On Tuesday, Spotify (SPOT) tried to change the mold for Unicorn IPOs. Though not the first company to use the direct listing method, given its $20+ billion estimated value heading into the day, it was one of the biggest. And I'd call the first day of trading a huge success for the company. The opening trade placed Spotify's market cap just shy of $30 billion dollars and it closed the day at a $26.5 billion valuation. These numbers successfully cleared anything we saw on the private market, so this goes down as a major win for Spotify. Will it become a trend? I would expect another unicorn to try this same approach, but not every company can. Spotify didn't need money. Any company that does will have to pursue a more traditional path.
The big question is whether Spotify is an attractive investment. The company is the paid subscriber leader in the streaming music industry. No one has more paid subscribers or streams as many hours per month as Spotify. It's not even close.
Unfortunately, Spotify has some competition in the waters with sharp teeth.
Apple (AAPL) Music has reached a paid subscriber base of more than half of Spotify. Furthermore, it is poised to have more U.S. subscribers by the end of this year. Apple, like Amazon (AMZN) , is a name that scares many companies.
Amazon is another competitor in terms of music. And Alphabet's (GOOGL) Google is yet another growing name in the streaming music space.
Having Apple, Amazon and Google as potential competitors is about as bad as it gets. Spotify also faces challenges from Pandora (P) , SoundCloud, and JOOX.
Spotify does hold a major advantage over its competition. And that advantage is China, unless, of course, pesky tariffs get in the way. I don't think they will because of the way in which Spotify's Chinese advantage exists.
After a recent deal with the music arm of Tencent (TCEHY) , Asia's first $500 billion company, Spotify has a first-mover advantage into the huge Chinese market.
This is huge. In fact, until we see one of Spotify's major competitors show true growth in China, the partnership with Tencent is enough to interest me in the company.
Despite using the direct IPO path, we can still get a solid view of some early investors in Spotify via the $2.7 billion of debt and equity the company has raised over the past decade.
Goldman Sachs is considered one of the lead investors in Spotify, while Fidelity also holds a sizable position. Valley venture capitalist lead investors include TVC, Founders Fund, Horizons Ventures, and Accel Partners.
The biggest name happens to be the most recent: Tencent Holdings. The Asian company holds a ginormous 7.5% stake. Did I mention access to China?
Spotify isn't a young company, but it still has explosive growth potential because of China. Domestically, it is giving way to Apple, so that market will act as little more than a core for investors to consider. Unfortunately, we haven't seen any of the Far East potential. The deal is simply too new. For now, 90% of SPOT's users are from Latin America, North America, or Europe.
I do find the diversity and balance of user age an appealing statistic. Streaming services have not offered much in the way of profitability. Spotify is no different and that's a concern. Losses have swelled over the past few years as the company's latest quarter produced a loss of 3.87 Euros per share. The company has been able to produce free cash flow in 2016 and 2017 - while growing sales at a 45% compound annual growth rate. With a low 5.1% churn rate, Spotify is proving stickier than almost every other streaming service on the market. Revenue has doubled over the last three years, and gross margins have almost doubled as well, but without profitability soon, none of this will matter. At the very least, we can look to the fact streaming music remains in its infancy.
With a close near $150, we can see the trend of a rising valuation has exploded over the past year.
In my view, Spotify has run too far, too fast. Without seeing some evidence the Chinese market is going to pay dividends, I have a hard time seeing why this has doubled in value versus the private valuation late last summer. I won't consider dipping my toes until at least $120, although I'm more likely to wait until sub $100.
Bottom line: Investors will need to see how shares trade the first few weeks before they make any move. The fundamental story doesn't quite justify the current valuation although Spotify does have catalysts unlike many mature Unicorns that have come to market lately. That being said, I see the sidelines as the best play currently.