Financial Analysis: Is Spotify a Good Business?

Spotify, launched in 2008, has grown rapidly and become the largest audio streaming company in the world. Its core product, the audio streaming platform containing over 70 million songs and 2.2 million podcast titles, is available on smart devices such as mobiles, computers, tablets and smart speakers. Users can have limited access to music and podcast content for free or subscribe to Spotify Premium plan with around €10 per month for a full experience including ad-free, on-demand playback and offline download. With the freemium business model, Spotify now has 345 million users in 93 countries, 45% of them being Premium subscribers. (Spotify, 2021)

Looking at the global music paid subscriptions, Spotify dominates with 32% market share, followed by Apple Music (18%) and Amazon Music (14%). (Midia, 2020) Such success results from continuous market expansion and product innovation. Spotify’s freemium model reduces entry barriers and fuels its expansion from Europe(2008) to new regions such as the US (2011), Japan (2016) and India (2019). It also increases social buzz by integrating sharing features with platforms including Facebook(2011), PlayStation(2014) and Uber(2016) and retains users through data-driven personalization. (Goodwater Capital, 2018) A good example would be the iconic Spotify Wrapped feature, which shows top played songs, favorite artists and other user insights throughout the year, increasing users’ brand loyalty and social sharing.

From economic viewpoint, the audio streaming market that Spotify belongs to is an oligopolistic market with high barriers to entry such as high R&D costs, strong brands, exclusive contracts and vertical integration, leading to a small number of firms including Spotify, Apple Music, Amazon Music and YouTube Music occupying a majority of market share. These firms are interdependent, inclined to provide similar services and reach price rigidity to avoid price war. (Economics Online, 2020) Although the high entrance barriers deter new entrants, Spotify faces great pressure from its close rivals Apple, Amazon and Google treating their streaming platform as loss leaders to lure customers to their core service, which may lead to highly competitive behaviors such as lower prices or better terms with label companies. (Trainer, 2018)

Financial Position Analysis To understand the value and profitability, Spotify’s financial position is closely examined by comparing income statement and balance sheet between 2018 and 2019. 1. Income statement

Sales Revenue

Compared with 2018, Spotify’s total sales revenue grew by €1,505 million or 29%. This increase was attributed to a 29% growth of Premium users and adverts sold based on a 32% rise of ad-supported users. (Spotify, 2019) Spotify Premium is sold directly to end user and business partners such as telecom companies for bundle sales. Monthly subscription fee ranges from €1 to €10 per person depending on different plans as well as consumer purchasing power in each local market. Ad-supported users, on the other hand, can enjoy music and podcast for free supported by sales of display, audio and video advertising across music and podcast content. The sales revenue increase indicated a growing user base that was driven by Spotify’s business strategy in 2019: podcast investment, new partnership with Curry’s PC World and XBOX and geographic expansion to India. (Spotify, 2020)

Cost of Revenue

Spotify’s main costs of sales are royalty costs paid to record labels, music publishers and other rights holders and distribution costs for content streaming. Thus, the growth of Premium and ad-supported users in 2019 in turn created more content usage and led to an increase of cost of revenue from €3,906 million to €5,042 million (29%). Looking at the ratio between sales revenue and cost of revenue, it is observed that the ratio went down by 0.5%. This implies Spotify became slightly less efficient in 2019 due to additional podcast acquisition and development costs.

Gross Profit vs Fixed Costs

Goss Profit is an indicator of a company’s survivability, which explains whether a company has enough of profits to cover its fixed costs. In 2019, Spotify’s gross profit increased by 27% and reached €1,722 million as compared to 2018. However, the gross profit failed to cover its fixed costs of €1,795 million, attributing to negative operating profit. The high fixed costs primarily resulted from two segments: Research and Development (R&D) and Sales and Marketing. Compared with 2018, R&D expense increased by €122 million to support the product enhancement, and sales and marketing costs increased by €206 million for advertising and discounted or free trials in acquiring new subscribers. (Spotify, 2019)

Net Profit/Loss

Due majorly to an increase of operation costs, the net loss rose by €108 in comparison to 2018. This suggests that, despite being the largest audio streaming platform, Spotify was not economically viable as of 2019 and raised the uncertainty of Spotify’ profitability in the future.

2. Balance sheet

Assets

In accordance with IFRS 16 effective on 1 January 2019, Spotify recognized lease right-of-use assets, contributing to a total asset increase by €786 million or 18% as compared to 2018. (Spotify, 2019) For current assets, cash and cash equivalents rose from €891 million to €1,065 million, occupying 47% of total current assets, while account receivables remained constant in two years and only accounted for 18% of current assets. This indicated cash, generated by growing direct sales, is Spotify’s key source of agility to react to the market trends.

As for fixed assets, it is noticeable that long term investment in 10% of Tencent Music’s shares comprised half of fixed assets.(Ingham, 2017) The acquisition of Podcast companies including Gimlet, Anchor and Parcast were mostly recorded to goodwill, resulting in 227% growth. Also, property and equipment went up by €94 million largely due to Spotify’s investment in its operations. In 2019, Spotify completed the build-outs of leased office spaces in New York, Stockholm, Boston, London and São Paulo to accommodate more talents in the future. (Spotify, 2019)

Liabilities and Equity

In 2019, most of the current liabilities came from accrued expenses including salaries, taxes and fees to right holders (58%), followed by account payables (22%). Each increased by €362 million and €122 million respectively as compared to 2018. The delayed payments allowed Spotify to improve its cash position in the short term and reinvest to the operations. In respect of long-term liabilities, lease liabilities were disclosed with the adoption of IFRS 16, attributing to a significant debt increase of €553 million for leased office spaces. (Spotify, 2019)

Regarding equity, although capital increased by 10% to €4192 million, Spotify’s operating losses since product launch in 2006 had accumulated to €2,709 million, resulting in a decrease of equity by €57 million compared to 2018. This shows Spotify had been struggling to generate sufficient sales revenue to offset content and royalty expenses as well as operation costs; hence, failed to achieve profitability.

Financial Ratio Analysis To evaluate the overall financial health of Spotify, financial ratio analysis is conducted consisting of liquidity ratio, debt management ratio, profitability ratio, efficiency ratio and investment ratio.

Liquidity Ratio

The liquidity ratio including current ratio and quick ratio suggests Spotify’s ability to meet its short-term financial obligation. Given the fact that Spotify has no inventory, the current ratio and quick ratio are identical, reaching 1.05 in 2018 and 0.91 in 2019. Although slightly declined by 0.14, current ratio remained positive at around the optimal number of 1.

Debt Management Ratio

Looking at total debt to assets ratio, it is observed that Spotify’s debt increased by 8% and reached the optimal number of 60% in 2019 mainly because of lease liability added for IFS 16. This had reduced Spotify’s capacity to increase debt. What’s more, despite a 92% growth in EBIT, the operating loss resulted in a negative time interest earned ratio of -2.05 in 2019, meaning Spotify had insufficient profit to pay for its interest expense. By adding depreciation and calculating the cash coverage ratio, the capacity to increase its debt moved up a little ; yet, still remained negative at -0.02.

Profitability Ratio

Profitability ratio is calculated based on net profit and consists of three segments: net profit margin, return on asset and return on equity. Seeing that Spotify had been experiencing net losses since its inception, the profitability in each segments left rooms for improvement. In 2019, both net profit margin and return on asset decreased by 2% to -3% and -4% respectively as compared to 2018, implying Spotify is not making any profit through its sales or assets. The return on equity funded by investors also dropped by 5% to -9% and attributed to a larger losses to shareholders.

Efficiency Ratio

Spotify’s efficiency can be firstly measured by days sales outstanding. In 2019, Spotify increased its efficiency and liquidity by collecting receivables in 21.91 days, around 6 days earlier than last year. However, due to the construction of built-outs, the property and equipment usage was less efficient with fixed asset turnover ratio reduced by 18.03.

Investment Ratio

Owing to the continued net losses, Spotify had a negative price-to-earnings ratio of 373.38 (2018) and 136.99 (2019), indicating its unprofitability and hidden risks of bankruptcy. Yet, a positive market-to-book ratio of 12.51, though it may be overvalued, suggested investors’ confidence in Spotify’s future growth and market dominance.

Conclusion

Gathering insights from financial analysis, it’s evident that Spotify’s business model has its strength and weakness. One of the key strengths is the liquidity driven by zero inventory and freemium. Spotify’s freemium model, supports by the near-zero marginal costs of platform economy, not only creates demand-side economies of scale but sustains steady cashflow from sales of advertising and monthly subscriptions. With the cash, Spotify can react quickly to market trends and expand to adjacencies like acquiring podcast companies and investing Tencent Music in 2019.

Along with the accelerating user growth, the underlying concerns of unprofitability emerged. The royalty and content distribution expense give rise to high cost of revenue. Moreover, to prevail competitors like Apple and Amazon and sustain leading position, Spotify has been improving its service and expand market through discounted trials, which attribute to increased costs for R&D and marketing. The two factors have led to significant net losses since launch. Nevertheless, market-to-book ratio shows investors’ faiths in Spotify. By increasing dependency of the platform and strengthen network effects, it is believed to achieve monopoly and profitability in the future.