Spotify: A Look At Valuation

It’s not an understatement to say that Spotify (SPOT) is the most anticipated IPO of the year. The Swedish music streaming company, over the past several years, has risen to nearly one hundred million paying subscribers and has become one of the world’s largest unicorns. In December of last year, Chinese internet conglomerate Tencent (OTCPK:TCEHY) bought shares of Spotify at a reported valuation of $19 billion.

Just seven unicorns are larger than Spotify at the moment, according to the definitive list from CBInsights. These include Uber ($68 billion), which has topped the chart for years; Didi Chuxing ($56 billion; and effectively “China’s Uber); Airbnb ($29.3 billion); and Palantir ($20 billion). With none of these companies signalling intentions for a public offering in the near future, Spotify is likely to be one of the highest profile deals for a long time.

By now, most investors also know that Spotify’s IPO is an unusual “direct listing” – meaning no investment bankers, no roadshow, no capital raise, and no set price for the deal. Supply and demand will determine where Spotify trades on its first day of trading, instead of IPO underwriters determining a price to fill the order book. As most are aware, the typical IPO sees a “pop” on Day 1 because underwriters artificially price a stock somewhat low in order to guarantee institutional investors a good return and generate the “pop” in the first place. Dropbox (DBX), for example, priced at $21 but opened for trading at $29 – a 40% pop.

The bottom line for Spotify – without an artificially low starting price, and without investment bankers stabilizing the offering in either the up or down direction, Spotify could see far more volatility than the typical deal. With so many investors clamoring for a piece of the pie, having a feel for Spotify’s valuation as it gyrates throughout its early life as a public company is of utmost importance.

One of the benefits of a direct listing is that brokers aren’t subject to a quiet period. RBC Capital Markets was first out of the gate with a $225 price target; other brokers have a target of $200. At the top end of that range, with 183.852 million shares currently outstanding, RBC implies a market value of $41.4 billion for Spotify – more than twice its most recent private valuation. At the moment, the $200-$225 mark is the only anchor the public has on Spotify’s share price.

Is this a reasonable target, or was it a number pulled out of a hat? Let’s look at Spotify’s valuation against three important metrics: revenue, subscribers, and MAUs.

By revenue

The easiest valuation comp for Spotify is also probably the least reliable. Revenue multiples are useful in evaluating SaaS IPOs because all the companies in the comp set typically have similar characteristics – high gross margins in the 70s-80s, and a mostly recurring revenue subscription base. But in the internet sector – particularly in Spotify’s case – the revenue and margin profiles vary widely.

Spotify recently released guidance for FY18 that called for 4.9-5.3 billion of revenue, or 20-30% y/y growth:

Figure 1. Spotify guidance

Source: Spotify 6-K filing

At today’s exchange rate of $1.23 to the euro, this implies a revenue range of $6.03 to $6.52 billion. Against the high price target of $225 ($41.4 billion market cap), this implies a price/revenue multiple of 6.6x.

Since Spotify is primarily a subscription business (though free ad-supported users make up more than half of Spotify’s MAUs, advertising revenues make up barely a tenth of its revenues – see the revenue breakdown below), it makes sense to compare its revenues against other internet subscription businesses. And since Spotify has earned a popular moniker as the “Netflix of Music”, it makes sense to compare this valuation against Netflix (NFLX) itself.

Figure 2. Spotify Premium vs. advertising revenue

Source: Spotify F-1 filing

Though Netflix has not formally issued FY18 revenue guidance, its CEO Reed Hastings has been quoted predicting $15 billion in revenues this year. Wall Street analysts, to be more specific, have a consensus revenue target of $15.82 billion (+34% y/y), as reported by Yahoo Finance.

Against Netflix’s current market cap of $128.17 billion, that’s a price/revenue multiple of 8.1x. So certainly, RBC’s target isn’t too far out of left field. Do note, however, that Netflix had gross margins of 34% in FY17 – Spotify, only 21%. So in theory, Netflix’s premium is justified by the fact that its revenue stream is worth more in gross margin dollars. Netflix’s film content is expensive to acquire and produce – but Spotify’s music licenses are even more so. Note also that Netflix’s expected 34% growth rate is also higher than the top end of Spotify’s growth range of 20-30%, despite being more than twice the scale, justifying even more of the premium.

There’s one more comparison that’s apt to make, and that’s against Pandora (P), Spotify’s only real pure-play comp in the music streaming space. Pandora has a current bite-sized market cap at just $1.28 billion. Like Netflix, it hasn’t formally issued FY18 revenue guidance, but Wall Street has a consensus of $1.51 billion in revenues for the year. This puts its price/revenue multiple at 0.9x.

To be fair, Pandora is somewhat dying – a death inflicted by none other than Spotify. Its ad revenues are faltering, while growth in its subscription and ticketing revenues aren’t enough to eke out more than flat y/y growth. But still, the valuation gap between Pandora’s <1x multiple and Spotify’s expected multiple above 6x is quite wide.

By subscribers

We can also compare Spotify’s valuation against its subscribers, comparing it to the subscription bases of the companies above. Since Spotify Premium’s cost of $9.99 per month is equal to Pandora Premium and Netflix’s monthly cost of $9.99, a comparison of the subscriber counts is apt, excluding the gross margin deltas discussed above. (We note also that Pandora has a streaming radio offering called Pandora Plus at $4.99 per month, but we’ll consolidate this in the total here).

Spotify is the only company to have issued subscriber guidance for FY18, so we’ll use FY17’s subscriber counts here. Here’s a look at Spotify’s historical growth in Premium subscriptions:

Figure 3. Spotify Premium subscribers

Source: Spotify F-1 filing

Barring any pricing abnormalities, each Premium subscriber brings in $120 per year – so if this subscriber base experiences zero churn (historically, churn has been between 5-6%, though net adds have more than made up for it), a subscription base of 71 million users is worth $8.5 billion in annual recurring revenue. For FY18, we’ll note also that Spotify is expecting 92-96 million Premium subscribers, up 30-36% y/y.

Again using Spotify’s top valuation mark of $41.4 billion as our starting point, Spotify has a market value per subscriber of $583, based on FY17 subscriber counts. When you think about the fact that each subscriber brings in $120 of annual revenue (not counting their month’s free trial or churn), that’s not too unreasonable.

Netflix, on the other hand, had 110.64 million paid subscribers at the end of FY17. That comes out to a market value of $1,158 per subscriber – again, a large premium to Spotify.

Pandora had 5.48 million paid subscribers (Plus and Premium) at the end of FY17, a measly amount compared to Spotify. That comes out to a market value of $234 per subscriber – but again, a large portion of Pandora’s subscriber counts come from the lower $5/month Pandora Plus offering.

One other comparison we can make – iQIYI (IQ), the so-called “Netflix of China,” just went public in the U.S. last week. Its current $10.99 billion market cap stacks up against 50.8 million paid subscribers, or $216 per subscriber.

By MAUs

Finally, we can also gauge Spotify’s valuation on a MAU basis, as many internet investors typically do. Using MAUs as the user metric rather than subscribers captures the value of Spotify’s free tier users – though they don’t generate as much revenue as the Premium listeners, they do contribute to Spotify’s scale. Subscription businesses like Netflix don’t report monthly active users, but other large internet companies like Facebook (FB) and Twitter (TWTR) do.

Spotify reported 157 million MAUs in FY17, as shown below:

Figure 4. Spotify MAUs

Source: Spotify F-1 filing

Using the same logic as above, a market value of $41.4 billion for Spotify would imply $264 per MAU. We’ll note also that MAUs are expected to grow 26-32% y/y in FY18 to a range of 198-208 million.

After the Cambridge Analytica outbreak, Facebook is left with a market cap of “just” $464.19 billion. The company reported 2.13 billion MAUs at the end of FY17, coming out to $218 per MAU. When considering that Facebook is already heavily saturated and its MAU growth rate of 14% y/y is much lower than Spotify’s, this makes Spotify’s per-MAU valuation appear reasonable.

Twitter also is seeing rather flat MAU action. In FY17, it reported 330 million MAUs. Against a current market cap of $21.78 billion, that’s $66 per MAU.

The one other big internet company that reports similar user metrics is Snap (SNAP), though it reports in terms of daily active users (DAUs) instead of MAUs. DAUs, clearly, are much more valuable than MAUs – so it doesn’t translate exactly into an apples-to-apples comparison. Snap had 187 million DAUs at the end of FY17 against a current market cap of $19.47 billion, or $104 per MAU.

Key takeaways

When using Netflix as an anchor for Spotify’s valuation, a price range of $200-$225 doesn’t seem all to unreasonable. At the top end of that range, a market cap of $41.4 billion for Spotify, though more than twice its most recent private valuation at $19 billion, is still less expensive than Netflix on a revenue or per-subscriber basis.

We do have to take some common-sense cautions, however. Netflix’s gross margins are substantially higher than Spotify’s – theoretically making its revenue stream and subscriber base more valuable than Spotify. Netflix is also growing slightly faster and generates strong EBITDA.

With Spotify’s underwriter-free offering, volatility is bound to be accentuated. Keep an eye on Spotify’s valuation and take care not to trade blindly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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