Spotify (SPOT.US) has been accumulating a 20% revaluation since the presentation of its quarterly report on January 31, 2022. This growth is mainly supported by better than expected user growth together with a guide presented by the company to reduce spending of podcasts and better spend management in general.
Spotify has managed to maintain its subscriber growth figures without increasing subscription prices compared to other subscription models such as streaming companies. The growth in users together with a very modest increase in ARPU (Annual Return per User) and a better monetization of advertising will drive a gradual improvement in profitability in the coming quarters.
However, Spotify did not meet the revenue or profit estimates, but that did not seem to matter to investors since they did "comply", it was with the data that mattered, the metrics at the user level. Modest improvement in gross margins and added marketing spend to sustain subscriber growth and monthly active user growth sent shares higher after earnings releases.
Podcasts cost money that shareholders simply don't want to spend
From all-time highs at $360, Spotify is down -66% to the current price of $120 in February 2023. It's always attractive to see a company fall with this force, because if the fundamentals are strong and the price is looking to converge with the book valuation, the company will be correctly listed. It's certainly a platform that should take great care of its audiobook and podcast content, however we're not sure how much money the company should spend on offers for this type of content, as some of the offers are extremely expensive for what they can offer , and that they have been cutting costs on podcasts is good news.
Perhaps the negative bias would change if Spotify reduced the amounts paid for the podcasts of some of the Tier1 Hollywood celebrities who came with too high a price while shareholders have been choking on it. Like other tech companies, Spotify will lay off 6% of its workforce, which will translate into a staff reduction of 600 workers, making margin and profit exceptions better, but not much.
What is really relevant in costs will be preceded by a reduction in the cost of content linked to podcasts with a shift towards marketing and not by the dismissal of a small proportion of the workforce.
Spotify Financial Model 2022-2025
The company's chief financial officer, Paul Vogel, commented in the latest earnings presentation: "Gross margin of 25.3% was 80 basis points above estimates primarily due to lower podcast spend." .
Assuming Spotify CEO Daniel Ek was sincere in his year-end report presentation, we should see more effort from the company to drive spending towards marketing and reduce content acquisition costs. Translating into better user growth metrics and thus improve profits.
Spotify financial model, SeekingAlpha
Additionally, efforts to convert the existing user base to premium subscribers could positively impact margins and revenue contribution per user, so this is positive for the underlying growth and business model profit drivers. Daniel Ek can steer the ship in one of two ways, drive beats in user metrics by spending more on marketing generating revenue beats. Or, take the second approach and get even more aggressive on cost reductions with another 5% layoff of the workforce over the course of the year, and scale spending on audiobooks and podcasts at a slower rate of execution, which which had an immediate bottom line benefit, despite sacrificing top-line growth by reducing content.
In either scenario, the earnings ride is where many growth investors fail to track the share price. In terms of key factors, such as the estimates in the table above, we can argue that the stock's valuation based on this model is adjusted for a 4x average price-to-sales (P/S) ratio. But we also apply a 33X P/E multiple, and a 15x EV/EBITDA multiple in FY '25 estimates that will allow price, based on valuation, to target $161 on Spotify, implying +35%. potential share appreciation.
Even so, the company could increase its earnings valuation to 43.5x of fiscal '25, which is quite high, but given the implicit user base of 776 million monthly active users, and the revenue figure of $20,000. million for fiscal '25, the top-line figure of the estimates keeps the stock at a high valuation. As most internet stocks trade above 4x sales unless there is something structurally wrong with their business model.
Spotify's story remains compelling in 2023
The stock lost some momentum in the past two years with the entry of music streaming competitors. To some extent, the introduction of Apple Music and Apple's rapid scale with the services, as an attempt to diversify beyond hardware, led it to become Spotify's biggest competitor. Apple Music revenue was estimated at $8 billion and 88 million paying subscribers in 2022, according to the Business of Apps report, which compares with 205 million paying subscribers, which Spotify reported in its fourth-quarter report. of 2022
There's also SoundCloud with an estimated 130 million monthly users, which compares to Spotify's 500 million monthly users, but both apps serve the mass music audience. We believe Spotify is on track to reach 1 billion MAUs (monthly active users) by 2030 assuming an average growth rate of 10%-11% in users over the next 7 years. Anticipating an opportunity in the global music market that has a potential subscriber base growing over time.
However, the lack of profitability has not turned out to be what shareholders expected. The profitability comes from the pricing power despite the costs of high-profile celebrity podcasts. Joe Rogan, Prince Henry, Meghan Merkel, and Kim Kardashian are collectively worth millions of dollars. We can at least make the case that Spotify stays one step ahead of the failed era of digital radio in a world where "professional podcasters" fill that space. Although we doubt that Wall Street appreciates the direction the company has taken in the past two years, evident in the share price. The stock may already have bottomed out, and the emphasis on improving costs to keep economies of scale above 1, i.e., spending incrementally less on content deals tied to the podcasting category and spending more in other areas of the business such as customer acquisition. Perhaps a hiring freeze and some additional reductions in the number of workers similar to what has been seen in Meta (META.US) could be necessary to reorient the company towards a combination of sales and profit growth in the coming years. .
Analyzing competitors
Vertical
The CEO of Universal Music recently suggested that the current streaming business model should be revamped as it is unfair to artists. Lucien Grainge suggested that music streaming should better reward artists, regardless of whether they are signed to a major company. This comes after publishers and streaming services recently agreed on royalty fees that extend to 2027. Payments to rights holders are currently calculated by dividing the revenue pool from subscriptions and advertising according to the share of views. totals that accrue to the rights holder. UMG is reportedly working towards a model that will provide fair compensation for creators, regardless of the content format (audio or short-form video). Record labels are the main beneficiary of the current deal, taking a disproportionately large share of the value created. Universal's position is probably driven more by concerns that streaming services are slowly accumulating bargaining power, rather than genuine concern and interest to artists. It also appears to be a response to the growing importance of short videos and the potential bargaining power of platforms like Tiktok, YouTube, and Instagram.
Horizontal
While Spotify has established itself as the dominant music streaming service globally, and likely faces little threat from services like Apple Music (AAPL.US), there is a looming threat from Tiktok. Bytedance appears ready to launch its own music streaming service, Tiktok Music. Spotify has suggested that they are not currently seeing competitive pressure from Resso (TikTok) in these markets. This rumor is supported by job openings and a US trademark application for "Tiktok Music" filed by Bytedance. However, this is not the only strategic move of Tiktok related to music. Tiktok launched a music distribution and marketing platform, Soundon, in 2022. It allows musicians to upload tracks directly to Tiktok and distribute them on other streaming platforms.
Tiktok is also trying to compromise in negotiations with record companies. TikTok has tested limiting users' access to mainstream music licensed by the Australian record label. It is believed that if the experiment shows that the main music does not affect user engagement, it will significantly improve Tiktok's bargaining position. Major labels currently receive a lump sum payment from Tiktok in exchange for access to their artists. They have been trying to broker a deal that would give them access to a share of TikTok's ad revenue.
Users positioning and interest
Search data indicates that interest in Spotify's platform is expanding, which should support user growth in 2023. Spotify continues to add MAUs (monthly active users) at a fairly healthy rate, although subscriber growth continues not tracking overall user growth.
Search interest "Spotify". Source: Google Trends
The subscriber growth clearly demonstrates that Spotify has established itself as the dominant music streaming service globally. Growth has been quite strong in all regions, with Latin America an area of particular strength. MAUs (Monthly Active Users) have a tendency to convert to premium subscribers with a time difference in the 12-18 month range, which could suggest strong subscriber growth in 2023
Streaming service subscribers. Source: Google Trends
Spotify has yet to make any real progress in improving gross profit margins, although this is expected based on guidance published by the company itself. The first quarter of 2023 is expected to be the low point for gross margins in 2023, as the podcasting business is expected to weigh less on margins going forward. While Spotify has suggested that music gross margins are improving, it sounds like this could be an accounting exception to some degree. Marketplace tools and services are used by record labels and this is counted as a cost offset rather than a source of revenue.
Therefore, the market business is helping to improve music gross profit margins, although it is likely to be better viewed as a separate business with its own revenues and costs. This would make the market business seem more attractive at the expense of the music business.
Spotify premium users. Source: Google Trends
Spotify gross profit margins. Source: Google Trends
2022 was a year of significant investment for Spotify, both in terms of products and customer acquisition, which has weighed on both gross margins and operating profit. Like many tech companies, Spotify is now increasing its focus on efficiency and cost controls. The Company has implemented a new organizational structure that optimizes decision making and prioritizes speed and efficiency.
Spotify has also reduced its workforce by 6% to reduce the burden of operating expenses. R&D spending has risen in recent quarters as Spotify has been investing in new product development. Sales and marketing expenses were also high in 2022 as Spotify increased marketing spending to expand its user base. Management continues to take the long view and has stated that if advertising costs are low, they will take advantage of it by increasing ad spend to accelerate user acquisition.
Spotify operating expenses. Source: Google Trends
Technical analysis
Spotify's price structure shows recent wear in the local range (red). However, the current trend of the company's fundamentals could help strengthen the bullish movement towards the next resistance zone (blue).
SpotifyD1. Source: xStation
Should profit taking take precedence over buying, there is a large area of support levels that could contain the price above $100.
Conclusion
Spotify's business model continues to be depreciated by investors due to low gross profit margins. This has led to Spotify being poorly valued, a situation that is unlikely to change until the company starts generating significant operating profits.
Through discounted cash flow analysis, Spotify shares project a value of $170 per share. While Spotify is unlikely to have high profit margins, gross margins are only one aspect of the business. Spotify has limited competition and offers a superior product, which should lead to low sales expenses and redirect capital towards marketing over time.
Darío García, EFA
XTB Spain
