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Spotify, a music streaming application, with most of its business in the United States has achieved over a $30 billion valuation. This has come as a surprise for many given the fact that the music industry was considered to be all but dead because of declining revenues.
An extremely high valuation in an industry with rock-bottom margins is definitely an anomaly. This is the reason why many, including Prof. Aswath Damodaran from the NYU Stern School, have been trying to make sense of this mega valuation.
In this article, we will have a closer look at what the business of Spotify is and what are the competitive pressures surrounding its business. We will try to evaluate the mega valuation given to this tech startup
Spotify is a Swedish music company which was launched in 2008. It provides its users with access to rights protected music content for free. This means that users do not have to indulge in piracy and they can still listen to their favorite music for free.
Spotify follows a freemium business model. This means that they provide additional services like more content, faster downloads and no advertisements to users who are willing to pay an additional fee. This application is very popular amongst users. This is because they do not have to spend money on buying a single album. Instead, they can pay a subscription and get access to thousands of songs.
Also, Spotify uses modern technology which minimizes the amount of data spent while streaming music. The soundtracks recently played by the user are stored on the cache memory. Hence, the amount of data used while playing this tracks is abysmally low.
Spotify provides access to a music library. It has both free as well as paid users. Hence, it has developed a business model wherein it can earn money from both free as well as paid business users. The revenue model has three primary sources of income:
Spotify has decided to list its shares via the direct listing model. This meant that all the investment banks which are considered to be indispensable for an IPO were simply cut out by Spotify.
Despite not having any professional help, the Spotify IPO was a grand success. The company did lose some money as the market valuation slightly declined after the listing. However, that is only a tiny hiccup and investors seem bullish about the company’s prospects.
At the present moment, Spotify is a profitable and cash flow positive company. However, the amount of money being made is very less i.e. the company is not very profitable. The biggest reason behind this is that Spotify pays close to 88% of its revenue to artists in the form of signing fees and royalty payments.
The good news is that the cost structure of the company is such that when an additional user is added the additional cost is negligible whereas the additional revenue is significant. Hence, as revenue increases, the proportion of costs may start to go down.
Prof. Damodaran has predicted that within five years, Spotify may be able to reduce this cost to 70% of its revenue. However, that is not really a very good position to be in. The gross profit of Spotify will only be 30%. The company will have to manage all its overheads and also make a profit within this 30%
Another major problem with Spotify is that it is facing competition from a giant like Apple Music. Apple is not really trying to make money from its music applications. Instead, Apple just wants to keep users hooked onto the iPhone ecosystem.
Revenue from Apple Music amounts to about 1.2% of the company’s revenue. Apple can afford to lose money on its music applications. The same cannot be said for Spotify. Hence, Spotify is at a competitive disadvantage. It is likely that Apple will give better deals to record label companies and music artists and try to keep their songs off Spotify.
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