Just this week, Spotify went public directly priced at $132 a share, even when, with revenues of US$5 bill., it sustained losses of $1.5 bill. One analyst even gave the buy target at $180 a share! (At this writing, the stock was floating around $163 a share.) When I spoke to a financial journalist friend, who did author an article of Spotify’s direct listing, I reminded him about another company with a similar financial profile of losses that yet went public, my old employer, Viatel. Like Spotify, it went public even though suffering losses since Day 1, it also went public in a very heated tech IPO market. And never did the company reach profitability until it filed for bankruptcy and was finally delisted. Viatel, a company, whose public valuation was marked at U$2 bill. was sold at auction for $25 mill. First, let me go about discuss Viatel history and then address the similarity between that company and Spotify.
As a CxO of Viatel, I had access to all corporate and financial records of the telecom startup, Viatel. I knew that the founder lent the Colorado company $250k, paid back by later funding rounds, and the founder’s father in law and the founder owned all outstanding shares. The company offered “call-back” international call services to foreigners attempting to call the U.S. At that time, because of huge disparities of international regulatory markets, it was cheaper to call from the U.S. to Argentina, than vice versa. So Viatel applied a software switching platform that allowed a foreigner to call the U.S. as if the caller was in the U.S. Note that the differential margins were noticeable as long as the foreign carriers maintained international toll charges substantially higher than the U.S.
The other part of this equation is to note that Viatel had to purchase large volumes of international minutes at fixed prices from the U.S. established facility-based carriers such as AT&T, Verizon, MCI, and Sprint. The key word is “facility based.” Viatel was a reseller of minutes from these facility-based carriers. Facility-based carriers had invested billions in a complex, engineering networks of submarine cables, radio towers, switches, and landlines. Therefore, these carriers can control their underlying costs, amortize the hardware, and manage the infrastructure with over 400k employees. (Note that Viatel personnel never amounted to several thousand throughout its short history.)
Not so for Viatel, as this reseller carrier can only control pricing to its retail customers, which it did by selling the minutes way below what it paid to the U.S. based carriers. Why? To underprice the foreign carriers such as Telecom Argentina, Viatel had to sign up customers with better than 20% price differentials. That led to a very high explosive growth of new customers month to month that attracted investors such as George Soros. However, the model only works if investors are willing to finance more and more losses that paralleled the growth that allowed Viatel to standout from over 300 other competitors in the same callback space. In fact, the faster the company sold minutes, losses ballooned. Meanwhile, the founder not only paid himself over $500k in salary but also sold his father in law’s and personal Viatel equity for millions prior to the IPO to other investors and made millions. The founder stuffed his pockets richly from a company never making a profit from greedy investors.
This profit loss model seemed even peculiar to others outside of the U.S. Once I had been registering Viatel in Argentina where I had been required to provide proformas for the last three years. The regulator called me and asked me how this company was still operating with these bleeding losses. What could I say? That Soros, Goldman Sachs, Comsat and others kept throwing millions to this loss leader to later exit through an IPO?
So, let’s accelerate the Viatel history after the IPO. Wall Street was not so forgiving after several quarters, so the Street canned the Founder. (As a side note, the Founder was an extreme braggadocio in the same vein as Donald Trump. When I first met him, he claimed to have a successful real estate company and then later, founded a company with a “cure for AIDs”. I was skeptical of both since I witnessed lawsuits from his real estate partners for misappropriation of funds, and I had not seen NIH announced any cure for AIDs at that time. Now he was a telecom “visionary.”) The reason behind this antecedent discussion was that he would hire senior staffing with little or no background in the telecom industry. His de facto replacement at Viatel was an IT guy with zero telecom experience after the IPO.
But now this new management team of a publicly traded company became desperate. The founder and early round investors walked away with hundreds of millions. The last guys in the musical Wall Street chairs faced a dilemma: The so-called disparity margins in international calls reached increasingly asymptote to zero between each country’s international call tolls as all carriers worldwide reduced their international toll calls to market prices. As a non-facility-based carrier, Viatel had limited options on controlling its cost structures. Their solution?
Viatel had only one card left: become a facility-based carrier. Now we have a “team” with zero telecom experience while not knowing what it takes to get there. A trans-Atlantic submarine cable costs half a billion to build and $50k a month to maintain it. And we are not even discussing “last mile” solutions to bring a call to someone’s phone. In Paris, it costs about $1 million just to dig a street for every kilometer. Verizon has over 240k employees staffed with thousands of engineers. Viatel, on the other hand, was populated by telecom wannabees swimming underwater. In other words, Viatel’s team was incapable of managing and building a telecom network.
Yet, Wall Street gave it another chance with half a billion dollars of debt to build infrastructure and, indeed, Viatel contracted the construction company, Bechtel, to build “Circe” a land European based fiber ring. That ring finally brought the whole Viatel company down—yes, facility-based infrastructure is important but includes many components – last mile solutions, grids, international cable, long distance cable, wireless towers, etc. Partial infrastructure solution was not enough, and the company failed to satisfy investors and lenders and closed its doors after 2 years as a public company. All throughout its existence, Viatel never reached profitability. Its “team” led the company to its downfall and billions of dollars were lost to banks and institutional investors. Sill, the early stage investors and Founder made a killing.
So why do I give the sobriquet Spotify, Viatel II, to my writer friend? First, like my earlier blogs, I refer to check off the 5 T’s when evaluating tech companies. Here, the Spotify founders are programmers entering the music business. Unlike Napster, it demonstrated that their model would compensate the content providers, AKA, the music industry, the labels, musicians, producers, with a streaming model. Note that the former Spotify board member, Sean Parker, was a Napster co-founder, who made his $2 bill. fortune not as Napster founder but as a Facebook President. Napster had similar legal controversies as Viatel, in that it was charged for illegal services. (In the U.S., Viatel was charged for providing international telecom services without an FCC license. The case was litigated under my supervision and Viatel did win. Napster did not. To allow users to listen to music without paying royalties to the music industry became illegal.)
To software programmers, the world is populated by simple coding consisting of grammar and syntax. Beyond those software instructions, the rest of the world is irrelevant. What do the Spotify founders know about the music industry? Do they know the inner workings of Sony, Warner Brothers, or Columbia records? Like the telecom industry, the music industry is sui generis – its overall management and development of talent has decades of experience and hundreds of thousands of staffing to support and fostering musical talent. But not Spotify.
One interesting Spotify team member, its CFO, came from Netflix, another streaming enterprise. Netflix, like Viatel, just redistributed DVDs in the mail-order business and then moved on to streaming. But streaming someone else’s content has its limitation – one must pay royalties. Solution: create or finance your own content and create a more profitable portfolio of content. Then, of course, you are competing directly against Paramount, F/X, Hollywood. And the Netflix business development team must reflect that. That is the Netflix solution for improving its margins.
Besides reviewing the Spotify team, one must look at the initial investors. Prior to the IPO, Spotify had only 74 investors ranging from Goldman Sachs to Lakeview to Sean Parker. In other words, at the time of the IPO, these investors split over $20 billion of valuation. That is so like Viatel where few can liquidate their holdings from an unprofitable company in the short run.
And Spotify’s runway for initial investors to sell its stock holdings was extremely short through the direct listing. My theory behind Spotify’s reluctance to go public with underwriters comes from the fact that pre-IPO shareholders can sell their stock from day 1 without incurring the SEC sanctions to hold off selling holdings for at least one quarter under the standard IPO rules. Spotify claimed that they would save millions by not using underwriters. And truly, that is what happened: Sony sold off quickly about 17% of its holdings within a few days. The founders made a “Viatel-like” killing. (By the way, this approach resonates another Viatel like P.R. excuse. When E&Y moved its due diligence from Viatel to its Founder prior to the IPO, the Founder announced that he was moving the Viatel headquarters from NYC to Madrid, claiming it was the “center” of European telecom, although all submarine cables land in the U.K. The true story was that the Founder had never paid U.S. taxes and Spain has no extradition treaty with the U.S. Another P.R. falsehood.)
Now, like Viatel, Wall Street will only provide a short tether of a few quarters for Spotify to reach profitability. And now it faces several challenges. Can it compete with infrastructure? The telecom equivalent in IT is handling data centers. Amazon and Google/YouTube – both already streaming content – own and operate many data centers costing about $60 million each, in the U.S. and internationally. Like Viatel’s Circe, Spotify would have to invest considerable capex to improve that part of its profit margins. Then it would have to convert its management team from software programmers to hardware guys – a major managerial stretch, just like Viatel.
Then there is the Netflix route – create content. That would mean moving corporate operations from Lichtenstein (not Sweden, since it is incorporated in Lichtenstein!) to Los Angeles – the mecca for the music industry. That would be a major challenge for any company. For a company that infringed copyright owners, now it must abide by them.
Another Viatel approach is to expand internationally, another mistake learned too late by Viatel through Circe. Spotify could consider China and India, containing 30% of the World’s population. But it should heed the lesson learned by Uber rather expensively that incumbents founded and managed by locals will defeat any new entrant. Uber spent over $2 billion of investors’ money to attempt to dislodge competitors if its “technology” was somewhat superior. That dog did not hunt. Nor will it for Spotify when both China and India already operate with Spotify-like companies.
How about hardware add-ons being promoted by Spotify? Remember the Spotify team? A bunch of software guys. Wait, does not Apple manufacture hardware for decades? Wait, does not Apple also distribute musical content? But, wait, does not Apple hold innumerable patents in its hardware industry? That strategic route does not bode well for Spotify.
Had Spotify been making a profit prior to its IPO, I never would have considered Viatel being analogous to Spotify. It took Wall Street a couple of years post-IPO and continuous Viatel financial losses to take away the keys from Viatel. How long will Spotify reach that barrier?