A quick and dirty look at Spotify’s finances
After years of speculation, the Spotify music streaming unicorn is finally planning to go public. In this Industry: technology clip, host Dylan Lewis and Motley Fool contributor Evan Niu review some of Spotify’s most important financial data metrics and explain what they mean for the company. Additionally, the hosts take a look at Spotify’s complicated capital structure and what it meant for the business last year, which eats away a large chunk of Spotify’s revenue, and more.
A full transcript follows the video.
This video was recorded on March 9, 2017.
Dylan Lewis: Evan, looking at finances, I think the first place you start here is the top line. Growth has been quite strong there. The company collected 4.1 billion euros in 2017, an increase of 39% over one year. When you look at the breakouts, it’s pretty clear that this business relies on the premium side of their business for the bulk of their revenue.
Evan Niu: Law. Premium subscriptions account for around 90% of revenue, which is quite telling. If you look at this breakdown of the user base, 71 out of 160 million. It’s less than half, but they make 90% of the income.
Lewis: And something encouraging, also in finance, is when you look at what’s going on with the gross margin. It is currently 21%, compared to 12% two years ago. Part of that is that blend of profitability we were talking about, where even though most of the money came from Premium users, the fact that free users were losing money for the business obviously weighed on what was going on. in the gross margin side. Now that the gross margin is positive on Free’s side, that will obviously help a bit too.
Niu: Law. The cost of record company royalties is really the big chunk we’re talking about here. This was around 80% of revenue in 2017. These costs are huge, which is really hard to squeeze out of any kind of profitability because you don’t have a lot of money to cover all of your operating expenses.
Lewis: Yes, even for that increase in gross margin that we’re seeing, that still means license costs and royalty payments consume around 80% of revenue. This means that a lot of the cost savings, even if they renegotiate the deals and get more favorable terms, don’t really flow through the bottom line, because as a percentage of sales you’re looking at research and development costs. , their sales and marketing, their overheads, all increased in 2017.
Niu: Law. This is what is so difficult in this industry. The cost structures are just not very favorable to these services, whereas the record companies have a very strong negotiating position there.
Lewis: And trying to paint a picture of what the profitability of this business might look like is a little difficult. We had an operating loss for them in 2017. Then on top of that they had a huge line hit with their financing costs which put them even more in the red and took them to 1.2 billion euros in losses for 2017. Most of this has to do with this very complex structure of the company’s debt and convertible notes. Evan, you have some experience with this. Do you want to try to give a quick explanation there?
Niu: Without going into detail, I would say that it is important to note that these finance charges, which I believe amounted to some 970 million euros last year, are non-cash charges mainly related to the variation the fair market value of these convertibles they issued a few years ago. They raised debts in 2016 and issued these notes. As the value of these notes fluctuates, which is also a function of the price of their private market share, which more than doubled last year, this increases the interest charges associated with these notes. But, these are non-monetary charges. It’s not like Spotify is paying that much in cash.
Lewis: But it’s an expense they must recognize for GAAP accounting purposes, isn’t it?
Niu: Correct. Although technically Spotify complies with IFRS, International Financial Reporting Standards. It’s the international version of GAAP, but a different standard. So based on IFRS, they have to take that into account.
Lewis: So when you look at everything that’s going on with them as a business it’s a little hard to guess how much of an ongoing expense that’s the steady state of what’s going to be the future. for them ? How does this relate to the capital structure they chose with these convertible notes? We talked about how the margins would only give them a limited amount of money to work with, and how much is that really going to impact the bottom line there? Funding is going to be an ongoing issue with this business. And Evan, I know we didn’t want to spend too much time talking about it on the podcast because it really doesn’t lend itself to audio, but you plan to put together a track explaining what’s going on with convertible debt from Spotify, right?
Niu: Yes. I will take a closer look at their capital structure. The big thing is really this debt financing and this convertible note structure.
Lewis: And depending on how they handle it over the next couple of years, it can be something that weighs on profitability or makes things a little easier. Of course, there are a lot of other moving parts as it disappears as a line item. That’s all to say, listeners, once Evan releases this track, if you’re interested, write on the show, and we’ll make sure to send it.