Should you invest in Spotify when it floats on the stock market?

Music streaming service Spotify is about to become the latest large technology firm to float on the stock market, but should you invest?

Although companies such as Amazon and Google have made investors huge profits since opening up to public investment, not every technology firm that has floated has had such a smooth ride.

Snapchat, the picture messaging service valued at $21bn (£16bn), floated last year, but it has struggled to deliver returns, with its share price sinking following its flotation. It has only recently recovered to exceed the price the shares were initially offered at.

Twitter has similarly struggled. Its share price has declined more than 20pc over the past three years.

Spotify is expected to list on the New York Stock Exchange the week beginning April 2, according to Bloomberg. Here’s all you need to know.

The case for

Spotify has more than 150 million active users and over 70 million who pay for its “premium” subscription service. This is a fraction of the number of users that social media platforms such as Facebook have, leaving room for expansion.

The number of paying subscribers has more than doubled since 2015, as has its turnover, and the company stands to benefit from growing smartphone use in emerging economies.

Russ Mould, of broker AJ Bell, said: “The number of paying customers is a huge difference compared to, say, Snapchat or Twitter, which have both struggled to monetise their user bases. Spotify subscribers pay up front too, which helps with cash flow.”

Spotify also currently occupies a dominant position in its sector. As of 2016, it had a 42pc share of the global music streaming market, including 59pc of the US and 41pc of the UK markets.

Daniel Eck

The case against

To start with, Spotify is loss-making. Although its £1.1bn loss in 2017 included an £860m accounting charge, according to Mr Mould, it has still not yet made a profit.

This is despite already having a significant market share and a large number of paying customers, which leads to the question of how much more dominant it needs to become to break even.

Laith Khalaf, of broker Hargreaves Lansdown, explained that there are two key pressures on the company.

First, four music companies control the rights to 87pc of the music that is streamed via Spotify. That gives them a large amount of bargaining power to get “their pound of flesh” from Spotify’s earnings, Mr Khalaf said.

Second, its competitors include tech giants Amazon and Apple, who have huge amounts of cash at their disposal to invest, and produce hardware such as the iPhone and Amazon Echo which they can pre-load with their own services.

“Spotify will face intense pressure from competitors at one end and from its suppliers at the other. Apple and Amazon are not competitors to be taken lightly in terms of resources and innovation, and Spotify is also vulnerable to trial by social media if it displeases one of its recording artists,” said Mr Khalaf.

He added that Snapchat has demonstrated how easily features can be copied by rivals with deep pockets.

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Spotify’s business model also faces numerous challenges. Mr Mould explained that it struggles to increase its profits as every stream of a song involves paying a royalty to the artist, meaning its costs rise with its earnings.

“Spotify acknowledges that its royalty payment scheme is complex, and that it’s difficult to estimate the amount payable. This could damage its ability to turn sales into profits over the long term,” he said.

Valuation

In private transactions between January 1 and February 22, shares were trading hands for between $90 (£64) and $132.50 (£95) a piece, valuing the company at between $14bn (£10bn) and $20bn (£14bn).

Mr Mould said: “That equates to up to four times its historic sales, which is pretty punchy for a loss-making company where there is uncertainty about when it will be profitable.”

Verdict

Spotify has been growing rapidly, and has further room to expand, but the risks and threats to its long-term profits are clear.

Chris Beauchamp, of trading service IG, explained that Spotify could be an acquisition target for one of its larger rivals, but also runs the risk of the kind of share price stagnation experienced by Twitter if it continually fails to find a route to profitability.

“Spotify is quite small users wise, and is still a growth company, but one that is burning through cash at an impressive rate. I think it has a better chance of succeeding than many flotations, but the valuation may be quite pricey, and there are concerns it is a flash in the pan,” he said.

Any investor needs to believe in the company’s ability to continue growing rapidly, see off the threats from its rivals and record labels, find a way to grow earnings faster than costs, and solve its accounting issues.

They also need to be comfortable with the fact that the two founders of the business are going to maintain 80pc of total voting power, despite owning just 39pc of the company.

“It is a stock only suitable for patient, risk-tolerant investors who like growth stories, and are prepared to accept price volatility. Anyone who prefers value or income stocks is unlikely to find Spotify suitable for their needs,” said Mr Mould.

Spotify’s float method

Spotify has chosen to float via an unusual “direct” listing on the New York Stock Exchange.

This means it will not be issuing new shares to attempt to raise money from its flotation.

Instead, investors will be able to buy shares directly from existing private stakeholders.

This also means there are no investment banks and other middle-men involved to set an initial offer price, and there won’t be a roadshow to convince investors.

Mr Beauchamp explained that as Spotify is already expecting there to be enough demand for its shares, it was able to save a substantial amount of money by cutting out the middle-men.

The starting price of the shares on the day will be determined by demand from orders placed with brokers. Significant share price movements are to be expected.

British investors will be able to buy the stock via an investment shop that offers international share dealing.

 


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Author: James Connington
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