As for Spotify, some may recall that back on January 3, the company confidentially filed IPO papers with the SEC, which meant that the public was not yet privy to most of its financial information. That changed last night when the company filed its F-1, giving investors their first true look under the hood. As we discuss in more detail below, its financial results are what one would expect for a younger tech company: very strong revenue growth, but, not close to profitability due to sky-high costs.
But, before diving into its financials, there are a couple key points to make about this IPO. First, as you may be aware of by now, SPOT is taking a very unusual route to the public markets. Specifically, the company is not hiring underwriters. The NYSE stipulates that the company must have advisers on board (it is using Morgan Stanley, Goldman Sachs, and Allen & Co) to consult with the market maker, but, there will not be a book-building process. This means that there will not be a set price range for the IPO. Instead, the opening price for SPOT shares will simply be based on buy and sell orders that come into the NYSE prior to the opening.
Of course, the positive side of this is that the company will save on underwriting fees. And, based on its financials, it could use some help on expenses. However, there is also significant risk involved because there will be no road show and no marketing of its IPO to large institutional investors. Also, underwriters typically have the option to purchase shares of an IPO, sometimes in support of the stock price if things turn south. That, too, will not be available for SPOT. Consequently, the stock will be more at the whim of smaller retail investors and will be lacking more stable support from institutional buyers, relative to other large deals. Some may also recall that Facebook (FB) made its IPO available to retail investors as well, and its IPO day and the weeks that followed were turbulent to say the least.
Another significant risk to be aware of is that in its filing, SPOT disclosed that it has identified a material weakness in its internal control regarding financial reporting. This is not unusual and is oftentimes simply overlooked as boiler-plate legal disclosures. However, SPOT's disclosure is garnering much more attention due to the nature of its business model. Like Pandora (P), SPOT's largest expense is royalty payments to artists and record labels, which are regularly negotiated and sometimes lead to legal issues. If SPOT's material weakness in its financial reported are related to how it is paying out royalties, any change or increase in royalty payments could have a severe impact on its financials and whether it could achieve profitability -- something Pandora has never achieved.
It's not all gloom and doom, though, for SPOT. The company is growing rapidly and many of its key operating metrics are moving in the right direction. For instance, for FY17, revenue grew by 39% year/year to EUR 4.09 billion as monthly average users (MAUs) jumped by 29% to 159 million. Premium Subscribers, which pay a monthly rate to have unlimited online access to commercial-free music, were up 46% to 71 million. Premium ARPU did dip to EUR 5.32 from EUR 6.20, but, churn also declined to 5.5% from 6.6%.
As expected, SPOT is not profitable as its operating loss for FY17 widened to EUR 378 million from EUR 349 million in FY16. Cost of Revenue, which includes those aforementioned licensing fees, takes a huge chunk out of the topline. In FY17, Cost of Revenue was EUR 3.2 billion, representing a whopping 78% of total revenue. That leaves little margin for other expenses if SPOT wants to run profitably.
But, SPOT does indeed have significant other expenses. Namely, R&D and Sales and Marketing are also cutting into profitability, up 91% to EUR 396 million, and 54% to EUR 567 million, respectively. As a result, SPOT is bleeding a lot of red ink from an operating profit perspective. The silver lining, though, is that SPOT generated positive free cash flow of EUR 109 million in FY17, up from EUR 73 million. That does help to offset some of the profitability concerns.
To conclude, the IPO market is poised to make a lot of headlines in the coming weeks and SPOT's IPO figures to be the main event. There are many moving parts to this IPO, both in terms of the mechanics of it, and, the fundamentals of the company itself. Buzz and excitement surrounding the IPO is a certainty. What is far less certain, however, is how SPOT's stock will perform once the dust settles.