Trouble Brewing for Spotify

Rumors and excitement around a Spotify IPO have been buzzing around since 2015, and the company seems closer than ever to actually putting itself on the market.

While Spotify is growing its paid subscriber base at an exponential rate, that hasn't been translating to exponential growth in earnings. There are also more than a few major issues that are keeping the company from profitability.

Listen to this clip from Industry Focus: Tech to find out why investors might want to steer clear of this IPO until Spotify figures out how to fix its business model.

A full transcript follows the video.

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This video was recorded on Dec. 8, 2017.

Dylan Lewis: To circle back on that financial breakdown, they lost just over $500 million in 2016 on $3 billion in revenue, and that was a widening lost off of 2015, where they lost just under $250 million off of $2 billion on the top line. We talked about the economics of the music industry. It's probably worth diving into that now, and why they aren't really great, because those financials seem to illustrate it pretty well. It's not a space where the numbers are going to work out for a lot of these players.

Evan Niu: Going back to Iovine's comments, he basically just argued that there's no margins in music streaming. He mentioned some examples of other companies that have bigger businesses. Apple obviously has a humongous business with all the other stuff it sells, and it makes the money there, so it doesn't really need to make money on streaming. Same thing for Amazon or Google , most of these companies that participate in music streaming have huge other businesses. The only pure plays that are really out there are Spotify and Pandora . Pandora is obviously the only public pure play comparable, I think. Pandora has a completely different model, and they've also been a pretty disappointing investment over the years. But, yeah, there's just not a lot of money to be made. One of my big questions about Spotify in particular is, why are there costs so high that they're losing this much money? Certainly, royalties are the biggest part of their costs, and that makes sense, but as far as other operating expenses, what is it that they're spending this money on? As a private company, we have no way to tell, because we don't have any real insight beyond the occasional leaks. But the occasional leaks only give you the top and bottom line, they don't give you any granular detail of the cost structure, specifically their operating expenses. What are they spending all this money on?

Lewis: I have to imagine that some of that is supporting the really rapid user growth that the platform has seen. They've really had exponential growth. You go back to 2014, they had 10 million users on the paid side. 2015, 20 million. 2016, 40 million. So, they've had several years in a row of 100% user growth. And now, most recently in 2017, they're around 60 million paid users. If you back that out and look at the folks that are using it on the ad supported side, that's the free accounts, they're north of 140 million active users at this point. So, they do --

Niu: That's total. Total is 140, paid is 60, so the free is 80.

Lewis: Oh, sorry, thank you for that clarification there. But, that's a lot of people using the service that they need to provide the tech support for and the hosting costs for.

Niu: Right. I would really want to see what they're spending money on. Beyond the royalty aspect, which would be the gross margin side of it, are they making enough on the gross profit to actually cover operating expenses? Certainly, we need to get an actual look at what their income statement looks like before we can make real strong calls on it. But generally speaking, take Iovine's word for it. This guy has been in the music industry for 30 or 40 years. If he says there's no margin, I believe it.

Lewis: And because they don't have another part of their business, and I think Iovine went on to say, Amazon can decide to bundle this into Prime at an even cheaper cost. I think right now, there's a certain part of the music catalog that is free on Prime, and if you want access to even more music, you can get Amazon Music Unlimited and pay for that on a monthly basis. But Iovine's point was, if Jeff Bezos decides, we're just going to drop it to $7.99 a month, what does that do to Spotify?

Niu: It's completely reasonable. You could totally see Bezos doing that, because that's how he rolls. [laughs]

Lewis: And there really isn't all that much differentiating these services. It would be easy to liken Spotify to a Netflix for music streaming, but I think the difference is, Netflix has built up this really amazing catalog of Netflix Originals, and that's content that you can't get anywhere else. You don't really see that exclusivity in the music streaming space.

Niu: Right. It's a completely different sector, even though music and video, people tend to think of them similarly. But the businesses and the industries are totally different. Like you mentioned, all of the songs are basically everywhere, give or take maybe small discrepancies in the timing based on exclusivity or whatever these different companies score from time to time. But those exclusivity windows are generally limited for a few months or weeks or whatever. But one of Iovine's points was, music is everywhere these days. You can go on YouTube and find songs for free, and that's an example he specifically mentioned. There's just so many places where you can get this content for free, and it's all the same and it's all everywhere. So, that presents some really unique challenges to the music industry that the movie, TV and video industry doesn't necessarily have to deal with. Of course, there's a lot of licensed content out there too, but a lot of it is much more differentiated, it's much more exclusive to certain platforms or certain networks. It's just a very different beast.

Lewis: To borrow a term from the Thursday's Energy show, I think in some ways, digital music has been commoditized. And when you're working in that space, you need something that sets you apart from other players, otherwise you don't have any pricing power. And I think that's one of the big things, when I look at Spotify, that I see for them as a long-term struggle. If they can't make the numbers work now, it's not like they're going to be able to Netflix it and raise prices $1 every year or every eight months or something like that to eventually hit the point where they're making margins on their content. They'll hit a certain point where people are going to be like, I'll just switch over to Apple Music because it's still $9.99 a month and I'm getting access to all of the same stuff.

Niu: Right. It's a race to bottom on the price. It's interesting, because what could Spotify do? There's not a whole lot they could do. I guess another question, relating back to wanting to get more detail on the cost structure is, can they scale it? Is this really scalable? Because this should be something that's really scalable. There should be some point where they might be able to make money if they can get large enough. But they're already so huge and they're still losing money. So that undermines the idea of scalability, if they're already at 60 million paid users and still losing quite a bit of money, where's the operating leverage?

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares), Amazon, and Apple. Evan Niu, CFA owns shares of Apple and Netflix. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Netflix, and Pandora Media. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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