilya S. Savenok / Getty Images for Spotify
– Daniel Ek
Spotify founder and CEO Daniel Ek appears onstage at Spotify Investor Day on March 15, 2018, in New York City.

The future of recorded music was on trial April 3.  Financial news station CNBC spent most of the morning reporting on music streaming service Spotify’s pending listing on the New York Stock Exchange. KISS bass player Gene Simmons appeared, praising Spotify’s management but trashing streaming services for paying artists too little. A few hours later, Gavin Rossdale, frontman for Bush, spoke highly of Spotify’s ability to reach fans. Equity analysts spoke bullishly about the company’s future. The occasional guest was skeptical. It was quite a spectacle. 

The hype is real. RBC Capital Markets’ Mark Mahaney, a veteran tech analyst who built a reputation on his coverage of Apple, gave Spotify a $220 price target, representing a 33-percent upside from the opening price. Rob Sanderson, an Internet analyst at MKM Partners, put a $200 price target. Sanderson and other analysts place revenue growth, margin and the churn rate over profit. And analysts always love a market leader. If for no other reason, investors would be interested because Spotify is the largest company in a disruptive business that has helped change how music is heard and monetized.

But can Spotify live up to this level of hype? Investors must understand the slim margins inherent to digital music. A licensing deal will typically give rights holders at least – and often more than – 70 percent of revenue. For Spotify to improve margins it can improve its video and podcast catalogs. Reports have said Spotify has a hardware play but nothing has been made public.

Wall Street is exuberant nonetheless. Mahaney’s $220 price target values Spotify at over $40 billion, about $13 billion more than Vivendi, the parent company of Universal Music Group, and four times Live Nation’s roughly $8 billion market capitalization, (which was in flux at press time following a New York Times report on the promoter’s alleged anti-competitive business practices). Internet radio company Pandora, the slow-growth streaming company, had about a third of Spotify’s 2017 revenues but investors give it a $1.2 billion value.

Growth rates are the differentiator. Investors believe Spotify has the potential to be a far larger company (the usual thought experiment is to compare the number of streaming subscribers worldwide to the number of smartphones in use globally).
Live Nation’s 2017 revenues are over a third more than Spotify’s ($10.3 billion to $6.3 billion) but the music subscription market is younger. Pandora lacks Spotify’s momentum and is limited to the United States for the foreseeable future.

At a $165.90 opening price, Spotify had a market capitalization of around $30 billion; by the end of the trading day, Spotify’s share price had fallen 11 percent to $149.60, wiping out nearly $4 billion of market value. There’s no cause for panic, however, as the opening price was something of a guess based partially on the highest price paid in private sales before March. But this opening-day tumble embodies the difficulty in gauging the value of a digital music company. Typically, a share price represents the current day value of a company’s future cash flows. A money-losing Internet company requires more guesswork.

The multibillion-dollar question remains: now that Spotify is a public company beholden to investors’ quarterly expectations, will financial success carry over elsewhere in the industry.

CNBC viewers witnessed opposing views. “Artists are getting slaughtered” by streaming because people aren’t paying for music, said Simmons. The KISS bass player mixed free-market principles with an artist’s view on streaming economics. “Spotify’s gettin’ rich and God bless them for it. Record companies are making money. Where’s the money for the people who make it all possible? There’s going to be no Beatles, no Rolling Stones, nothing, because they won’t be able to quit their day job to devote full time to the art,” Simmons bellowed.

Rossdale of Bush, the counterpoint, was more Zen about the new digital paradigm. To him, Spotify is both an artist development tool and a community of fans. “Everything we do has a lot to do with Spotify these days,” said Rossdale, noting that Bush looks at its most popular songs on Spotify to help build playlists. Rossdale added that Bush might use Spotify to allow fans to pre-order concert tickets, something bands like Metallica have already done on the platform. And for the new fans of this decades-old rock band, Spotify makes digging through a back catalog easy. “If someone hears your song they can investigate you without having to give up hard-earned money,” he said.

The fast-growing streaming market is far from being saturated. Spotify expects its global listeners to reach 200 million by the end of the year. Subscribers are expected to grow from 71 million at the end of 2017 to 94 million this year; another 23 million paying customers would be worth about $1.3 billion. But Apple Music, Amazon and Pandora are also vying for subscribers.

Russ Crupnick, managing partner at market research firm MusicWatch, believes an additional 50 million potential subscribers might exist just in the U.S. Crupnick estimates there were 35 million subscriptions across all services at the end of 2017. At those levels, subscription services would far exceed the
24 percent of the 13-and-over population that has ever purchased a digital download. “It’s going to be so easy to use in your car. It’ll be so easy to use voice-assist. This will be so much easier from a usage and technology standpoint,” Crupnick said. “I think streaming will easily pass the number of digital downloaders.” The upper bound is the 90 percent of consumers who purchased CDs at the format’s peak.

Customer acquisition costs are a concern. Spotify is adding a steady number of new subscribers each year – from 20 million to about 23 million – but sales and marketing expenses will rise 110 percent from €368 million (about $451 million) to €773 million ($947.5 million in three years. The cost of each new subscriber jumped from €18.4 ($22.5) in 2016 to €24.6 ($30.2) in 2017. Based on an estimate from guidance Spotify issued in March, each new subscriber could cost €33 ($40.4) this year. “It’s going to get difficult,” says Crupnick. “You start to hit an adoption curve. You skimmed off the easy group, then the second group, and it will get more difficult” to get subscribers.

There’s a reason Spotify is a market leader and the change agent for an industry on the rebound: it has a great product. It’s too easy to forget what subscription services were like before 2009. RealNetworks’ Rhapsody, the legal version of Napster, and Microsoft’s Zune failed to excite consumers and pull the subscription business out of its niche status. Before Spotify launched here, Americans were figuring out ways to mask their IP address to access the service in European countries. Spotify changed the way playlists are experienced, built and shared. Its smart design and user interface set a standard other companies must attempt to reach to remain even remotely competitive. More than anything, Spotify, like the iPod a decade before it, and Pandora to an extent, made people fall in love with music again.

The bottom line will eventually be the bottom line. Spotify loses money and margins aren’t improving as fast as customer acquisition costs are growing. But RBC’s Mahaney believes
Spotify can improve gross margin – revenue
minus content costs – from 21 percent in 2017 to 30 percent by 2022 as licensing terms become more favorable. A gross margin improvement of nine percentage points would be worth about €650 million ($797 million) –more than enough money to achieve an operating profit. That’s worth some of the hype if Spotify can achieve it