Why Spotify is likely worth more than Pandora, and why it matters

Spotify is a company on the upswing, snagging oodles of fresh users, and setting new records in terms of its total paying subscribers. Here’s a rule of thumb: if a company is blogging about its paying subscribers figures, it’s happy with the numbers.

And so when Spotify announced that it had hit some 2.5 million paying subscribers, the world sat up and took notice. Information published in Forbes today, outlining several important revenue figures for the music giant, meshed with our previous reporting have allowed us to deduce a few points from the data. Our primary conclusion is that Spotify is worth a multiple of rival musical titan Pandora.

Of course, we only have hard data from Pandora, as it is a public company and Spotify is not. However, the most recent official information from Spotify was released a single day after Pandora put out its most recent earnings report (not a coincidence, we think), so we can stack the two together and draw fair conclusions.

Spotify, in late November, hit the 2.5 million paying subscribers mark. 85% of its paying subscribers shell out $10 a month, while 15% of those who do pay only 5. The rest of its users deal with advertisements. Pandora has a similar system, in which users can pay to ditch ads. Now, to calculate Spotify’s revenues per year at 2.5 million subscribers, strictly from that revenue stream, is child’s play:

((2,500,000*0.85*10)+(2,500,000*0.15*5))*12 = $277,500,000

Again, that is only the company’s subscriber revenue, assuming that over the next twelve months it does not gain, or lose, a single subscriber from that moment in November. Of course, that’s bollocks, and the company is growing at a tremendous clip (more on that later), but it’s an important figure to have.

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In its last reported quarter, Pandora had revenues of $75,000,000. Extrapolated over four quarters, that’s some $300 million. However, only a fraction of that revenue came from subscribers, while the bulk of it came from advertisements:

In short, Pandora makes 7.31 dollars off its ad business to every one dollar that it makes selling subscriptions to Pandora One, its premium service. If you used that ratio to calculate the ad revenues of Spotify, you would guess that the company has billions in ad revenue. That number should trip every single bullshit meter that you have.

But it is critical to note that ads remain a huge, and vital, component of monetizing streaming music. In my recent testing of Spotify, I have become quite aware of this fact. Let’s put aside 7.31:1 and use a 1:1 ratio for Spotify. That, so far as we can determine, is a conservative way to determine Spotify’s ad revenues in comparison to its growing subscription business. It says, in effect, that Spotify makes a bit more than Pandora on a quarterly basis on ads. That feels right, given the explosion of Spotify use that the world has seen in recent months.

At a 1:1 ratio of subscription sales to ad receipts, again using that November data, Spotify should see total revenues of $550,000,000, again assuming no growth. That’s far north of Pandora’s $300 million. If you employ Pandora’s revenue to valuation ratio (5.5:1), Spotify is worth some $3.025 billion. However, given what we know about Spotify’s growth curve, we suspect that it is growing more quickly than Pandora, and is therefore worth more (from a rough PEG perspective, if you will). Here what we said in November:

Spotify’s deep integration with Facebook since September visibly had a very positive impact on its results as well; in August, estimates were that the company only had 1.675m subscribers worldwide. According to Spotify’s chief content officer and managing director of North America Ken Parks, the service has gained 500,000 subscribers since its advanced partnership with the social network, Bloombergreports.

This announcement also comes as a validation of the freemium business model, as a significant portion of Spotify’s users are paying for its premium service. As we reported in August, Spotify had already managed an impressive conversion rate of 12.5% among its then 1.4m US users.

It even outdid the expectations of the research firm Enders Analysis, which had forecast that Spotify would only reach the 2.5m figure (and profitability) by early 2012.

With numbers like that, Spotify is set to explode that 2.5 million subscriber figure (it alread has, now almost 2 months later), and thus its revenue and valuation. Pandora, comparatively, should do around 85-7 million in revenue in the coming quarter, assuming that its past pattern keeps up. That’s enough to move its numbers up, assuming margins hold, but compared to the Spotify curve, it’s not gaga.

Therefore, Spotify’s likely revenue advantage and, so far as we can deduce, superior growth rates value the firm at a fat multiple of Pandora. Given that its last raised money was at the $1 billion dollar mark, there are some very, very happy investors out in the world today.

Finally, why does this matter? It shows that Spotify’s model of letting users pick what songs they want to listen to, as opposed to a ‘focused radio’ system, is winning the market. That’s food for thought.