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is Spotify a worthwhile investment?

is Spotify a worthwhile investment?

April 10
20:54 2018

Spotify shares started trading earlier this month on the New York Stock Exchange: the music streaming company took an unconventional path to public ownership. It chose a direct listing, meaning its shares began trading on the NYSE without going through the usual initial public offering process.

Spotify did achieve a smooth trading debut, but will it prove a good long-term investment?

We put the question to MBA students at some of the world’s top business schools.

Are the MBA students right? Join in the discussion in the comments below

Jay Kiew, Ivey Business School — Western University, Canada

Spotify’s biggest strengths lie in how it provides music access and music discovery. Whether it is a worthwhile investment will be determined by its ability to tie these strengths to profitability.

In terms of music access, the days of Apple’s 2001 iPod commercial boasting of “1,000 songs in your pocket” are long gone. Spotify’s vast catalogue of 30m songs due to its licensing deals with Sony, Warner and Universal allows users to access practically any song they want. But this is a double-edged sword when it comes to royalties, a monumental variable cost that accounts for about 75 per cent more than what YouTube pays. This makes me bearish on whether future profitability is likely.

Spotify’s use of algorithms to provide “Discover weekly” playlists according to music preferences works well. However, should Apple, Google or Tidal’s playlists catch up, there may be little to prevent customers from switching.

Momentum may carry Spotify for the short-term, but who knows what the future may hold.

Leke Sodipe, Yale School of Management, US

Spotify has legitimised digital music streaming, and by extension, forever changed the industry. Streaming music is the definitive way that individuals will consume music for the foreseeable future.

However, Spotify will live or die by how successful it is at doing two things. First, converting its members on the free tier into paid subscribers — and so far they have: paid subscribers are expected to jump to 46 per cent in 2018. The company’s second and more challenging task is to find a way to reduce the proportion of revenues it pays out as royalties to musicians and studios, while keeping these same content producers happy. It is a tough task, and one Spotify will need to solve, otherwise, its business model will be at risk of disruption.

As the company grows, perhaps it will be able to use its muscle to negotiate better royalty rates, reduce its cost of sales, and eventually become a profitable business.

Udit Parihar, Rotterdam School of Management, Netherlands

The traditional valuation methods may not be pertinent to the valuation of video and music streaming companies. Spotify needs to be valued based on its expected subscriber base and profitability. It has significantly lower content costs when compared with its peers and is expected to remain the market leader of the segment. Also, we need to add a premium on the valuation as it uses significantly less investment in working capital when compared with companies such as Netflix, which either produces or buys content.

Although Spotify has posted significant losses in the past and is expected to post a loss in 2018, the revenue is growing at a rate of about 40 per cent, which should result in future profits considering economies of scale. While the overall prospects look good, it needs to find a balance between reducing content costs and retaining popular artists.

The consistent growth in revenue, lower content costs and wide customer base makes it a value proposition even at the current price levels.

Matthew Capasso, SDA Bocconi School of Management, Italy

A direct listing is a daring introduction to public markets even for a company as innovative as Spotify. On the one hand, the direct listing is a management vote of confidence in the business, publicly displaying the non-need for dilutive capital raises. On the other, perhaps the method is a signal that private valuations have reached their peak, and that the company felt pressure to circumnavigate a conventional exit for its shareholders. Without a lock-up period, existing shareholders on day one of listing can unload their stakes.

With this in mind, it will not pay to be an investor in Spotify’s early trading sessions. In the short term we should expect algorithms to fight it out on the exchanges. Volatility will undoubtedly define the stock, but fundamentals will eventually take over. At this point, investors will be left with a company posting heavy losses in an increasingly hyper-competitive music streaming market.

At current prices Spotify shares will probably create more headaches than capital gains.

Tiago Stampfli, Esade, Spain

Spotify’s share offering was unusual because the company opted for a direct offering rather than an IPO. Despite the liquidity and resulting volatility risks of this method, the stock price traded above the recommended $132 per share. Combined with the fact that none of the shareholders had a lock-up period and were free to liquidate, it shows investors truly believe in this new business model for the music industry.

The financials of the company have been constantly improving but the net income is still negative and, due to the nature of the licensing business, an increase in revenue always comes with an equal increase in cost.

In conclusion, the current evaluation of Spotify is based on the belief that the streaming business model is the future and not upon fundamental factors. This belief will not change in the near future and would classify Spotify as a good short-term (a couple of years) investment.

Sherman Leow, Singapore Management University

Whether Spotify is a worthwhile investment depends on its growth rate and long-term margins.

First, growth rate. A reasonable maturity multiple for a business could conservatively be about 16 times earnings before interest and taxes, which means Spotify should more than double current sales to justify its price. This is improbable due to market saturation and competition. This is also evident from Spotify’s growth levels, which have shown signs of deceleration from 50 per cent in 2016 to 40 per cent in 2017.

Second, is the long-term margin. Arguably, Spotify will have lower long-term margins as it needs to continue spending more money to capture customers to achieve its growth. Today it is paying 79 cents per dollar revenue to suppliers.

Tight opportunities to expand the business, and lower margins do make Spotify a less attractive investment.

Edoardo Pisciotta, Esade, Spain

There is no simple answer — at the moment the company is not a worthwhile investment, but it could be in the future.

There is a successful growth story — Spotify has 70m paying subscribers. Apple is a distant second, with 30m paying subscribers, although with a higher growth rate in the US.

However despite increasing revenues, Spotify has not been able to generate a profit and it lacks any real asset, other than its user base. To achieve sustainable profitable growth, Spotify needs to find a way to monetise its offerings, a challenging task in the highly competitive music industry.

I would adopt a “wait and watch” strategy.

Varun Maryada, Ivey Business School — Western University, Canada

The positive outlook bodes well for Spotify in the face of competition from Apple. However, the company posted an operating loss of $350m in 2017, which could be a cause for concern and turn away some investors.

Based on the financial outlook, Spotify is in a position of growth and a buy, as it continues to grow and expand its premium subscribers.

Eric Bowler, SDA Bocconi School of Management, Italy

I see risk in the bullish sentiment surrounding Spotify. While Spotify has improved its gross margin from 16 per cent in 2014 to 21 per cent in 2017, it is difficult to see a clear path towards the stated gross margin target of 35 per cent for three interrelated reasons.

The music industry is extremely concentrated. An estimated 87 per cent of Spotify’s streamed content came mostly from the big three studios. Spotify faces increased competition from Apple, Amazon and Google, which are more diversified and may be willing to take lower margins for streaming services. Also, Spotify has not yet shown a strong commitment towards developing its own content. Spotify appears to be staking future content ownership on smaller artists signing with it in the hope of being discovered through Spotify’s vast listener network. Needless to say, this is a long-term strategy and highly uncertain.

Unless Spotify is able to take action to increase market power and improve gross margins the profitability outlook and valuation remains questionable.

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