The share price of Spotify Technology SA (SPOT, Financial) has experienced significant volatility since its initial public offering in 2018. Initially priced at $165.90 per share in April 2018, it soared to an all-time high of $334 by February 2021. However, it subsequently plummeted to an all-time low of $77.26 in November 2022, before rebounding to around $240 currently.
In my opinion, Spotify is still cheap at this price and could provide decent upside for investors over the next several years.
Consistent growth in subscriber base and revenue
Spotify is the world's leading global audio streaming subscription service, with the large community of 602 million monthly active users, including 236 million premium subscribers worldwide across 184 countries. Spotify is considered a platform, a two-sided marketplace, for both subscribers seeking to enjoy high-quality music and podcasts online and and for creators and artists looking to publish their content.
Its revenue is primarily derived from two sources: premium service subscriptions, which provide users access to ad-free, high-quality streaming, and ad-supported revenue, which comes from selling display, audio and video advertising space to agencies. In 2023, the majority of Spotify's revenue, amounting to $11.57 billion, or 87.30% of its total sales, was generated from premium subscriptions, while the ad-supported service contributed $1.68 billion, representing 12.70%.
Investors would be amazed by its consistently high growth in both subscriber base and revenue. In the first quarter of 2015, there were only 68 million monthly active users. However, the number of subscribers has continued to increase significantly, surging by nearly nine times to 602 million in 2023.
Source: Statista
Simultaneously, revenue has mirrored this upward trend. Over the past nine years, revenue has increased every single year, from $2.11 billion in 2015 to $14.44 billion in 2023, reflecting a strong double-digit annualized growth rate of 23.80%.
Incurred operating losses, but improving with workforce reduction
Regarding profitability, Spotify has seen a decent improvement in its gross margin, which has risen from just 11.65% in 2015 to a consistent range of 25% to 26.80% since 2018. This significant uplift in gross margin can be attributed to new licensing agreements with major partners such as Universal Music Group, Sony Music Entertainment and Warner Music Group, which have effectively helped in reducing content costs.
Despite these gross margin improvements, Spotify's operating income has remained in the negative for eight out of the past nine years. In 2023, the company produced operating losses of $486 million. The persistent operating losses are primarily due to increasing selling, general and administrative expenses as well as research and development costs. Since 2015, the company's SG&A expenses have surged from $354 million to over $2.30 billion, while R&D spending has increased from $148 million to nearly $1.90 billion. SG&A expenses as a percentage of revenue have fluctuated between 19% and 25.64% and settled at 21.50% in 2023. Meanwhile, R&D expenses as a percentage of revenue have grown from 7% in 2015 to 13% in 2023.
Source: Author's table
To enhance its operating performance, Spotify has initiated a third round of layoffs, cutting approximately 17% of its global workforce, which is around 1,500 employees. Since the third quarter of 2022, there has been a significant reduction in the year-over-year growth of operating expenses. In the fourth quarter of 2023, the company's operating expenses increased by about 2% compared to the same period last year, primarily due to severance payments and restructuring costs related to the layoffs. Moving forward, I anticipate these measures will make the business profitable.
Source: Spotify's presentation
Consistent positive cash flow generation
Despite the consistent operating losses, Spotify has maintained consistently positive operating cash flow and free cash flow every single year since 2016. Its operating cash flow increased from $106.54 million in 2016 to $741.60 million in 2023. And the free cash flow rose from $78 million to $735 million over the same period, delivering a compounded annualized growth rate of 32.40%.
The difference between operating income and operating cash flow was mainly attributed to the increase in trade and other liabilities, which are the amounts Spotify owes its suppliers, including content creators who have not yet been paid, and the non-cash share-based compensation expense, which grew from $30.5 million in 2015 to $350 million in 2023.
Robust balance sheet
Spotify's financial health is robust, characterized by a strong balance sheet and minimal debt. As of December, it had $2.53 billion in shareholders' equity. Its cash, cash equivalents and short-term investments were recorded at $4.20 billion. The total of its exchangeable notes and lease liabilities amounted to nearly $1.70 billion, positioning Spotify with a net cash reserve of approximately $2.50 billion. The company's free cash flow for the year reached $735 million, resulting in a debt-to-free cash flow ratio of 2.30. Furthermore, with the recent workforce reduction, the company's free cash flow is expected to keep growing in the future. Thus, Spotify is in a comfortable position to cover its debt obligations.
Potential upside
Let's use the discounted free cash flow analysis to value Spotify. Assuming that its free cash flow will grow by 30% per year in the next five years, following this period, the growth rate is projected to decelerate to a terminal rate of 5%. With a total number of shares outstanding of 197.10 million and a discount rate of 8%, the analysis suggests Spotify's intrinsic value should be approximately $352 per share, 47% higher than the current trading price.
Key takeaway
Spotify's journey since its IPO has been marked by significant volatility, but its underlying growth metrics and strategic improvements signal strong future potential. With a solid increase in subscribers and revenue, along with improved operational efficiencies and a robust financial position, the company is poised for further growth. Notably, a discounted free cash flow analysis reveals an intrinsic value of $352 per share, indicating a potential 47% upside from its current price. This analysis indicates Spotify is an undervalued investment with considerable growth prospects, suggesting a compelling opportunity for long-term growth investors.
