Business Matters: A $3 Billion Valuation Brings Spotify Expectations Back to Earth
Business Matters: A $3 Billion Valuation Brings Spotify Expectations Back to Earth

A business model that pays rights holders nearly every dollar, euro or pound generated is clearly not sustainable. This fact is obvious to Billboard readers as well as a digital service's management and the company's investors.

Last week I wrote about Spotify's financial statements posted at PrivCo, a website that posts the financial statements of privately held firms. My first impression was that PrivCo's numbers looked off. After PrivCo's CEO sent me a link to the full financials and walked me through the numbers, I better understand how the numbers line up -- but I don't agree with his negative assessment.

Spotify is indeed losing money, but I don't think its business model is unsustainable.

The difficult with assessing Spotify's prospects is that its financial statements tell many stories at once instead of one single story. Because the service operates in many different markets and launched at different times, Spotify is effectively many companies within a company. And each of those companies has a business model that apparently needs time to develop.

Spotify operates a freemium business model that offers free, ad-supported listening in the hopes of luring paid subscribers. The model is a leap of faith. Spotify is on the hook for the free streams whether or not it monetizes them. It hopes people will sign up for the paid subscriptions. Labels and publishers hope, too.

But the model has attracted investors in spite of its critics. According to the financials posted at PrivCo, Spotify ended 2011 with cash and cash equivalents of €104,271,498 ($135 million), up from €47,251,972 ($62.6 million) in 2010 and €2,083,601 ($2.99 million) in 2009.

More money is reportedly on its way. The company is said to be near a $400 million round of funding that would value the company at $4 billion.

Paris-based Deezer, which operates the same freemium business model, just raised $130 million in a round led by Access Industries, the owner of Warner Music Group. Deezer now has 2 million subscribers to Spotify's 4 million subscribers.

There should be a natural lag time in the success of a freemium business model. When Spotify enters a new market, it has a relatively high number of free listeners, a relatively low number of marketing partnerships and a relatively immature advertising sales force.

The model itself suggests a lag will occur. Free listening is used to encourage people to try the service before becoming subscriber. The more people use the Spotify, the more people share listening on social media, the more likely they are to eventually subscribe.

If we could see Spotify's financial results from just one country, we could isolate its business model and reduce the noise from other markets. Financial results from one country might show this lag. Financial results for the entire company show more than a dozen lags happening at different times.

Indeed, proof of the lag time can be seen in the UK. As Billboard.biz reported in September, Spotify reported a net loss of only £2.1 million in the UK in 2011. Clearly the launch in the U.S. in the summer of 2011 weighed heavily on the financials of the company.

Financial statements for 2011 found online show Spotify Ltd., the UK subsidiary, posted a £2.06 million loss in 2011 after posting a net operating loss of £26.5 million in 2010. Revenue grew 51.1% to £95.5 million from £63.2 million. (Due to an intracompany sale of intangible property, Spotify Ltd. actually turned a net profit in 2011.)

The key evidence of the freemium model's lag time appears to be Spotify Ltd's improved cost of sales, which represents royalties paid to rights holders. The UK subsidiary's cost of sales dropped to 85.7% in 2011 from 102.6% in 2010. In other words, Spotify Ltd. paid rights holders about 1.03 for every pound it generated in 2010 but paid out only 85 pence from every pound it generated in 2011.

Another key factor was the improvement in subscriber growth. Subscriptions accounted for 84.8% of revenue growth in 2011 and grew as a percent of revenue from 71.3% in 2010 to 75.9% in 2011. The company obviously got better at converting free listening into paid listening and using partners - such as Virgin Media - to bundle the Spotify with broadband service.

These two factors show the freemium model has potential but will experience a lag as cost of sales becomes manageable and the lure of the freemium model takes time to positively impact subscriber counts.

The key is cost of sales. When Spotify Ltd improved cost of sales by 16.9 percentage points in 2011, it gave itself an additional £16.1 million to cover costs. By lowering costs of sales again in 2012 - through better monetization of free users and better conversion to subscribers - Spotify Ltd. will generate even more gross margin. At its current pace, Spotify Ltd. should be able to turn an operating profit in 2012.

When Spotify US will turn an operating profit is another story. It goes without saying that the Spotify launched in 2008 in the U.K. would have a far better cost of sales last year than the service that launched in the U.S. in July. A large market such as the U.S. will require years of hard work.

Every market is different. In Sweden, for example, Spotify helped streaming services account for 89% of all digital revenue in the first half of 2012, according to the Swedish Recording Industry Association. But nothing is mentioned about Spotify's inability to resuscitate a moribund Spanish digital recorded music market that ranked five places behind Sweden -- #9 vs. #14 - even though Spain has population five times greater.

The freemium model might not work in Spain right now. Not much is working in Spain right now. Even a workable business model has to deal with difficult exogenous factors such as social norms and economic malaise. But the 2011 financials for Spotify UK show that a freemium model can work over time.

Questions? Comments? Let us know: @billboardbiz

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