Spotify Technology SA (SPOT, Financial) embarked on a quest in 2023 to prove to investors that it was responsible and mature enough to restore order in its financials while growing at the same time. When activist investors bought stakes in the music streaming giant a year ago, the company's quest to improve its expenses became more real.
Since then, Spotify has taken many measures to improve its costs, but it has also set ambitious growth targets based on the pipeline of products waiting to be rolled out to its user base.
Investors so far have liked what they saw in Spotify, with the stock returning close to 140% in 2023. What is more interesting is the stock was up 9% in the first three weeks of 2024, still beating the S&P 500 Index, which has just broken even for the year.
Recap of Spotify's business model
Spotify is a household name in the area of mobile apps and technology. The company is usually credited with changing the business model of the entire music industry, which used to be heavily dependent on music CD sales while being plagued with music piracy at the same time. Over the last decade, Spotify grew its market share in the U.S. from 7% to a whopping 83% as users welcomed the idea of paying low-cost, periodic subscriptions to get access to the platform's vast library of music. On the supply side, Spotify is tasked with constantly growing its audio library by signing on more artists to upload their music catalogs to its streaming platform. In return, Spotify pays artists royalty fees based on how often users stream the artists' music catalog.
The majority of Spotify's revenue comes from its paying subscribers in the Premium segment, which makes up approximately 87% of its revenue. This is also the higher-margin revenue segment, fetching around 29% gross margins. Hence, I will always focus on growth trends in this revenue segment moving forward since it is Spotify's core segment. The rest of the revenue comes from the ad-supported tier.
Spotify is proving to be a lean financial machine
The company made meaningful changes to its platform costs early last year. By streamlining its product costs, the company was able to get the margins to grow again as compared to the same period in the previous five years. But the improvements were mainly driven by better improvements seen in the Premium business segment, which to me is very reassuring. I had noted in the earlier section how it is very important to see positive trends in Spotify's Premium segment.
One of the earliest changes Spotify made to its expenses was reducing headcount early last year. According to the employee-layoff tracking tool, Layoffs.fyi, Spotify reduced its employee headcount by almost a quarter. It did incur severance charges of around $47 million from the layoffs, which impacted margins in the first quarter, but I see how the most recent third quarter looked much better in terms of growing operating margins.
Downsizing its headcount has definitely helped reduce their overall costs. This was also noted by Jeremy Deal, founder and portfolio manager of JDP Capital on an episode of the GuruFocus Value Insights podcast two weeks ago. I suspect much of the benefits Spotify observed in its positive operating margins were driven by the prudence shown in its expenses, as can be seen in the chart above. Sales and marketing expenses fell 13% year over year for the first time in this quarter since the pandemic. Further, I believe the company has gotten more efficient at acquiring users because it was able to grow revenue despite sales and marketing expenses falling, as can be seen above.
What valuation models suggest for Spotify
In an investor presentation with market participants in 2022, management laid out its North Star goal of growing the company at a compound annual rate of 20% over three to five years. I will assume the same targets in my valuation since management has exhibited their faith in the ambitions on multiple occasions in subsequent investor presentations. Since Spotify had achieved $12.6 billion in 2022, using that as my base, I estimate Spotify will grow its business to about $30 billion by 2027. I will also be less optimistic than management and forecast Spotify's 20% CAGR growth at the higher end of its growth timeline at the five-year mark.
Consensus estimates peg Spotify's earnings per share to grow to $2.24 at the midpoint of expectations. This will translate to the company achieving roughly 2.5% margins on an adjusted Ebitda basis in 2024. Due to the addition of new products and features and the incremental benefits that I noted earlier, I expect the company to almost double its margins to around 5% in 2028. This means Spotify will grow its income by approximately 32% over five years. I think it is plausible to expect at this point that Spotify will grow its earnings in line with revenue at around 24%, which is three times the S&P 500's 10-year historical growth of 8%. Hence, I will be willing to pay three times the premium to invest in the stock . Given my estimates, I see around 18% to 20% upside in Spotify.
Risks and other factors to consider
With Spotify having initially proven it has been able to control costs, its biggest threat is its pace of innovation. If the company fails to innovate, Spotify could falter on its growth ambitions despite having demonstrated financial prudence. This will affect the growth multiples attached to the stock. Moreover, the music streaming industry is currently large and diverse, with many large competitors looming, such as Apple Music, etc.
However, I believe Spotify has set an ambitious roadmap for product-led growth, and I think it has enough products and features planned in its roadmap to get to those growth levels. For example, the company was able to grow its podcasting business after signing on huge personalities early on, when the podcasting business was still a nascent market, such as Joe Rogan and Michelle Obama. Further, Spotify also entered the Audiobooks industry late last year by offering over 150,000 audiobooks for free to premium subscribers. I think these are extremely proactive, growth-driven product initiatives focused on increasing Spotify's premium user base, which has started to grow again, as can be seen in the chart below.
Another core assumption here is that despite changes in key management personnel, the company will continue to achieve its targets. I say this because, at the end of last year, Chief Financial Officer Paul Vogel announced he would be leaving the company by March 31, 2024. Per the announcement, Spotify will look for an external candidate as CFO. At all times, I expect the company to continue to honor the commitments upon which my valuation is based.
Takeaways
After reviewing Spotify's financial efforts last year, I am encouraged by the early results I am observing from its financial initiatives. Management has shown remarkable restraint in controlling expenses and costs while still leveraging existing infrastructure and resources to continue growing the platform meaningfully. Keeping these initiatives in mind while looking out over a five-year horizon, I find Spotify is still undervalued at current levels.
