The unconventional initial public offering (IPO) of Spotify (SPOT) on April 3rd is the biggest US tech listing since Snapchat owner Snap went public last year.

Unlike traditional market debuts, the company is using a direct listing that sidesteps the usual investor roadshows and team of investment bankers underwriting the offering.

It is expected to be the biggest launch since the Snap IPO last year and comes at a time when the number of tech IPOs as a proportion of total US listings is at a two-decade low.  Many hope that a successful IPO could encourage other unicorns like Airbnb and Uber to list publicly, having so far gone down the private funding route.

What is a direct listing?

 

A direct listing is a very unconventional approach and though not the first, Spotify will be the largest company to go down this route in the US. It cuts out the banks as the middle men who usually underwrite the offering and who can often sew up a fairly large chunk of the stock at a discount before shares go public. This may level the playing field, but it is also likely to result in a much more volatile debut for Spotify without a benchmark price for investors to go on. Nevertheless, private share dealings offer a guide.

The direct listing also comes without the usual lock-up period associated with an IPO, allowing founders and other early shareholders to sell immediately. This poses risks if they seek to offload large amounts at the same time. Spotify is not seeking to raise cash by issuing new shares – the shares can be traded publicly will be those that are already held by shareholders.

One key benefit of the listing is the lower cost – Spotify anticipates spending around €40m on the IPO, versus the roughly half that Snap paid. But given the company is not getting anything back from the listing, it’s not that cheap.

What do Spotify financials look like?

 

Ahead of the IPO, management delivered a bullish assessment of future growth. Guidance revealed last week shows they expect sales to rise to between €4.9bn and €5.3bn this year, up 20-30% year-over-year. Although this is a slowdown from the 38% growth in 2017, Spotify expects losses to shrink and gross margins to improve. Margins of 23-25% are expected in 2018, up from 14% in 2016. Operating losses of €230m-€330m is forecast for 2018, down from €378m last year.

This is based on forecasts for stronger growth in user numbers. Subscriber growth itself needs to be split in two – paid and active. The number of total monthly active users is expected to rise to 198-208 million in 2018, up 26-32% year-on-year. Premium subscribers, who pay a recurring monthly fee, are expected to rise to 92-96 million, up 30-36% y/y.

Growth of the free ad-supported service has been just as crucial as the premium service. Last year it was able to use this as a lever to get better terms with record labels, offering to withhold the biggest releases from the free service in return for lower fees paid to artists. The free service got so big that labels were willing to go along with this.

The question is can Spotify convince investors that it’s able to turn a profit? The guidance suggests a company growing fast but facing inherent, structural problems in its model that have stopped it from making a profit.

Spotify wants to be the Netflix of music – its whole model is based on scale and therefore it needs to see strong subscriber growth. Unlike Netflix, however, Spotify cannot produce original content – it relies on good relationships with music labels to deliver content to subscribers. Indeed nearly 90% of the music is supplied by just four big record labels.

Critical to its success is not just subscriber growth, but improved margins. Management is confident it can do this but it requires the firm paying record labels less for content than they do now. This may be a significant stumbling block.

These firms have considerable bargaining power; if Spotify is getting too profitable they can simply jack up royalty fees. They also own a fair chunk of Spotify equity. But this leverage cuts both ways – one of the reasons Spotify was able to renegotiate more favourable licensing terms last year was because labels did not want (for reasons relating to a complex convertible bond ) to see their shareholdings diluted.

If the labels choose to sell out their stocks, the outlook for licensing deals and margins changes.

Competition

 

Spotify is the biggest streaming service but it faces stiff competition, notably from Apple. The problem for Spotify is that the Apple Music service is not an apples-for-apples comparison. Apple can afford to run this as a low margin add-on to its wider product and service offerings , an incentive to ensure users stick with iOS rather than a standalone streaming service. Therefore Spotify could struggle to improve margins. Developing its own content would be a way to get round this – a la Netflix – but becoming a record label is probably not as easy as making hit TV programmes, nor does Spotify indicate any willingness to go down that route. Moreover, the existing big labels would not take too kindly to Spotify emerging as a direct competitor.

Where will SPOT trade?

 

Spotify shares will launch on the NYSE on April 3rd with the ticker SPOT. With no underwriting or banks acting as a ‘stabilisation agent’ when the stock debuts, it is expected that the share price could be very volatile.

A valuation of around $23bn has been estimated based private dealings that have seen the stock change hands for as much as $132.50, but it is hard to assess precisely where this will trade without an IPO strike price to go on. And while there is no hard and fast expectation of where the stock should trade, investor expectations are already well focussed on that kind of valuation.

Could it bring more companies to the market?

 

Tech IPOs have been a bit thin on the ground lately and it’s hoped that with Spotify and the recent Dropbox listing, it may encourage a few more waiting in the wings to go public. The likes of Airbnb and Uber are a couple of the big name private companies, or ‘unicorns’, which investment banks and investors are itching to get a piece of.

It’s thought that the direct listing approach may appeal to these disruptive companies who may prefer to keep Wall Street at arm’s length.

So far in 2018, the US IPO market has been strong, albeit with a lack of tech firms coming to market compared to previous years. What remains to be seen is the extent to which the recent stock market selloff and heightened volatility affects investors’ appetite for Spotify. A strong debut could encourage the unicorns to come to market; a flop might send them running for cover. Either way, Spotify's debut is one of the biggest stock market events of 2018.

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