The numbers powering Spotify’s $21 billion+ IPO

By Rohit Kulkarni, SharesPost

The highly anticipated initial public offering of music-streaming service Spotify is likely to be held in the late Q1 or early Q2 timeframe.

We have published a previous Spotify research report about the firm’s growing clout in the global music industry, as well as the pros and cons of a direct-listing approach. We believe that Spotify IPO could be the largest IPO in the past 5 years.

Yes, at an estimated $21.5 billion, Spotify’s market cap would be bigger than Snap’s post-IPO valuation of roughly $20 billion.

While Spotify’s official S-1 filing remains confidential, the company has filed its annual financial statements for the past five years at the Luxembourg Trade and Company Register. Based on the most recent period ending Dec 31, 2016, we have constructed a detailed financial model, including a historical income statement, balance sheet, and a statement of cash flows.

We have also included assumptions for key revenue and cost drivers, such as number of monthly active listeners, monthly subscription revenue per paying listener, and gross margin for subscription and ad-based revenues.

• Revenue: Spotify reported 2016 revenues of €2.93 billion ($3.25 billion), up 52 percent year-on-year. We estimate Spotify’s 2017 revenues increased 44 percent YoY to €4.24 billion ($4.80 billion) and will increase 39 percent YoY to €5.89 billion ($7.25 billion) in 2018. Key revenue drivers are monthly active listeners, paid premium subscribers, advertising revenue per user and monthly subscription revenue per subscriber.
• Gross Profit: Spotify’s gross margin in 2016 was 15.4 percent. However, it increased significantly to 22 percent in first half of 2017, largely driven by direct deals with music labels. Spotify’s cost of revenue consists primarily of royalty and distribution expenses related to content streaming. We expect Spotify’s gross margins to continue to improve due to three factors: (1) more direct content distribution deals with record labels with minimum guarantees; (2) better ad revenue monetization and targeting; and (3) growing global scale. In our model, we have assumed that Spotify’s gross margin increased to 16.4 percent in 2017 and would rise to 17.5 percent in 2018, leading to accelerating growth in gross profits. Given the series of licensing agreements Spotify signed in 2017, including Warner Music, Merlin and Universal Music, our gross margin assumptions may turn out to be fairly conservative.
• Operating Expenses: We expect Spotify’s operating expenses to continue to grow at a slower rate than the company’s top-line growth because of economies of scale. To further break down costs, we have divided Spotify’s Operating Expenses into three parts: (1) Product development, which consists primarily of costs incurred for the development of products related to Spotify’s streaming service as well as new advertising products; (2) Sales and marketing, which consists primarily of employee compensation and benefits, events and trade shows, PR, branding, customer acquisition costs, direct advertising, the promotion of new releases, and costs of providing free and discounted trials of the premium service; (3) General and administrative expenses, which consists primarily of employee compensation and benefits for functions such as finance, accounting, legal, HR, and others.
• Cash and cash flows: Spotify reported positive operating cash flows for 2016 and a cash balance of roughly €600 million ($666 million) at the end of 2016. Ninety percent of Spotify’s revenues come from high-visibility subscriptions, which have led to positive cash flows despite negative operating margins. Spotify’s ratio of paid subscribers to free users has steadily risen from 2012 to 2016 – from 20 percent to 35 percent. We expect Spotify’s cash balance to grow from €600 million ($666 million) at the end of 2016 to €1.32 billion ($1.63 billion) at the end of 2018. In our model, we assume that the company does not raise any capital from its upcoming IPO, which would be another testament to company’s successful business model.
• Balance sheet: In April 2016, Spotify raised $1 billion via a convertible note from an investor group led by TPG and Dragoneer. This capital influx included specific terms about the timing of an IPO. In line with Spotify’s announcement and subsequent media reports, we assume that TPG/Dragoneer converted 50 percent of their debt into equity and sold it to Tencent as part of the latter’s secondary equity investment at the end of 2017.

Rohit Kulkarni is a managing director and head of research at SharesPost.

Photo of headsets in front of a screen displaying a Spotify logo on it, courtesy of Reuters/Dado Ruvic.