Spotify Research Report

The Rock Star of Streaming Services

Streaming music is becoming, if it is not already, the premier mode of music consumption. Spotify has been at the forefront of this secular change displacing traditional modes of listening with on-demand service. We are updating our initiation report and introducing our new valuation based on comparative valuation and DCF analysis. We are reiterating our positive thesis on Spotify given the company’s strong competitive position on the back of key differentiating factors such as ease of discovery, deep social element, loyal user base, a high free-to-paid conversion rate of listeners, and a large untapped addressable market, particularly in the emerging markets.

METHODOLOGY

Our research process involves proprietary channel checks with users, competitors and industry experts, and synthesis of publicly available information from the company and other reliable sources.

KEY POINTS

  • Still the Incumbent Leader… Spotify is the largest on-demand music subscription service in the world, with over 30M paying subscribers and 89M active listeners. The company has maintained its competitive edge by virtue of its vast library of content, a freemium model combined with a high conversion rate, and compelling price points across its products. We expect 39M paying subscribers in 2016 and roughly 50M by 2017.
  • ….But Space is Getting Crowded. Revamped music services from tech giants are coming on strong, led by Apple Music, followed by Alphabet’s YouTube, and Amazon’s Prime Music. But unlike Spotify, which is a pure-play music company, the driving purpose of these companies is to reinforce their respective brands, pull users into their respective ecosystems, and ultimately sell their core products.
  • Product Update. Spotify has expanded its product offering, in step with its competitors. While Apple continues to maintain its “walled garden” of only providing its Music app on Apple TV, Spotify is partnering with other technology companies with a living room presence. In Q1 2016 Spotify became available on Android TV and Amazon Echo, expanding the Spotify use cases from mobile and desktop to other media formats. In addition, the company announced its video initiative and deepened its tie-up with Facebook.
  • Royalty Payments Remain a Hurdle to Profitability. Spotify distributes roughly 70 – 75% of all the revenues that it receives back to rights holders – labels, publishers, distributors, and independent artists. We expect Spotify to leverage its growing scale and constructive relations with the record labels to negotiate lower royalty rates and move toward profitability. 
  • Spotify Fairly Valued At $9.5B. Spotify’s comparative EV/Rev valuation is $10.91B and our 10-year DCF valuation is $8.06B. We believe Spotify is fairly valued at the mid-point of these two values, or $9.48B. We believe the premium valuation to its last private round of $8.5B is justifiable given the company’s strong subscriber growth, its high conversion rate, the recurring subscription model, constructive relations with the major record labels, and its strong competitive position.

 

Exhibit 1: Spotify User Base (Mil)

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Source: Spotify, MVR Estimate

 

Exhibit 2: Spotify Revenue ($Mil)

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Source: Spotify, MVR Estimate

 

Spotify Update – Leading the Pack

There have been a few changes since our initiation report in December 2014. The company beefed up its offering, is more widely available, raised more money including a convertible debt round, and made three acquisitions. Through it all, Spotify has maintained its competitive lead in on-demand music streaming, exiting 2015 with 89 million total listeners, including 28 million paying subscribers and 61 million free listeners.

 

Figure 2: Spotify Listener Base (Mil)

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Source: Company reports, Manhattan Venture Research (MVR) estimates

Product Update

As competition heats up in the streaming space, Spotify has continued to expand its product offering in the hopes of converting more subscribers to its streaming service. While Apple continues to maintain its “walled garden” of only providing its Music app on Apple TV, Spotify is partnering with other technology companies with a living room presence. In Q1 2016 Spotify became available on Android TV and Amazon Echo, expanding the Spotify use cases from mobile and desktop to other media formats.

The expansion likely served as a pairing with Spotify’s other big push—moving into video. The company announced original video content on the service in May, with music-focused programming that could eventually lead the way to greater advertising revenue and more branded content. The enhanced streaming video could be an interesting addition to Spotify’s push to move more original and artist-specific content—for example, streaming concert performances.

In a similar vein, Spotify is seeking to use its strong presence in social to further its user experience and brand. Facebook data drives its new Discover Weekly playlist, which has been hailed for its “uncanny” accuracy in finding new music users like—taking Pandora’s main value-add and enhancing it significantly. Likewise, Spotify is integrating its data into Bumble, a popular dating app, to help users select potential dates based on common music preferences, and is now featured in Twitter audio cards as well.

 

Figure 3: Spotify Discover Weekly Playlist – Screenshot

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Source: Spotify Website

Pricing

Spotify has also had to accept more competitive pricing in recent months. Apple Music and Google Play Music already had family plans available at $14.99 for up to 6 people, while Spotify charged a monthly fee for each additional user until it shifted to the $14.99 price point. Overall, however, pricing in the industry seems stable despite a few new entrants.

Spotify’s Discover Weekly playlists have 40 million listeners and Apple Music will get a cleaner interface for finding new music when iOS 10 launches this fall. All seem to be hunting for that sweet spot where a little bit of user choice guides a ton of algorithmically-chosen songs.

Other than the promotions and occasional tweaks, the company’s pricing grid remains the same: Premium subscription for $9.99/month beginning with a free 30-day free trial. The subscription comes with the following features: shuffle play, ad-free, unlimited skips, ability to listen offline, play any track and high-quality audio. The Free option allows only shuffle play and does not include the other features of premium subscriptions.

Acquisitions

Twitter’s recent investment into SoundCloud highlighted the value media and tech companies now see in direct user engagement. Spotify has managed to stay ahead of the curve here, using cash from the late 2015 funding round to bolster its position on both sides of the app: engagement with artists and the user experience. Spotify’s success comes from both increasing its user base and deepening their engagement, and the company is using acquisitions to drive the latter with purchases of Soundwave, Cord, and CrowdAlbum.

  • Soundwave will help enhance Spotify’s already popular music discovery features like Discover Weekly and playlist radio. Expanding users’ music tastes with new songs and artists fits into Spotify’s hope to increase usage of the app by existing users;
  • Cord, which designs voice messaging for phones and tablets, likely figures into a similar plan to create a messaging product that will take advantage of Spotify’s social integration and allow users to discuss their favorite songs more easily;
  • Streaming services increasingly see helping smaller artists monetize their audiences as part of their value proposition. Spotify’s April 2016 purchase of CrowdAlbum will enhance the artists’ ability to gather content from their live performances and deliver and promote the content to audiences.

Overall, Spotify’s record of acquisitions this year shows the company is keen on creating a more comprehensive listening experience that connects artists and listeners in as many ways as possible.

Funding

Spotify has raised $2.1 billion to date from a wide range of investors. Except for the most recent convertible debt offering of $1 billion, all seven funding rounds were equity rounds from a wide range of investors. Prominent investors include Kleiner Perkins, Accel Partners, Fidelity Ventures, Goldman Sachs, Li Ka-Shing, Coca-Cola and Technology Crossover Ventures. The last equity funding round in June 2015, Series G, was for $526 million at a post-money valuation of $8.5 billion.

Spotify tapped the debt markets this past spring, raising $1 billion in convertible debt from a number of prominent investors including TPG, Dragoneer, and clients of Goldman Sachs. As Spotify gears up for a battle to protect market share against its deep-pocketed rival Apple, additional funds will help make acquisitions and fund growth in marketing to artists and subscribers.

Terms on the deal include 5% annual interest, with the option to convert debt to equity at a 20% discount. There is also a condition increasing the interest rate and discount if Spotify does not conduct its initial public offering (IPO) by March 2017—suggesting the company is strongly considering one and increasing the incentive to do so. With the strong numbers released for 1H16, another strong performance combined with a thaw in the IPO market might bring the right ingredients together to go public—and would undoubtedly be one of the blockbuster offerings of the year.

Given Spotify’s balance sheet position holding nearly $1B in cash, the company seems confident about its prospects going forward and saw the opportunity to raise cash without diluting current equity holders.

On a related note, it is worth noting that the record labels are early investors in Spotify. The five companies and their respective holdings include the following: Sony BMG (5.8%), Universal Music (4.8%), Warner Music (3.8%), EMI (1.9%), and Merlin (1.0%). These investments are particularly noteworthy given that Spotify has become the poster child for all that is wrong with the music industry – including dwindling industry revenues and declining artists’ compensation. On one hand, the labels are holding onto the status quo, while on the other they have a vested interest in Spotify’s success.

 

Figure 4: Spotify Funding Rounds

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Source: Pitchbook

 

Industry Update

The recorded music industry has evolved further since our initiation report in December 2014. As we noted in the report, the industry has been a helpless bystander in the face of changing music consumption pattern and dwindling industry revenues. But there are signs of changes – for the better. After two decades of sequential declines, and for the first time since the Napster-led industry crash, 2015 was a pivotal inflection year in a number of respects: revenue grew globally, music consumption exploded all over, and digital revenues overtook revenues from physical formats for the first time. Global sales of the recorded music in 2015 touched $15.0 billion, well below the high of $29 billion in 1999 and a most recent high of $16.8 billion in 2008, but increasing sequentially to $15 billion from $14.5 billion in 2014.

 

Figure 5: WW Digital Sales versus Physical Sales ($B)

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Source: IFPI Global Music Report 2016, MVR

The Rise and Rise of Streaming Services

Streaming music is becoming, if it is not already, the premier mode of music consumption, outpacing the traditional modes of listening. The competitive landscape has become more intense with the renewed focus of Apple, Google and Amazon to enter and/or beef up their respective music offerings. Spotify remains the incumbent leader in terms of premium on-demand subscribers with over 28 million paying subscribers and  89 million listener base (as of Dec. 2015), well ahead of Apple Music, the company’s closest competitor, with 15 million paying subscribers.

Digital sales have been a bright spot in the music industry. Sales grew sequentially since 2008 touching $6.7 billion in 2015 (+10.2% Y/Y), driven in large part by growth in subscription services. Subscription revenues grew 45.2% in 2015, more than offsetting the decline in downloads and physical formats. A number of factors have contributed to this surge: increasing broadband penetration and internet speeds making the listening experience better; access from multiple devices – particularly mobile; successful bundling deals with ISPs and mobile operators; and integration with popular social networks such as Facebook and Twitter. All these factors in combination with a low monthly subscription fee have made the value proposition of subscription services too compelling to ignore.

Globally, digital now accounts for 45% of total industry revenues, and now account for more than half the recorded music market in 19 markets. In 2015, an additional four countries – Colombia, New Zealand, Philippines and Taiwan – saw digital revenues cross the 50% threshold.

Streaming remains the industry’s fastest-growing revenue source. Revenues increased 45.2% to $ 2.9 billion and, over the five year period up to 2015, have grown more than four-fold.

 

Figure 6: Global Streaming Revenue Growth ($Mil)

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Source: IFPI Global Music Report 2016, MVR

Helped by the spread of smartphones, increased availability of high-quality subscription services and connected fans migrating onto licensed music services, streaming has grown to represent 19% of global industry revenues, up from 14% in 2014. Streaming now accounts for 43% of digital revenues and is close to overtaking downloads (45%) to become the industry’s primary digital revenue stream.

Premium subscription services have seen a dramatic expansion in recent years with an estimated 68 million people now paying a music subscription. This figure is up from 41 million in 2014 and just eight million when data was first compiled in 2010.

 

Figure 7: WW Streaming Subscribers (Mil)

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Source: IFPI Global Music Report 2016

Downloads remain a significant offering, accounting for 20% of industry revenues. Income was down 10.5% to $ 3.0 billion – a higher rate of decline than in 2014 (- 8.2%). Full album downloads are still a major part of the music fans’ experience and were worth $1.4 billion. This is higher than the level of sales in 2010 ($983 million) and 2011 ($1.3 billion).

Performance rights revenue – revenue generated through the use of recorded music by broadcasters and public venues – increased 4.4% to $2.1 billion and remains one of the most consistent growing revenue sources. This revenue stream now accounts for 14% of the industry’s overall global revenue, up from 10% in 2011.

Revenues from physical formats declined, albeit at a slower rate than in previous years, falling by 4.5% compared to 8.5% in 2014 and 10.6% in 2013. The sector still accounts for 39% of overall global income and remains the format of choice for consumers in a number of major markets worldwide including Japan (75%), Germany (60%), and France (42%).

Audio Streaming Surpasses Music Videos

Despite the popularity of video streaming, Americans are consuming more on-demand audio streaming than music videos. According to data from BuzzAngle, an analytics provider, since the start of 2016 Americans purposefully played 114 billion audio streams on apps like Spotify, Tidal, and Apple Music, versus watching 95 billion music video streams on apps like YouTube. This represents a big resurgence for pure listening since the rise of MTV.

On-demand audio streaming was up 107.8% in the US in the first half of 2016 compared to the first half of 2015, while video streaming grew 23%. On-demand streaming as a whole rose 58.3%, and these numbers don’t count online radio streaming like Pandora.

 

Figure 8: Audio Streams vs Video Streams: 1H16 vs 1H15

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Source: BuzzAngle

 

Investment Thesis

We are reiterating our positive thesis on Spotify. We believe the company has established a strong competitive position in the on-demand music streaming business and is well positioned to capture a growing share of the addressable market ahead. Our positive opinion is tempered modestly by the high royalty payout structure and rising competition from the Internet majors. We highlight the key positives and negatives below.

Positives

  • Curated Access. The music world has come a long way from the days when ownership of physical records or listening to the non-interactive terrestrial radio was the only way to listen to music. Today it is all about curation and discovery to engage a fickle audience and build loyalty. Spotify is at the forefront of this changing dynamic, if not the key service driving this change. The company has staff-curated playlists, and users can also make their own playlists. There are more than a billion playlists on the site, essentially functioning as the album of the streaming world. Users can attract followers, follow friends, share and co-generate playlists. Users in motion can crowdsource and share on uniquely mobile and social platform. Well, known artists have and are emerging as hundreds of thousands of followers play and discover songs and artists from those whom they follow.

Engagement and sharing make Spotify compelling and sticky while using social network effects to speed and lower the costs of new customer acquisition. The company has invested in improving the algorithms to drive the discovery process and keep listeners engaged and sharing. The acquisition of Echo Nest gave Spotify an enormous competitive edge. With Echo Nest’s expertise in music intelligence and Spotify’s access to a large trove of valuable data on listener preferences, the in-house programmers have developed powerful discovery tools. In effect, Spotify is using song analytics and user data to help both human and intelligent machine curators select the right songs for certain activities or moods, and build playlists for those moments. The harvested data, strategic partnerships and learning algorithms erect barriers to entry and make the Spotify experience unique and hard to replace.

  • A Deep Social Layer. Spotify has been on the forefront of driving social initiatives. In our view, music is a fundamentally social experience; we recognize that every activity, be it sports, dining, or entertainment, has natural personal and shared benefits, and we believe music is no less a shared experience than any of these. The company’s partnership with Facebook has been vital to its successful launch in the U.S.

Spotify has developed a unique “Play” button, whereby its service can be available on other social networking partner sites (Google+, Twitter, Yahoo, among others), and third party websites (Huffington Post, Entertainment Weekly, Mashable, Guardian, among others). Spotify’s platform allows for the development of third-party apps, and content/service providers, such as Songkick, Rolling Stone, Pitchfork, Fuse, and Billboard, to develop apps on Spotify. Mobile apps and mobile usage dominate Spotify engagement today and are increasingly the way users consume audio entertainment. The company is able to be ever present and serve all of the needs of users. This is behind their best in class ability to convert free users into paid subscribers and retain their subscribers in the face of growing competition.

  • Constructive Working Relations with Record Labels. Spotify has excellent relations with the major record companies and publishers. This is based on talking to a few music industry executives who have worked closed with the streaming companies. The motive of the labels for having good relations with Spotify is understandable for two reasons: (1) Streaming services are generating material revenues for the labels at a critical time in the evolution of the music industry; and (2) Record labels have an equity stake in Spotify. Beyond good relations, several important rights owners have actively partnered with Spotify.

Spotify and Pandora, its closest peer, are actually generating money for the music labels. Warner Music Group, for instance, indicated that streaming services contributed 25% of the digital revenue in fiscal 2013. What’s more encouraging for Warner — and presumably the rest of the big labels — is that streaming revenue is growing at a healthy rate and offsetting decline in download revenue – a key revenue source for the labels. Just as encouraging from Warner’s perspective is that the declines in physical revenue continue to outpace digital revenue’s growth in the recorded music industry, something the industry has been aiming for since the late 1990s.

Not just the major labels, Spotify has also developed good relationships with individual record labels. While Spotify’s on-demand, online streaming model necessitates the signing of licensing deals on a label-by-label basis, our channel checks suggest that these relationships are far deeper than simple revenue-sharing arrangements.

Another noteworthy aspect of the relationship between the record labels and Spotify is the former’s ownership stake in Spotify. According to a report published in TechCrunch, the record companies were awarded roughly 17% of the company in the early days of the company. Assuming this report to be accurate – albeit counter-intuitive given that Spotify has disrupted the music consumption model – we believe the record companies have a vested interest to work constructively with Spotify for the mutual benefit of both. And they are doing just that. The record labels have helped, and continue to help, Spotify develops various audience growth and marketing initiatives, and jointly plan various strategic actions. In return, Spotify has paid out more than $500 million in royalties to the labels and has been transparent in all its dealings.

 

Figure 9: Ownership Stake of Record Companies in Spotify

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Source: Company reports, MVR

Spotify’s relations with the record labels have meaningful financial implications. The company pays out 70% of its revenues in royalties, severely clouding its path to profitability, and threatening the sustainability of its business model.  Spotify has been losing money consistently since inception, and the biggest obstacle has been the high payout rate of 70% to 75% to the labels. To the extent the company can prove its “absolute value” to the labels and the industry as a whole – which we believe it will – we expect the payout rate to get more favorable in the near future and remove any doubts about its business model. We believe that the value of Spotify has been demonstrated and that all leading labels now understand that streaming music is the future.

  • Growing Addressable Market. The global music market is large and growing. According to market data, radio accounts for 80% of total music listening or roughly 13 hours per week per person, and in any given week, 93% of the U.S. population listens to the radio at least once. Additionally, nearly half of all radio hours are consumed in cars, while just over one-third are consumed at home. The majority of the rest are consumed during office hours. Furthermore, 84% of all radio listener hours are on the traditional terrestrial radio. The remaining 16% is split evenly between satellite radio and Internet radio. Pandora dominates the Internet radio category with nearly three-quarters of all Internet radio listening hours. Sirius XM dominates the satellite radio category.

Against this backdrop, Spotify, with roughly 100 million active listeners, and presence in only 59 countries, has just scratched the surface. Two particularly significant growth opportunities lie in tie-ups with telecom carriers and automobile companies given rising smartphone penetration worldwide and improved broadband speeds.

Negatives

Two concerns underlie our positive thesis: a complex and prohibitive royalty structure, and an increasingly competitive landscape driven in large part by the Internet majors Apple, Google, Amazon.

  • Complex & Prohibitive Royalty Structure. Spotify pays royalties for all of the listening that occurs on its service. The current contracts stipulate a distribution of roughly 70% to 75% of all the revenues that it receive back to rights holders – labels, publishers, distributors, and, through certain digital distributors, independent artists themselves. The payout is split amongst the rights holders in accordance with the popularity of their music on the service. Essentially, the music companies get paid percentages of each subscriber and then get a per-stream rate or a share of the ad revenue, whichever is greater. The label or publisher then divides these royalties to each artist depending on their individual deals. Furthermore, when Spotify pays a rights holder, it provides all the information needed to attribute royalties to each of their artists, thereby ensuring complete transparency.

Spotify’s high royalty rate is a cause for concern and has clouded the company’s path to profitability, despite its strong revenue growth. In 2015, the company reported a net loss of €173 million, and we expect profitability to remain elusive at least early 2018. We believe this is partly a function of the industry at large, which has seen multiple players grow revenue at a fast pace but ultimately find it challenging to generate profits because of high royalty levels. Spotify’s ad-based radio offering, however, has similar economics as that of Pandora, and, therefore, to the extent that the company can grow this offering, Spotify could see some relative margin lift. We have modeled profitability in mid-2018 given the current payout structure and the cost run rates.

  • Hyper Competitive Landscape. The music streaming industry is overcrowded with too many players chasing elusive profits and a fickle audience. The biggest beneficiary in this hyper-competitive landscape has been the active music listener. At any given time, he or she can consume music from a wide range of outlets: Internet Radio, on-demand services, downloads, terrestrial radio, or personal collection of physical records.

 

Figure 10: Listening Options

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Source: MVR

Spotify competes primarily in two categories of this landscape: on-demand streaming service and non-interactive streaming service – commonly referred to as Internet Radio. Regarding the other two areas, Spotify does not sell music downloads (it offers premium subscribers similar access, without ownership, in its offline functionality), and terrestrial radio, with 84% market share of the radio listening audience, is more a feeder of new listeners for Spotify than a competitor.

The following chart shows Spotify’s competitive landscape by category, including the terrestrial broadcast radio companies.

 

Figure 11: Competitive Landscape by Category

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Source: Company websites, MVR

The arrival of Apple Music has validated the space and raised the awareness of streaming music in the mainstream. Spotify continues to grow rapidly and has introduced innovations such as its much praised Discover Weekly feature promoting new music. Rhapsody/Napster hit the 3.5 million subscriber mark in 2015. The service, a pioneer of digital music, is currently in 34 countries worldwide. It is available by paid subscription only and is highly focused on extending integration with social media platforms, having been integrated with Twitter in 2015. Alongside new launches, existing players in the streaming space are pushing the market forward with a combination of new product offers and services. YouTube launched its YouTube Red $9.99 subscription service in the US that covers access to both YouTube and Google Play Music.

Looking deeper, Google Play Music, having doubled user numbers internationally in 2014, launched new features in 2015 and extended to 62 countries including Japan. It offers a $9.99/ month subscription and a $14.99/month family plan for six members. It has made curation a big focus, extending its concierge song-recommendation service to 15 countries after the acquisition of Songza in 2014. Google has also launched an advertising-supported radio tier to its service in the US and Canada;

Since launching in June ’15, Apple Music has risen to a global On Demand streaming leader, reaching 15MM paid subs just a year after its launch, due in part to its huge iPhone install base (estimated at ~580MM) and 3 months free trial;

Amazon Prime Music is part of the Prime bundle and has gained traction on the back of its captive Prime subscribers. Recent press reports suggest Amazon is finalizing deals with record labels to offer a standalone On Demand streaming music service for $9.99/month launching in Fall ’16 vs only being available to Prime members currently.

YouTube has proved to be highly popular with millennials. The service has more than 800MM monthly music video viewers globally, per MIDiA and also offers a paid On Demand service as part of YouTube Red as well as Google Play Music.

Financial Outlook

Developing forward revenue estimates for Spotify is particularly challenging given the company’s geographic diversity and pricing plans. The company charges 9.99 per month for premium services in the local currency, whatever that may be. Therefore, when converting to a single currency, such as the euro, which is the company’s functional currency, an incremental subscriber in a particular region may not have the same economic value as one in a different geography.

That said, Spotify filed its year end 2015 financials with their regulatory authority in Luxembourg. We used the historical actuals through 2015 as a jumping off point to build our forward estimates.

Leading Market Share of On-Demand Subscribers

The company boasts the highest market share in terms of total paying subscribers. According to the latest market data from IFPA, there was a total of 68 million paying subscribers worldwide. Accordingly, Spotify’s market share stands at 41%, up from 38% in 2014.

 

Figure 12: Spotify Market Share of Paying Subscribers

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Source: IFPI Global Music Report 2016

Spotify has a growing free listener base. The company exited with 61 million free listeners in 2015. As with all freemium models, the company’s goal is to convert the free ad-supported users to paid subs. Paid conversion rates are improving, at 31% in 2015 vs. 25% in 2014, a positive for sub growth and acquisition costs. We expect the conversion rate to improve sequentially, in step with its initiatives to improve the stickiness on the app.

 

Figure 13: Spotify Active User Base Conversion Rate

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Source: Company reports, MVR estimates

For 2016, we expect the active user base to grow 26% year/year to roughly 112.4 million, including a paying subscriber base of 39.2 million. This implies a 35% conversion rate, which we believe is justifiable given the company’s growth initiatives, rising popularity, and a compelling value proposition.

 

Figure 14: Subscriber Base (Mil)

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Source: Company reports, MVR estimates

Revenue

Spotify generates revenues from advertisements and monthly subscriptions. We expect to see advertising revenue grow strongly this year as well. The primary contributor to ad growth will be growing number of users, and, of course, the associated hours of usage. Our channel checks suggest that new users on average spend as much time on the platform as older users.

One limiting factor for ad-based models is that music is fundamentally an audio experience. Listeners are often not looking at the screen while they are consuming the content (i.e., music). To this end, a number of brands we have spoken to have indicated that they are hesitant to spend too much on the music channel because ads that they serve have a tendency to go unseen at a higher rate than traditional display advertising. We believe this is a fundamental problem with the model, but we also believe that Spotify is in a better position than Pandora to be able to monetize advertising over the long-term as: (i) It is more social than Pandora, which we believe will lead to higher levels of engagement from the user base; and (ii) It has a richer suite of apps that are integrated with the service, which, like the social layer, will drive increased engagement, in our view.

On the subscription side, we expect revenues in maintaining its robust run rate on the back of higher conversion rates and a compelling value proposition at $9.99 per month, competition notwithstanding.

Accordingly, we expect total revenues of €2,745 million ($3,047 million) in 2016, an increase of 41.1% over 2015. For 2017, we expect revenue to grow to €3,564 ($3,956 million) million, an increase of 29.9%, on the strength of its rising active listener and paying subscriber base but limited in part by aggressive pricing and promotions by Apple, Amazon, and Google. ($/€ Exchange Rate = 1.11).

 

Figure 15: Spotify Revenue Estimates

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Source: Company filings, MVR estimates

 

Figure 16: Spotify Revenue Chart ($Mil)

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Source: Company filings, MVR estimates

Profitability

Despite the strong revenue growth, Spotify has had trouble finding its way to profitability. We believe this is partly a function of the industry at large, which has seen multiple players grow revenue at a fast pace but ultimately find it challenging to generate profits because of high royalty levels. Spotify pays out between 70% and 75% of all revenues; the music companies get paid percentages of each subscriber and then get a per-stream rate or a share of the ad revenue, whichever is greater. As such, we believe Spotify may not turn profitable until mid-2018.

That said, Spotify’s Internet radio offering (i.e. free service) has better economics. To the extent that the company can grow this offering, Spotify could see some relative margin lift. Additionally, if the company can successfully negotiate lower royalty rates, the profitability timeline could shorten considerably. In 2015, Spotify reported a net loss of €173.1 million ($192.1 million). We expect losses to decline to €121.7 million ($135 million) in 2016, and €100.4 million ($111.5 million) in 2017.

Similarly, on the EBITDA front, we have modeled EBITDA loss of €126.4 million ($140.3 million) in 2015. We expect losses to decline to €59.5 million ($66 million) in 2016, and €33.7 million ($37.4 million) in 2017.

 

Figure 17: Spotify EBITDA Projection (€Mil)

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Source: Company filings, MVR estimates

 

Figure 18: Spotify Net Loss (€Mil)

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Source: Company filings, MVR estimates

 

Valuation

We approached Spotify’s valuation from two angles: comparative valuation based on the mean EV/Revenue multiples of the peer group, and a 10-year DCF analysis.

Accordingly, Spotify’s comparative EV/Revenue valuation is $10.91 billion and our 10-year DCF valuation is $8.06 billion. We believe Spotify is fairly valued at $9.48 billion, the mid-point of these two values. We believe the premium valuation is justified given the company’s recurring subscription model, high conversion rate, constructive relations with the major record labels, and strong competitive position.

 

Figure 19: Valuation Summary

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Note: Diluted shares outstanding = 4.006 million

Source: MVR

The following section highlights the details of the two methodologies.

Methodology I: Comparative Valuation

Our comparative valuation methodology is based on a mean EV/Revenue multiple of the comparable companies on the Internet, Digital Media, and terrestrial radio groups. The implied valuation based on the revenue multiple is justifiable in our opinion given the company’s negative profits and cash flow position for the next two years. Moreover, we believe Spotify is still a revenue story as reflected in the management’s strategy to invest aggressively in growth initiatives at the cost of profitability to capture market share in an increasingly crowded space.

That said, we looked at a consolidated basket including pure-play streaming companies comprising Pandora SiriusXM, and Netflix, the three diversified big-cap Internet companies with music offerings – Apple, Google and Amazon; major publicly traded terrestrial radio companies; and finally a whole range of the Internet and Digital media companies.

Accordingly, we value Spotify at $10.91 billion, or $2,723 per fully diluted share, based on a peer group multiple of 3.5 times our 2016 revenue estimate of $3,046 million. This is a considerable premium to Pandora’s current valuation of $2.9 billion, and above the company’s last private round valuation of $8.5 billion in June 2015. We believe there is room for additional valuation upside if the company can show stronger than expected revenue growth on the back of subscriber growth and increased advertisement sales.

 

Figure 20: Comparable Public Multiples & Implied Valuation ($Mil)

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Source: Thomson Reuters. Yahoo Finance, MVR estimates

 

Implied Spotify Enterprise Valuation

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Note: Stock prices as of July 11, 2017, close; Multiples based on consensus estimates

Source: Thomson Reuters. Yahoo Finance, MVR estimates

Methodology II: Discounted Cash Flow Analysis (DCF)

We expect Spotify to turn cash flow positive in 2018. We projected our P&L model out to 2025 and constructed a 10-year DCF model. Using a WACC of 12%, which assumes a risk-free rate of 3.6%, a beta of 2.5, market premium 3.4%, and a terminal growth rate after 10 years of 4%, our discounted cash flow analysis supports a valuation of $8.1 billion, or $2,011 per share.

Below, we show our DCF calculation and the sensitivity analysis using a range of WACC from 10-14% and terminal growth rates between 2% and 6%.

 

Figure 21: Spotify Discounted Cash Flow Model (DCF)

picture1Source: MVR estimates

 

Model

Figure 22: Spotify Model (€Mil)

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Source: Manhattan Venture Research

 

About Manhattan Venture Partners

Our Research Methodology

Manhattan Venture Partners provides clients with accurate, timely and innovative research into the companies and sectors we cover. To that end, we have established an experienced team of analysts, researchers, economists and industry veterans that focus exclusively on private companies with a proven track record of success. Producing quality research on a private company is uniquely challenging. Our analysts communicate with employees, ex-employees, early investors, VCs, competitors, suppliers and others to gather valuable information about the company under coverage. This information enables us to create unique financial models that value the underlying company and provide insight to our clients and industry experts, leveraging years of experience working for bulge bracket firms.

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About the Analysts

Santosh Rao

Santosh Rao has over 18 years of experience in equity research, primarily within the technology and telecommunications space. He started his equity research career as an Associate at Prudential Securities and later moved to Broadpoint Capital (Formerly First Albany Capital), where he was the Senior Equity Analyst, and later to Evercore Partners, where he worked with the Telecom and Data Services Group. Prior to joining Manhattan Venture Partners, he was the Managing Director and Head of Research at Greencrest Capital, focusing on private market TMT research. Mr. Rao started his career as a Financial Analyst in the Operations Groups at PaineWebber (UBS) and Prudential Securities. Santosh has an undergraduate degree in Accounting and Economics, and an MBA in Finance from Rutgers Graduate Business School.

Max Wolff

Max Wolff is an economist specializing in international finance and macroeconomics. Before joining Manhattan Venture Partners, he was Chief Economist at Greencrest Capital, and prior to that spent four years as the senior hedge fund analyst at the Beryl Consulting Group LLC. Mr. Wolff teaches finance and statistical research methods in the New School University’s Graduate Program in International Affairs. Max’s financial markets and Macro-Economics work appears regularly in Seeking Alpha, The WSJ, Reuters, Bloomberg, The BBC, Russia Today TV, and Al Jazeera English.

Disclaimer

I, Santosh Rao, certify that the views expressed in this report accurately reflect my personal views about the subject, securities, instruments, or issuers and that no part of my compensation was, is, or will be directly or indirectly related to the specific views or recommendations contained herein.

I, Max Wolff, certify that the views expressed in this report accurately reflect my personal views about the subject, securities, instruments, or issuers and that no part of my compensation was, is, or will be directly or indirectly related to the specific views or recommendations contained herein.

Manhattan Venture Partners LLC (Hereafter “Manhattan Venture Partners”), the parent company of Manhattan Venture Research, does and seeks to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. This document does not contain all the information needed to make an investment decision, including but not limited to, the risks and costs.

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