This year’s IPO market is widely anticipated to be the year of the unicorn IPO market.  Snapchat, AirBnB, Spotify, Dropbox and even Uber are rumored to be considering an IPO this year.

A few potential investors at Graphene asked me to analyze the merits of participating in a Spotify IPO.  At an $8.5B valuation, Spotify’s near and long-term performance are bellwethers for other unicorns.

I share the insights below as a way for readers to understand my logic in analyzing late-stage investing and to engage with me.  Your thoughts are welcome here or via Twitter (@giannikoulis)

To Buy or Not to Buy?

Based on Spotify’s current traction and its current valuation:

  • Spotify is a short-term hold opportunity with moderate risk-adjusted returns.

  • Investors have a potential return of 25% within 2-years but with downside loss exposure of 33%

Spotify’s got upside

Though the music industry’s revenues have been decimated since the dawn of the internet era, digital revenues contribute  ~25% of its revenues and are growing.  In the music streaming space, Spotify, the 11-year old Swedish pioneer, leads the pack.

If you’re bullish on Spotify, it’s probably because:

1.  Spotify has scale & commands the attention of the music industry

With 40M paid users, 100M free users and revenues at $2.2 B, Spotify is far and above the leader in music streaming.

2. Record labels have vested interest in Spotify’s success

spotify-record-label-ownership
Spotify’s Annual Report

As of 2015, record labels owned up to 17% of Spotify.  Spotify’s protective moat seems strong.

3. Spotify outperforms the competition

Spotify’s large paid subscriber base (40M) and high conversion rate from free to paid (35%) outshine Pandora (4M paid & 80M free) and Apple (~17M paid users)

Monetizing music has been tough for most, but not Spotify.  Impressively, 90% of its revenues comes from paid subscribers.

4. Spotify’s valuation of $8.5B is fairly priced in today’s market

Based on 2015 sales of $2.2B, Spotify was valued at a multiple of 3.86x.  Comparatively, Sirius XM, trades at 5.2x LTM revenues, Netflix at 5.1x LTM revenues, and Pandora traded as high as 7.8x.

5. Even post-IPO, a Spotify acquisition could still be a possibility

Stand-alone offerings from Google, Amazon, Microsoft have not gained traction needed. Buying a paying user base for $212/user ($8.5B valuation/ 40M paid subs) may be inexpensive for the right large player.  Post-IPO acquisitions in today’s market usually command a 30% premium.

Be careful, Spotify’s downside is daunting

If you’re concerned about Spotify’s future, it’s probably because:

1. Path to profitability is uncertain

Paying nearly 85% to record labels means Spotify’s destiny is controlled by the record labels. A meaningful drop in COGS/ royalties is unlikely and Spotify has limited other means to reach profitability.

2. Upside growth limited

Spotify’s product innovation does not look ground-breaking.  Its failed Soundcloud acquisition limits options to grow at scale. Though Spotify Discover could be a record label replacement in the future, it will never supplant current streaming revenues.

Spotify’s growth strategy for emerging markets is interesting but may not drive massive revenue growth.

statistic_id190989_number-of-pandoras-active-users-2009-2015The competition has been challenged to grow.  Pandora’s users plateaued at 80M for past 3 years.

Even Jay-Z’s Tidal and Apple Music’s brand recognition and distribution weight have not demonstrated massive growth.  And who remembers Microsoft’s Zune and Groove?

3. Spotify’s appeal is declining with artists

Artists already complain about not making enough money via Spotify.  Some following Taylor Swift’s example are looking for alternatives to Spotify.

4. Deeper pockets with larger user bases are eyeing music

If music streaming is too tough to make profitable,  Amazon and Alphabet’s war chest of cash could use a free service as a loss leader to grow their core businesses.

5. Audio display advertising is less engaging than video

Lower interaction and awareness of audio ads commands lower CPMs.

 

Overall, Spotify’s lead in the music streaming industry presents a near-term return for investors.  However, maintaining that lead is still precarious.