Spotify – Straight record.

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Improvement masked by debt slip-up.

• Spotify will be going public in a somewhat unorthodox fashion next month, but the financial position of the company is not nearly as bad as many commentators have concluded as fundamental profitability is improving, albeit slowly.
• Most companies list via an Initial Public Offering (IPO) where the company issues new shares which are marketed and supported by one or more investment banks.
• This ensures that a range of big landmark investors will have a position as well as the shares will have some downside protection in the days immediately following the listing.
• However, Spotify has chosen to go for a direct listing which means that it simply lists exiting shares on the NYSE, guarantees that some shares will be available from existing shareholders and lets market forces do the rest.
• Spotify is now a global brand and needs no help in marketing itself to investors, but some clarification is needed on understanding the headline numbers and what they imply.
• This is where things come a bit unstuck as the headline numbers show that while revenues have grew to €4.1bn in 2017 from €1.9bn in 2015, losses have ballooned to €1.2bn (-29%) in 2017 from €0.2bn (-12%) in 2015.
• This is being used to highlight the weakness of the streaming business model, but one needs to look closer to work out what is really happening.
• This confusion ha been created by a transaction that Spotify entered into in 2016 where it raised €1bn through the issuance of a convertible bond.
• Under general accounting principles, the market value of bonds has to be reflected in the balance sheet with the changes being reflected as non cash profits or losses in the income statement.
• Towards the end of 2017, Spotify reached an agreement to convert some of the bond into equity with the rest being likely to follow before the listing, resulting in a large non-cash loss being reflected in the income statement for 2017.
• This was largely responsible for the €974m financial costs item recorded in the 2017 income statement which has nothing to do with the business model of streaming.
• Removing this reveals a very different picture:
  • First, gross margin: In 2015 gross margins were 11.6% and these have improved to 20.8% in 2017.
  • This is undoubtedly due to the better deals that Spotify has been able to sign thanks to it becoming a crucial part of the music industry (see here).
  • Second, operating margin: Spotify is also beginning to see some of the benefits of operating leverage as operating margins are improving.
  • EBIT margin in 2015 was -12.1% which has improved to -9.3% in 2017.
  • There is still a long way to go in terms of reaching possibility but it is important to note that Spotify is still growing quickly which requires substantial investment in OPEX.
  • Third, cash flow: Spotify has the envious position of running negative working capital.
  • This is because it receives money from its subscribers and advertisers long before it has to pay it out to the rights holders.
  • With no physical assets to sell (yet), this means that working capital produces cash as the company grows and it is this that is largely responsible for the positive cash generation the company is experiencing.
  • While the money has to be paid out eventually, this provides a cash cushion which makes growth much easier to manage.
  • This, combined with the non-cash financial expense charge is now a net loss in 2017 of €1.2bn can be converted into cash flow from operations of €179m in 2017.
• Negative working capital also allowed Spotify to generate cash from operations in 2016 and to be close to break-even in 2015, raising the question of whether the convertible bond was a necessary transaction?
• I think that this is the one mistake the Spotify has made over the last couple of years but now that full conversion to ordinary shares has been agreed with the bond holders, the impact of it upon the share capital will be fully visible from day 1 of public trading.
• Spotify is still growing quickly and needs to continue investing in order to remain the number 1 global streaming service, although it is being caught by Apple Music in USA.
• When it comes to the service, I still think that Spotify’s ability to categorize and recommend music is the best available thanks to intense investment in its algorithms but whether it is worth 4x historic revenues is something that the public market will have to decide.