The message to investors from Spotify last week had a familiar ring for any veteran of the tech gold rush: “The trend towards profitability is clear.”
The music streaming service is hoping to banish the memory of a difficult year for technology flotations. Similar promises of digital alchemy – heavy cash investment transforming into an ever-burgeoning bottom line – followed the stock-market launch of Snap last year. So far, investors in the owner of Snapchat have been underwhelmed, but last week 35-year-old Daniel Ek, Spotify’s co-founder and chief executive, was adamant that his music streaming service would deliver the kind of returns that have proved elusive for tech upstarts since the blockbuster float of Facebook.
The test for Stockholm-based Spotify will come when it floats in New York on 3 April, while Dropbox, the online file storage company, is preparing to launch its initial public offering this week. Those companies must answer two simple questions: will Spotify ever go into the black and justify the near-$20bn (£14.4bn) valuation that private trades in its shares put on it; and is Dropbox really worth between $7bn and $8bn?
With both companies preparing to join US stock markets, they could determine whether investors regain their enthusiasm for new technology stocks after a disappointing year in 2017, during which Snap, meal-kit company Blue Apron and big-data business Cloudera all went for public listings – and disappointed. Shares in Snap are down a quarter since it floated – a poor performance for investors hoping it would emulate Facebook, which has risen nearly 400% since it floated in 2012. (Twitter, meanwhile, finally recorded its first quarterly profit last month, five years after going public.)
One analyst thinks the latest flotations will restore faith. “Spotify and Dropbox have a very good chance of success because the technology world is about one company dominating one sector,” says Mark Mulligan, a tech analyst at Midia Research. “Spotify and Dropbox are each dominant forces in their respective sectors. Snapchat wasn’t, because of the might of Facebook and its Instagram service. Snapchat is a second-tier player: Spotify and Dropbox are top-tier players. It is a completely different ballgame.”
Some big names are counting on Ek and his counterpart at Dropbox, Drew Houston. Lining up behind Dropbox and Spotify are ride-hailing service Uber – given a notional value of $50bn in 2015 – and the short-term letting agency Airbnb. The former isn’t profitable; the latter is. With markets jittery, both Spotify and Dropbox are working hard to push a story of future profits and growth.
On Wednesday, Spotify used a web presentation to reassure would-be investors that it has a clear path to profit, pointing out that revenues grew 39% to €4.1bn (£3.6bn) in 2017, though financing costs from a €1bn loan helped push operating losses up 8% to €378m. “The trend towards profitability is clear when you look at operating losses as a percentage of revenue,” it said soothingly.
Spotify is also taking an unusual approach to its listing – going direct, so that its shares aren’t handled by an investment bank or underwriters, but simply offered from the company on the exchange to would-be buyers.
Analysing that approach last year, the business magazine Fortune said: “If an IPO is like a wedding, a direct listing is running off to elope. A faster, easier, cheaper route to the same result.” Of course, like an elopement, you might not get the big benefits: an IPO guarantees money from institutional buyers snapping up millions of shares. A direct listing could flop.
Others aren’t so sure about Spotify’s potential, based on its finances and its business model. Spotify users have the option of a free service, in exchange for listening to adverts intermittently, or paying a monthly subscription fee of £9.99, $9.99 or €9.99 for no-advert streaming. It is a compelling service with 71 million paying users, but the cost in payments to artists and record companies is huge: it has forked out $9bn in royalties since it launched.
According to one investor, Spotify’s gross margin – a measure of profitability once certain costs are stripped out – is not high enough and indicates that royalty rates have to come down. “A 20% gross margin business is not a good business,” says venture capitalist David B Pakman. “One of two things has to happen: they have to enter new business lines with higher gross margins, or somehow magically transform the rate structure with labels.” The latter rate is how much Spotify has to pay per track streamed.
Dropbox, meanwhile, was valued at $10bn when it last raised capital in 2014, but that has been slashed to between $7bn and $8bn for its forthcoming IPO, which is intended to raise about $610m. Steve Jobs was famously dismissive of the company: in a 2009 meeting, the late Apple chief told Houston that he had “a feature, not a product”. In other words: Apple or Microsoft or Google could add Dropbox’s functionality – you drop a file in the folder on your PC, and it’s available on your phone or tablet – to their existing software for free.
Houston shrugged off Jobs’s disdain to build a company that in 2017 had 500 million users and $1.11bn in revenues. Not bad for a “feature”.
So why has its notional value gone down? Partly it’s the company’s revenues: in the absence of profits (it made a net loss of $112m in 2017, almost halved from $210m in 2016), a typical measure of capitalisation is a five- or six-fold revenue multiple. With the company’s filings showing revenues up 31% in 2017, the $7bn figure looks reasonable compared to rivals such as Box, which does the same file synchronisation but with a focus on commercial clients.
“The pricing [for Dropbox] had to come down to lure in the investors,” says Phil Davis of the investment advice service Phil’s Stock World. Eric Schiffer, of private equity company the Patriarch Organization, calls the pricing “a slap in the face to investors of the 2014 round”.
It’s therefore starting to look as though the sky-high valuations of a few years ago were mistakes born of over-optimistic expectations. In 2012, the venture capitalist Bill Gurley called Dropbox “a major disruption”, saying that Houston and his team had “taken a hard problem – file synchronisation – and made it brain-dead simple”. But now such synchronisation is a feature offered by almost everyone. Microsoft has OneDrive, Apple has iCloud, Google has Drive.
Dropbox’s broader problem is also its biggest opportunity. Of its 500 million users (of which 100 million signed up in 2017), only about 11 million pay for its extra features, such as more storage, administrative tracking, and integration with Microsoft Office.
With only 2% of users paying, there’s plenty of headroom for revenue growth: Spotify’s figure of 71 million paying users from a total of 159 million is an impressive 44%. Dropbox’s challenge is persuading people to flip over to paying for something they can largely get for free: Apple and Google both offer unlimited photo storage and as much free file storage as Dropbox.
So, for both companies, plenty of ancillary questions remain over these valuations. Is Dropbox really a product? Or has the march of technology turned it into just another feature? And will Spotify ever make a profit when its margins seem to be determined by its suppliers – the record labels? Investors’ feelings about the answers to those questions could have a knock-on effect on many other businesses.
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