Spotify Stock: We Expect A Gradual Profit Transition (NYSE:SPOT)

We like Spotify (NYSE:SPOT) heading out of its Q4 ’22 earnings call, as the stock advanced by +20% since announcing earnings on January 31, 2023. We think investors underestimate the value of paying subscribers in this environment and the value premium growth investors are willing to pay for larger subscriber pools.

Spotify has managed to keep its subscriber growth figures without increasing prices on subs when compared to other subscriber models like TV. We expect modest improvements to profitability in our model, as growth in users paired with a very modest increase on ARPU driven by better ad-monetization over time implies gradual improvement to profitability. Furthermore, it’s safe to say that the stock has bottomed out at this point. We have a price target of $161 for the US listed stock, and €147 for the Deutsche Borse Xetra listed stock implying +35% upside for the dual-listed stock. We also rate Spotify at Strong Buy, and recommend the stock to our readers.

Spotify investment thesis and risk/reward

Spotify didn’t deliver on revenue or earnings estimates, but it delivered in one area that mattered, which was user level metrics. The modest improvement on gross margins, and added spending on marketing to sustain subscriber growth, and monthly active listener growth was what made the stock go up following the announcement of earnings. We appreciate their efforts tied to podcasts, and also the growth in radio and various other media formats on the platform inclusive of audiobooks. We think SPOT is one of the best positioned stocks in music, along with Live Nation (LYV) $150 price target, and Apple (AAPL) $155 price target.

We estimate FY ’23 revenue of 14.295 billion euros or $15.72 billion, which compares to consensus estimates of $14.65 billion, or +7.3% versus consensus on revenue estimates. We make this case because of a combination of 1.5% ARPU growth paired with 20% MAUs growth driven by advertising growth and conversion of ad-supported listeners to paying subscribers. We could see greater contribution on the mix of users on a tier-basis, or improvements in advertising rates on the ad-supported tier driving an ARPU surprise all year. We anticipate Spotify to begin topping expectations on a combination of pricing mix, and user growth paired with cost shifting leading to gradual improvements on profitability.

Figure 1. Podcasts Cost Money Shareholders Simply Don’t Want To Spend

SPOT is down -66% from all time highs of $360 from 2021 to the current price of $120 in February, 2023. We like the reduced price levels we’re working with, and given the difficulty with comprehending the profit narrative, and absence of profits, we think investors gave up on valuing the stock ages ago.

Furthermore, the controversy tied to Joe Rogan, and the dependency on glam-type celebrities has had a mixed impact on Spotify, which costs Spotify $200 million spread over an undisclosed number of years. It’s certainly a platform that should curate audiobooks and podcasts, but we’re just not sure how much money they should spend on content deals, and some of the deals are extremely expensive by audio content measures, which is why we’re kind of grateful that they’ve been scaling back costs on podcasts. Maybe our bias would change if Spotify paid us for a podcast (we say this tongue in cheek because it’s not likely to happen).

We’ve seen Walt-Disney movies get produced for the amount paid to Joe Rogan. And no offense to Joe Rogan, we appreciate the show, and the funny dialogue from time to time, but the amount Joe Rogan is earning is comparable to the cost of producing a Mission Impossible movie. Kim Kardashian also got paid an undisclosed sum for her podcast on Spotify. We think Spotify’s hunt for Hollywood’s biggest A-list celebrities came with too much of a price tag and shareholders soured on it.

We expect a gradual profit transition and given the 6% workforce layoff translating to a reduction in staff of 600 workers the profit narrative does improve, but not by much. We think a reduction on content spend tied to podcasts with a shift towards marketing would drive the adoption thesis and kind of get the company out of hot water with shareholders with regards to its various expensive podcast deals with A-list Hollywood celebrities.

Figure 2. Financial Model Spotify 2022-2025

Given this criticism, the company’s CFO Paul Vogel, reported on the earnings call, “Gross margin of 25.3% was above guidance by 80 basis points due primarily to lower podcast content spend.” We expect a gradual increase in profitability in our financial model, as we exit FY ’25 forecasting an adj. Profit margin of 8%, which is very aggressive given the corporate history. But, assuming Daniel Ek was sincere on his year-end earnings call we should see some effort to shift spending towards marketing, and less spending towards expensive content acquisition.

This should translate to better user growth metrics and improvement to profits. Furthermore, efforts to convert the existing user base to premium subscribers could positively impact margins and revenue contribution per user, which is why we like the underlying growth, and profit drivers to the business model.

Daniel Ek can certainly steer the ship in one of two ways, drive beats on user metrics by spending more on marketing generating revenue beats. Or, he takes the second approach, and gets even more aggressive with cost reductions with another layoff of 5% the workforce over the course of the year and scales content spend on audiobooks and podcasts at a slower run-rate, thus driving an immediate profit spiral while sacrificing on some top-line growth given the reduced slate of content.

In either case scenario, the profit ramp is where a lot of growth and profit minded investors can’t keep track of the stock. In terms of momentum, we can argue that the stock’s valuation in our model skews towards 4x P/S ratio driving up the average. But, we also apply a 33x earnings multiple, and 15x EV/EBITDA multiple on FY ’25 estimates to arrive at an $161 price target on Spotify implying +35% upside to the stock.

We think the stock should be valued at 43.5x FY ’25 earnings, which is quite high, but given the implied user base of 776 million monthly active users, and $20 billion revenue figure by FY ’25 the top line figure keeps the stock at a high valuation as most internet stocks trade above 4x sales unless if there’s something structurally wrong with their business model.

Spotify story remains compelling in 2023

The stock lost some momentum over the past couple years with the entrance of music streaming competition. To some limited extent the introduction of Apple music and Apple’s rapid scale-up with services as a bid to diversify away from hardware led to Spotify’s biggest competitor. Apple Music revenue was estimated at $8 billion and 88 million paying subscribers in 2022, according to a Business of Apps report, which compares to the 205 million paying subscribers Spotify reported on its Q4 ’22 earnings call. There’s also SoundCloud with an estimated 130 million monthly listeners, which compares to Spotify’s 500 million monthly listeners, but the two apps serve different music audiences.

We think Spotify is on track to reach 1 billion MAUs by 2030 assuming an average 10%-11% growth rate in users over the next 7-years. We anticipate a global music opportunity and a deeper subscriber pool being valuable in a number of years. However, the absence of profitability or really the near break-even nature of the business in favor of growth hasn’t resulted in the outcome shareholders had wanted.

We think profitability stems from pricing power despite the costs of high profile celebrity podcasts. Joe Rogan, Prince Henry, Meghan Merkel, and Kim Kardashian cost hundreds of millions of dollars collectively. We can at least argue that SPOT stays a step ahead of the failing Radio-era into a world where “professional podcasters” fill the void.

Though we doubt Wall Street appreciates the direction the company took over the past couple years, which is already reflected in the price of the stock. We think the stock has bottomed out, and emphasis on improving cost stems from added scale and scaling back on content spend, which means spending incrementally less on content deals tied to the podcasting category, and spending more on other areas of the business like customer acquisition.

Perhaps a hiring freeze and some further reductions in the number of workers similar to Meta might be necessary to reorient the company towards a combination of sales plus profit growth over the next several years. We recommend SPOT at Strong Buy to our readers, as we expect the stock to appreciate by 30%-40% this year, making it a compelling large cap stock based on a unique set of factors that’s very differentiated from other large cap stocks we follow or trade for that matter.