After years of speculation, music streaming unicorn Spotify is finally planning to go public. In this Industry Focus: Tech clip, host Dylan Lewis and Motley Fool contributor Evan Niu go through some of the most important metrics from Spotify's financials and explain what they mean for the company. Also, the hosts look at Spotify's complicated capital structure and what it meant for the company last year, what's eating away at so much of Spotify's top line, and more.
Dylan Lewis: Evan, looking over at the financials, I think the first place you start here is the top line. The growth has been pretty strong there. The company pulled in 4.1 billion euros in 2017, which is up 39% year over year. When you look at the breakouts, it's pretty clear that this company is reliant on the Premium side of their business for most of their top line.
Evan Niu: Right. Premium subscriptions represent about 90% of revenue, which is pretty telling. If you look at that user base breakdown, 71 out of 160 million. It's less than half, but they're carrying 90% of revenue.
Lewis: And something encouraging, also in the financials, is when you look at what's going on with gross margin. It's currently at 21%, up from 12% two years ago. Some of that is that mix of profitability we were talking about, where even though most of the money was being made off of 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 they are gross margin positive on the Free side, that's obviously going to help a little bit, too.
Niu: Right. The royalty cost of the record labels is really the big piece that we're talking about here. That was about 80% of revenue in 2017. These costs are enormous, which is really tough to squeeze out any type of profitability, because you don't have a whole lot of money left over to cover all your operating expenses.
Lewis: Yeah, even for that increase in gross margin that we're seeing, that still means that licensing costs and royalty payments are eating up about 80% of the top line. That means that a lot of the cost savings, even as they renegotiate deals and get more favorable terms, aren't really coming down to the bottom line, because as a percentage of sales, you look at the research and development costs, their sales and marketing, their general expenses, all of those were up in 2017.
Niu: Right. That's what's so hard about this industry. The cost structures are just not very favorable to these services, whereas the record labels, they have a very strong bargaining position in there.
Lewis: And trying to paint a picture for what profitability might look like for this business is kind of tough. We saw an operating loss for them in 2017. Then, on top of that, they had a huge line item hit with their finance costs, which took them even further into the red and took them to 1.2 billion euros in losses for 2017. Most of that is related to this very complex structure of the company's debt and convertible notes. Evan, you have some experience with that. Do you want to try to give a quick explanation there?
Niu: Without getting too deep into it, I would say, it's important to note that those finance costs, which I think were about some 970 million euros last year, that's a non-cash charge that's primarily related to the change in fair market value of these convertible notes that they issued a couple years ago. They raised some debt in 2016 and issued these notes. As value of these notes fluctuates, which is also a function of their private market share price, which more than doubled last year, then that increases the interest cost associated with these notes. But, these are non-cash charges. It's not like Spotify is paying out this much in cash.
Lewis: But it is an expense that they have to recognize for the purpose of GAAP accounting, right?
Niu: Correct. Though, technically, Spotify is on IFRS, International Financial Reporting Standards. Which is the international version of GAAP, but, a different standard. So, on an IFRS basis, they do have to account for it.
Lewis: So, when you look at everything that's going on with them as a business, it's kind of hard to suss out, how much of this is a permanent expense that's the steady state of what's going to be the future for them? How much of this is tied to the capital structure that they've chosen with these convertible notes? We talked about how margins are only going to give them so much money to work with, and how much is really going to come down to the bottom line there? The financing is going to be an ongoing question with this business. And Evan, I know that we didn't want to spend too much time talking about this on the podcast, because it really doesn't lend itself to go to audio, but you're planning on putting a piece together explaining what's going on with Spotify's convertible debt, right?
Niu: Yeah. I'm going to take a deeper look at their capital structure. The big piece of it is really this debt financing and convertible note structure.
Lewis: And depending on how they handle that over the next couple years, that might be something that either weighs on profitability or makes things a little bit easier. Of course, there are a lot of other moving parts there as that disappears as a line item. That's all to say, listeners, once Evan gets that piece out, if you're interested in this, write into the show, and we'll be sure to send it out.
