Call it what you will (IPO, DPO, simple listing) but Spotify (NYSE: SPOT) will begin trading in the public markets on April 3rd. The shares have a trading and price history that the company includes in their prospectus - they place a high emphasis on “transparency” in their corporate culture.

Spotify is a company we’ll be following since they are at the heart of how technology is changing in the music and entertainment business. They are also the gorilla in this segment amidst very large technology companies - they have 157M monthly active users, $5B in revenue, $1.8B in cash and are cash flow positive.

There is no “price” on this deal. In order to get one, we used the transaction history summary from June 2017 through February 2018 with a weighting by volume (VWAP). Using 9 months of data the VWAP is $95.39. However, the average price for the first three months of 2018 was $109.58. If we average these two we come to a $102 price level that we’ll use as the “offer price” for our IV model. (Note that the transaction history doesn’t include volume at specific prices so this is the best anyone can do with the information provided.)

At $102 and 177M shares outstanding that puts the market capitalization at $18B. Our IV below suggests the shares should trade at $170. But there are some big caveats around this number. Nobody knows what the long-term operating model will look like. Every 1% difference in the long-term margin drives about 25 points on the stock.

Some banks have initiated coverage of SPOT in advance of the listing. Both RBC and MKM came put with “Buy” ratings and price targets of $220 and $200 respectively.

Distilling the SPOT Investment Case

There’s a plethora of filings, presentations, and commentary out there on Spotify. Plus investors have seen at least a somewhat similar deal when Pandora (P) came public in 2011. They came out at $16 and one research firm, BTIG, boldly predicted they would trade down to $5.50 and they hit that nail on the head. That same analyst, Richard Greenfield, wrote in March of last year "The intersection of 50 million subscribers, consumer love, great underlying technology supported by an engineering culture and a daily use app on mobile, makes Spotify one of the most compelling acquisition targets in media today.”

Here are the aspects upon which our investment view of SPOT rests:

1. The company has a great management team and corporate culture. Sometimes you are willing to “bet on a team” even when the industry is challenging. This team has considerable resources as well with their public stock value and $1.8B in cash. Investors can be “bribed by excellent results” by a strong team that keeps delivering. The situation reminds me a bit of GrubHub (GRUB) which most “experts” dissed at the IPO and is now up 4-fold.
2. Their current Life Time Value to Subscriber Acquisition Cost (LTV/SAC) ratio is 2.7xwhich is good. As long as that ratio remains the company will continue to be in “grow customer numbers” mode.
3. The biggest single negative for SPOT is that they have high variable costs. This means they can’t just “make it up in volume.” Contrast their structure with Dropbox (DBX) which has relatively high fixed costs but very little variable cost. In two years Dropbox gross margins more than doubled from 32% to 66%. Spotify can’t do this. More customers and more usage will keep driving costs up.
4. Efforts to reduce churn tend to aggravate the gross margin problem. For example, the “family plan” is a great way to lock people in lowers the price paid per user per month and some typical family members, particularly teenagers, may have worse-than-average unit economics.
5. The “two way marketplace” is interesting and helps to differentiate Spotify and give them a more noble mission. There have certainly been some notable success on the artist side and long-term this *could be disruptive* to the industry but it’s too soon to know. (see below)
6. Curated playlists are the solution for a big part of the industry and that part of the Spotify business is growing rapidly. It also gives them tremendous power to “break” new artists by introducing them to their curated playlist/brands when they fit.
7. Spotify is building a strategic asset for *somebody,* even of we don’t know who it is. Their customer base, revenue size and growth, and positive cash flow enhance their attractiveness as a core asset in consumer entertainment. It’s hard to picture one of the large technology players buying SPOT but other more consumer-focused companies like Disney (DIS) seem more likely.

Content Creation, Labels and the Potential “Netflix Effect”

Spotify has built the best consumer software music platform but they are working hard to also build an effective platform for the artists who create and deliver content. So far Spotify has built a combination of data, tools and curated entertainment properties that can catapult new artists into success.

Spotify offers a growing number of features that help artists create new content, connect with and engage more with their fans.

These included “artist pages” which could be used more effectively if consumers prefer an alternative to “sharing on facebook” when it comes to music. They also have software tools to help create content and data on fans in terms who they are and where they live. The latter makes selecting locations and venues for tours much more informed. Spotify even has some ticketing capability to allow artists to sell directly to “super fans” before the general public.

Spotify has also delivered some remarkable innovation around the smartphone. They give artists the ability to “take over” the screen when their song is playing. This creates some great effects and opens up opportunities for artists to do more than simply release a song and/or a video.

The growth of curated playlists has been strong and we expect it will continue. There’s just too much new music out there for consumers to manage it. The playlists have been a huge success and have now even morphed into “brands” or in some ways “labels” of their own.

That brings us to the whole comparison with Netflix (NFLX). It’s true that Netflix also has variable costs associated with serving content. They also have hugely ramped up their spending on new and exclusive content for their subscribers.

In the US Netflix has 46% gross margins on $6.2M of annual revenue. Their gross margin on their $5.1B of revenue is only 19% although it’s been climbing rapidly in the past two years. Overall operating margins at Netflix are 7%. Investors have decided to grant Netflix an “Amazon-like” status which comes with a 100+ P/E multiple and 10x sales.

Spotify still has a way to go before they can achieve this level of investor confidence. The stock is likely to trade on the momentum seen in new subscriber growth, reduced churn, and overall business metrics. If SPOT continues to outpace Apple and everyone else in music the shares probably will not be held up to traditional valuation metrics.

Valuation

We’ve built an intrinsic value model for Spotify which suggest a $170 stock price. Spotify faces huge competitors although it's hard to pinpoint just how important "music" is to Apple, Google and Amazon.

For example, when the iPod was meaningful for Apple it was critical to have iTunes and “own” the music consumer. They have continued to suggest music is important but it seems to be more because “it’s cool” and perhaps because Tim Cook doesn’t have much strategic vision and simply continues to push forward on the strategy that Steve Jobs forged years ago. Music is now a relatively small part of what Apple is about.

Our IV suggests there is fundamental upside based on the level the shares are likely to debut at on the NYSE tomorrow. Please note that the model is *hugely conditioned* on the long-term operating model. The 7% level is where we are starting out but *every 1% difference on the operating margin line creates a 25 point swing in the IV price.*