How can a company that has never come close to breaking even, let alone turning a profit, justify a $30 billion valuation?
Spotify’s flotation earlier this week is interesting for a number of reasons. In the wake of plummeting values for other online behemoths Facebook and Amazon in the last few weeks, it suggests that the tech bubble clearly hasn’t quite burst yet.
The streaming company’s revolutionary effect on the music business has long met with resistance from the traditional powers. This week’s success, then, represents validation for the Swedish company, the latest reminder that they are no longer just another new kid on the block: they’re at the very top table, and continue to shape the future of the industry.
Crossing the streams
Spotify is a company with a weird duality at its core - its free service and its premium subscription service are essentially in competition with one another. While it makes logical sense to see the free service as the gateway to committing to the Premium, the model doesn’t quite work like that.
As of the end of 2017, Spotify had 157 million users, 71 million of whom were premium subscribers. That means the majority of its listeners are still using the free model. This in itself is a unique business driven by advertising revenue, and with 86 million people to hear these adverts, across 65 countries, Spotify’s ad salesmen ought to be able to name a high price for that airtime.
That said, that price goes down as free users become paid up subscribers, eliminating ads from their listening experience. £9.99 a month is not inconsiderable, particularly if 71 million people are handing that over.
However, as the number of paid subscribers rises, the number of free listeners will logically drop, meaning that income from subscriptions will increase but its effect will be to decrease the value of advertising on the other side of the business.
It’s all a big balancing act, as Spotify tries to extract maximum value from every one of its 157 million users - though the year-on-year losses the company has continually posted since its inception in 2008 suggest it is struggling to do so.
To pay or not to pay
The issue in reality is the free service. Revenue generated by advertising was last year listed at just under €300 million, barely a tenth of the €2.64 billion brought in by subscribers.
The nature of Spotify’s deal with the traditional and dominant major record labels - whose audience share is at least two-thirds of all streams on the app - means that the fees it pays for the right to carry those libraries on its platform are significant.
It is all calculated on a ‘per play’ basis, meaning that an artist and their record company receive the same amount every time one of their songs is played, regardless of whether that was by a paid subscriber or a free listener. If you listen to Spotify a lot, the charges the company will then be required to pay the record labels will soon outstrip the value of your ears hearing an advert every 20 minutes or so.
This ultimately means Spotify lose considerable money on every free listener they have. And while 71 million subscribers give them a healthy revenue stream, they are outweighed by the 86 million whose listening is effectively being subsidised by those who don’t want to listen to adverts and are happy to pay for that privilege.
Back to the future
Clearly, the expectation from investors is that this imbalance can be rectified. Spotify’s $30 billion opening dwarfs the likes of Twitter, Snap and even Google when they opened on the market; in fact, only Facebook and Alibaba had higher initial valuations among the recent tech giants to go public.
Their sensible economic projections, their anticipated growth in both users and subscribers and the continuing decline in music sales are what will have emboldened investors - streaming is clearly the future, and Spotify are far ahead of their competitors in terms of the product and user experience they are offering.
How they remain ahead will be crucial. They also have new investors who will only hang around if the company starts delivering on some of its promises.
Realistically, this means three things: continuing to expand its user base; increasing revenue from its subscribers, both by adding to their numbers and, potentially, upping subscription fees; and renegotiating its obligations to the major record labels so that its popularity with listeners does not perversely cost it money.
Get this right and not too far down the line, we could well be asking: ‘How was Spotify only valued at $30 billion?
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