Spotify IPO Watch: Brexit’s Bubble Bursting Bang

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JACK

Lads that’s not good enough, we need to fire two broadsides to her one.

Want to see a guillotine in Piccadilly?

ALL

NO!

JACK

Want to call that raggedy assed Napoleon your King?

ALL

NO!

JACK

Want your children to sing the Marseillaise?

ALL

NO!

From Master and Commander: The Far Side of the World, written by Peter Weir & John Collee, based on the novels by Patrick O’Brien

If you’ve ever had a pint on the lawn of a country pub during the English summer, if you ever experienced the audience in a cinema rising to sing God Save the Queen, had Sunday brunch at the Dorchester Hotel, or ordered the meat off the trolley, then you probably weren’t surprised by the outcome of the Brexit referendum.  That outcome was the third political earthquake that the UK pollsters missed (SNP’s rise to dominance and the collapse of Labor in the last election being the other two).

So now that the relatively inevitable has finally come to pass, what impact will Brexit have on the near-term market conditions that are likely necessary to support a Spotify IPO?  I’ve long held the view that a Spotify IPO in the U.S. (or anywhere else, actually) will require a bull market bubble, a crisp answer from Spotify’s management team on where they are spending the money, and now an equally crisp answer about the knock-on effects from Brexit on earnings due to currency fluctuations.

Spotify’s Convertible Debt Will Require a Bubbley Valuation: Hanging over a Spotify IPO is the $1 billion in convertible debt that the company recently borrowed from Goldman Sachs, Dragoneer Investment Group, and Texas Pacific Group (TPG is also a Pandora lender, coincidentally–if you believe in coincidences).  Let’s assume that loan is in dollars.

If you take into account the loan’s 5% interest rate and the value of the warrant coverage in the deal, Spotify is essentially paying credit card interest on $1 billion (that 5% rate escalates 1% every six months until it reaches 10%, or Spotify registers an IPO).

Those lenders are not babies, see?  Loans have a clause called “events of default” and when one of those events is triggered, lots of bad things happen to the company that can include the lenders taking over the company.

Remember, companies IPO for a few different reasons, but one is to raise capital for the company, reward employees and allow shareholders to get some liquidity.  If at least the nominal point of a Spotify IPO is to raise money based on investor optimism about the future earnings of the company (also called the stock price), Spotify will need to raise a huge chunk of cash in order to retire even a substantial portion of that convertible debt and have any money left over to run and grow the company.  That will require an equally huge valuation, probably rivaling the Facebook IPO.

Spotify may be a lot of things, but Facebook it ain’t.

Spotify’s Spending on Growth is a Critical Deflection in its Story:  Why isn’t Spotify profitable?  I’d give you two main reasons that are necessary factors.

Wrong Business Model:  Spotify has wedded itself to its ad supported “free” service.  Here’s a chart and analysis from Motley Fool that offers an explanation of why free doesn’t work:

[Comparing Average Revenue per User on free vs. subscription shows] a massive difference in value based on the type of user. As such, making every effort to increase Spotify’s paid subscriber conversion rates seems like the key to eventually turning the service into a profitable entity. Importantly, the cost split between these users isn’t clear. However, Apple’s, Amazon’s, and Pandora’s preference toward paid subscriptions implies something positive about the business model, even though Spotify has yet to reach profitability via its freemium business model.

Spotify Earnings
Source: Motley Fool

Spending on Growing Business is Why Spotify is Unprofitable: Given that Spotify has a business model devoted to free that is out of step with its slower growing but likely more profitable competition, it’s easy to see why Spotify has to borrow money at credit card rates in order to grow.  And Spotify’s growth strategy is a toxic mix of high executive salaries, expensive real estate and seemingly endless collisions with artists and songwriters who make Spotify’s main product–who are increasingly impatient with free not to mention getting stiffed on the royalties that are owed.

It should not be lost on anyone that when Apple Music–Spotify’s main competition–needs money, they don’t have to borrow at credit card interest rates.  And all of Spotify’s snarky tweets about Apple won’t change that.

Tech IPO Trend is Down and Brexit Won’t Help:  Let’s assume for the moment that we can label a Spotify IPO as a “tech” play.  I’m not so sure that’s the right way to look at Spotify’s business–Red Hat it ain’t.  But then again, it’s not a traditional music play and it’s not radio (which seems to be how Pandora sees itself).  Let’s call it a tech company for IPO purposes.

The trend is not good in general for tech IPOs so far in 2016, Twilio notwithstanding.  That extends a bear market in tech IPOs in 2015 (28) that was the worst year for tech IPOs since 2009.  Not only that, but some of the IPOs that did happen performed poorly, in some cases getting an IPO valuation that was less than their last private financing (see Box and Square), essentially making their IPO a down round.  I shudder to think what a down round would mean for Spotify with the terms of that loan.

And then we have to consider that U.S. tech companies arguably have greater European exposure than any other U.S. business sector.  Ahem.  And Spotify’s principal banker, Goldman Sachs, gets about 25% of its revenues from Europe.  Any significant post-Brexit slowdown in trading or M&A, not to mention revenues, will also hit Goldman.  That may make Goldman more interested in less risky syndications that a Spotify deal.

If Spotify’s IPO will be syndicated with at least some European banks as one would expect, one would want to keep a close eye on how those banks perform in the coming weeks post Brexit.  If you’re like me and expect weeks on weeks of the world markets testing lower lows with oil trading in the $45-$50 range (that will likely go a bit lower due to a stronger dollar), I’ll be keeping an eye on Barclay’s, Credit Suisse, Deutche Bank, Lloyds and RBS.  All of which got the stuffing knocked out on Friday.  One thing about crashes, it’s usually not the first day that gets you, it’s the mutual fund redemptions and capitulation of retail traders especially when they have the weekend to think about it like they do right now.

Not to mention next Tuesday’s speech by European Central Bank President Mario Draghi at the European Central Bank Forum on Central Banking and Wednesday’s expected speech by the Fed’s Janet Yellen at the same forum.

I can’t imagine these central bankers will say nothing to see here, move along.  If you’re like me and believe there is a very real possibility of a European recession, all these banks will have their hands full.  In my view, too many balls to juggle to add a flyer on a Spotify IPO.  They’ll be more worried about keeping their respective economies afloat rather than a Spotify floatation.

Right now I see no reason to think there is any likelihood that those trend lines will change direction for the frothy bubble in the markets that I think is a necessary condition for a Spotify IPO (or even a real unicorn like Uber).  How long?  Weeks and weeks for sure and probably months and months, well into 2017.

And that makes an event of default under Spotify’s convertible debt all the more likely.  A fact that is not lost on the lenders who probably have a much more sophisticated political risk analysis than a free music service has available.

Brexit is Likely to Change Spotify’s Earnings to the Downside:  And then there’s earnings.  Remember earnings?  That’s the “E” in “Price/Earnings ratio”.  Even a “get big fast” Internet company like Spotify has to eventually come to grips with earnings.

Bob Pisano of CNBC (who is a guy I have a lot of time for) had this to say about the Brexit knock-on effects on earnings for companies in general:

One thing we do know: the companies with the largest exposure overseas have already been reducing their earnings and revenue projections by a greater degree than companies with a more U.S.-based focus….

Companies that generate less than 50 percent of their sales outside the U.S. are seeing earnings drop 2.8 percent; those with more than 50 percent of their sales outside the U.S. are expecting an earnings decline of 9.9 percent.

This is due to a combination of 1) the stronger dollar, and 2) weaker economic activity.

Even unicorns are subject to the laws of motion.

newtons_laws_in_latin

 

 

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