Spotify Technology S.A. annual report, Q4 FY2018

Spotify Technology S.A. — 2018 Form 20-F Summary

Business context and reporting period

Spotify is a Luxembourg-incorporated global music streaming company operating Premium subscription and Ad-Supported segments in 78 countries and territories. The filing covers the fiscal year ended December 31, 2018, prepared under IFRS as issued by the IASB. Although the request identifies 2018 Q4, this filing is an annual report; selected fourth-quarter metrics are included where disclosed. Spotify completed a direct listing on the NYSE on April 3, 2018.

December 31, 2018 MAUs: 207 million, up 29% year over year.
Premium Subscribers: 96 million, up 36% year over year.
Ad-Supported MAUs: 116 million, up 24% year over year.
Fourth-quarter Content Hours per MAU: 26 per month, up 5% year over year.

Financial performance and liquidity

€ millions, except percentages and per-share data	2018	2017	Change
Revenue	5,259	4,090	+29%
Gross profit	1,353	849	+59%
Gross margin	26%	21%	+5 pts
Operating loss	(43)	(378)	Improved by 335
Net loss attributable to owners	(78)	(1,235)	Improved by 1,157
EBITDA	(11)	(324)	Improved by 313
Operating cash flow	344	179	+165
Free cash flow	209	109	+100

Premium revenue was €4,717 million, up 28%, and represented approximately 90% of total revenue. Premium gross margin increased to 27% from 22%.
Ad-Supported revenue was €542 million, up 30%, and represented approximately 10% of total revenue. Ad-Supported gross margin improved to 18% from 10%.
Premium ARPU declined 10% to €4.81, primarily due to increased Family Plan adoption and foreign-exchange movements.
Cash and cash equivalents were €891 million; short-term investments were €915 million. Combined cash and short-term investments totaled €1,806 million, up from €1,509 million.
Spotify reported no outstanding indebtedness at year-end. The remaining convertible notes were exchanged for shares and reclassified to equity following the direct listing.
Total equity attributable to owners was €2,094 million, compared with €238 million in 2017; accumulated deficit was €2,505 million.
Capital expenditures were approximately €125 million in cash-flow reporting, while €145 million of fixed assets were capitalized during 2018. Planned 2019 capital expenditures were approximately €200 million.

Material changes versus the prior comparable period

Revenue growth accelerated operating leverage: gross margin rose five percentage points and operating loss narrowed substantially.
Content economics improved under new licensing arrangements, with lower Premium and Ad-Supported cost of revenue as a percentage of revenue and fewer rights-holder dispute charges.
Research and development expense increased 24% to €493 million; sales and marketing increased 9% to €620 million; general and administrative expense increased 7% to €283 million.
Net loss benefited materially from lower finance costs and higher finance income. Finance income included approximately €373 million of fair-value gains on warrants, while finance costs declined principally because the convertible-note liability was extinguished.
Income tax benefit of €95 million was driven primarily by deferred tax recognition related to the unrealized increase in the fair value of the Tencent Music Entertainment investment.
Other comprehensive income included a €572 million gain on long-term investments, primarily reflecting the TME investment. This gain did not represent operating profit or cash generated by the business.
Spotify repurchased 687,271 shares under its announced program for approximately €77 million during 2018 and authorized repurchases of up to 10 million shares, subject to a $1 billion program limit.

Guidance, outlook, risks and unusual items

The filing does not provide a clear formal full-year 2019 revenue or profitability guidance range. Management states that existing cash, short-term investments and expected operating cash flow should fund working capital, capital expenditures and other liquidity needs for at least the next 12 months, but additional financing could be required if growth investments, acquisitions or other needs exceed forecasts.

Minimum royalty guarantees totaled approximately €700 million, including €548 million due within one year.
Operating lease obligations totaled €833 million, and Google Cloud Platform minimum purchase commitments were approximately €270 million over the following two years.
Spotify continued to report a material weakness in internal control over financial reporting relating to rights-holder liabilities. Management’s disclosure controls were therefore ineffective at December 31, 2018, and no management or auditor attestation report on internal control was included under the applicable new-public-company transition period.
Royalty liabilities require significant estimates and remain subject to audits, disputes, late claims and potential additional payments. Rights-holder agreements cover more than 85% of streams and commonly include minimum guarantees, audit rights and most-favored-nation provisions.
The Ferrick copyright class-action settlement required a US$43 million cash payment, settlement costs, attorneys’ fees and potential future royalties; appeals had been resolved as of January 15, 2019, subject to the remaining period for possible Supreme Court review.
Key risks include dependence on third-party music licenses, competition from Apple, Amazon and Google, user retention and conversion, advertising monetization, fraudulent streams and accounts, cybersecurity, privacy regulation including GDPR, foreign exchange, tax audits, and reliance on Google Cloud Platform.
Founders Daniel Ek and Martin Lorentzon controlled approximately 77.9% of combined voting power through ordinary shares and beneficiary certificates, creating substantial shareholder-control and governance risk.
Subsequent to year-end, Spotify repurchased an additional 548,121 shares for €62 million and agreed to acquire Gimlet Media and Anchor FM for approximately €300 million, primarily in cash, subject to closing adjustments.

Important facts an investor should verify

Reconcile reported positive free cash flow with the continuing IFRS operating loss and assess the sustainability of working-capital benefits and royalty accruals.
Review the rights-holder liability material weakness, remediation progress, audit findings and any later restatements or additional royalty obligations.
Separate operating performance from non-operating valuation effects, especially the TME investment gain, warrant remeasurement gains and deferred tax benefit.
Assess whether the €700 million minimum royalty guarantees and €270 million cloud commitments are supported by subscriber, engagement and advertising growth.
Monitor Premium ARPU declines, Family Plan mix, Ad-Supported monetization and the economics of international expansion.
Confirm the final consideration, accounting treatment and strategic returns from the Gimlet Media and Anchor FM acquisitions.
Evaluate the dilution and governance implications of outstanding options, warrants, beneficiary certificates and the share-repurchase program.