Spotify’s next investors may face the music

May 26, 2016

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Spotify’s latest figures are both impressive and worrisome. The Swedish streaming-music service increased revenue 80 percent last year, to 1.9 billion euros, or about $2.1 billion. Its number of users swelled from 60 million in 2014 to nearly 90 million. And the 28 million paying subscribers it has signed up represent over 40 percent of the total streaming market. Even assuming generous growth and operating leverage in the future, though, it may be hard to justify a higher valuation than its most recent one.

The 10-year-old company led by cofounder Daniel Ek is confronting a common problem for digital music startups. A substantial portion of sales goes toward royalties and distribution fees. In Spotify’s case, the amount was 84 cents of every dollar last year, even higher than the 60 cents that hampers rival Pandora.

Because Spotify is losing money, there’s a tendency to accept non-standard methods of assessing its value. For example, the firm – whose June 2015 fundraising imputed an $8.5 billion valuation – is now worth more than four times revenue, a multiple on par with the $20 billion U.S. satellite radio company Sirius XM, a more established business that generates higher sales per subscriber.

Assume, however, that Spotify keeps expanding rapidly. Say it could roughly quadruple revenue by 2020, to $8 billion, with a greater proportion from advertising. That would give it nearly the entire market for streaming-music revenue, which research outfit Midia forecasts will be $8.5 billion in four-and-a-half years.

Spotify’s operating expenses account for about 25 percent of sales. If they could be pared to 15 percent and royalties to 75 percent, it would leave $800 million in profit. Taxed at 20 percent, that would net out to about $640 million. Using more conventional financial analysis and putting those earnings on a multiple of 15 would make Spotify worth about $9.6 billion.

Maybe the company expects its clout will enable it to pay even less to musicians and their labels. It also could be eyeing new sources of revenue, perhaps ones with higher margins. A $1 billion convertible bond Spotify issued earlier this year gives it firepower for acquisitions and investment. The terms also put it under greater pressure to go public soon. That may be when it faces the financial music.

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