Spotify: Top Recommendation For Potentially Explosive Upside

I first turned into a major Spotify (NYSE:SPOT) bull when shares were trading <$100 and promoted a Buy/ or Strong Buy recommendation ever since (For context, since my last bullish update in October 2023, shares are up close to 58%).

Also heading into 2024, and looking beyond, I am super bullish on Spotify stock. In fact, SPOT is my favorite long idea for potentially explosive upside: In my opinion, Spotify is poised for significant growth and increased profitability in 2024, building on strong product development and a focus on monetization as well as efficiency improvement. My fundamental projections suggest a 15-20% YoY increase in MAU, with sales growth mirroring this expansion. Profitability aims include a 50 basis point quarterly increase in gross margin, targeting a year-end gross profit margin of around 27%, bringing estimated annual operating profits to $550-600 million and free cash flow to $1.5-2.0 billion, likely sparking a possible buyback program as early as Q2 2024. On a more structural note, the company’s potential for user base expansion is considerable, with opportunities in monetization and diversification into podcasts, audiobooks, and educational streaming. Spotify’s long-term market opportunity could reach $170 billion by 2030, with $51 billion in sales for Spotify on a 30% market share assumption (Source: HSBC, research note dated 27th March: Spotify: Initiate at buy: Hitting the right notes). Considering updated valuation metrics, most notably a lower risk requirement for the equity, as well as an accelerated EPS growth through 2028 on the backdrop of a solid growth outlook, I update my valuation framework for Spotify; and I now calculate a fair implied target price of $368/share.

For context, SPOT shares have strongly outperformed the broader bull-market in U.S. shares YTD: Since the start of the year, Spotify stock is up about 40%, compared to a gain of 10% for the S&P 500 (SP500).

FY 2023 Results Point To Potentially Explosive Growth With Attractive Unit Economics

Spotify delivered an exceptionally strong Q4 and FY 2023, beating analyst consensus estimates on both topline and earnings: During the period from September through end of December, the world’s most prominent music streaming platform generated $3.67 billion in revenues, which represents a 16% YoY growth rate compared to the same period one year earlier. Dissecting the topline by revenue driver, I point out that 86% was attributable to Premium subscription (up 37% YoY), while ad-based sales accounted for slightly less than 14% (up 12% YoY).

On profitability, it is noteworthy to point out that Spotify’s gross profit in Q4 grew by 22% YoY, to $980 million, outpacing topline expansion by a strong 600 basis points. Meanwhile, operating loss narrowed from 231 million in Q4 2022, to only $75 million in Q4 2023. As the main driver of this profit inflection, management cited operating jaws and efficiency programs that help the company do deliver more output with less employees. In that context, the reduced headcount in 2023 vs. 2022 certainly helped reduce the cost basis, with management having announced 3 rounds of layoffs through 2023, cutting the number of employees by 17%. On that note, most of the efficiency benefit should be fully materialized only in 2024, and be sustainable on a long term perspective. Spotify’s free cash flow surged from negative $73 million in Q4 2022, to positive $396 million in Q4 2023.

In Q4, Spotify’s total user base grew at a solid 23% YoY growth and 5% QoQ rate, bringing the total user count to 602 million. Premium subscribers jumped from 205 million in Q4 2022, to 236 million in Q4 2023 (15% YoY).

For the full year 2023, Spotify’s topline came in at $14.6 billion (up 15% YoY compared to $12.6 billion in 2022), while free operating cash flow jumped to $751 million (up 1,500% YoY compared to $49 million in 2022). Lastly, I point out that Spotify closed the year with a very comfortable net cash position of $2.4 billion, up from $1.7 billion recorded in 2022.

In 2024, Expect More Growth, Higher Free Cash Flow …

Heading into 2024, Spotify is set for another strong year of growth and increasing profitability, as CEO Daniel Ek commented in the call with analysts:

So looking into 2024, you should expect a continuation of what you saw in 2023, strong product development, which leads to strong growth, but with an increased focus on monetization and efficiency, which in turn drives profitability

In financial terms, this would likely suggest that Spotify’s MAU base expansion should run at a 15-20% YoY rate, with likely a similar growth impact on sales. Relating to profitability, Spotify will likely aim for a 50 basis point uplift in gross margin per quarter, bringing gross profit margin at year end 2024 to ~27%, according to my estimates which are closely in line with consensus as collected by Refinitiv. Further, extrapolating that Spotify will likely run at a 0/+10% operating expense base compared to FY 2023, I estimate that FY 2024 annual profits could likely fall in the range of $550-600 million, while I model annual free cash flow at $1.5-2.0 billion.

While we no longer give full year guidance, we do expect healthy full year 2024 user growth that should be close to the average of the last few years and we expect strong subscriber growth as well. Gross Margin and Operating Margin are both expected to improve throughout the year to deliver meaningful full year expansion, with podcasting expected to deliver positive Gross Profit for the year. We also expect our Free Cash Flow generation to meaningfully exceed what we generated in 2023.

And Potentially Also Buybacks

With Spotify’s free cash flow expected comfortably above $1 billion in 2024, paired with a $2.4 billion net cash position, I argue the announcement of a buyback program as early as Q2 2024 could be likely. Investors should consider that Spotify needs very little cash for growth, as evidenced by the company’s enormously attractive incremental free cash flow on incremental CAPEX metric. For context, Spotify’s CAPEX/Sales ratio is 0.0005, while the company’s YoY 2024 vs 2023 operating expense investments of $50 million generated a gross profit uplift of $800 million.

Spotify Still Has Lots Of Growth Ahead

On a structural perspective, investor should note that there is still lots of penetration upside for Spotify. In fact, I argue that the demand for music is universal. And with Spotify clearly leading the streaming commercialization of this universal product, the company may see a user count similar to other global platforms such as Instagram/ Facebook, or YouTube, suggesting a MAU potential that could top 3 billion, in the most optimistic scenario.

In addition to the user base growth potential, I also see an enormous opportunity in monetization: In fact, the majority of SPOT’s earnings, around 85%, are generated from its premium subscription offerings, while premium subscribers account for less than 40% of the company’s total user base. The rest of sales, about 15%, comes from advertising income via its free, limited-access streaming platform.

Lastly, Spotify’s growth is supported by opportunities emerging from ventures into podcasting, audiobooks, educational streaming, and the Two-Sided Marketplace. On that note, I highlight work by HSBC, which estimated that Spotify’s 2030 market opportunity could top $170 billion, with $51 billion of sales for Spotify on a 30% market share assumption (Source: HSBC, research note dated 27th March: Spotify: Initiate at buy: Hitting the right notes).

Update Valuation: Raise Target Price to $368/ share

Given the accelerated growth of Spotify and the company’s profits turning around sooner and more robustly than initially anticipated, I’m revising my projections for Spotify. For the year 2030, I now predict that Spotify will reach a user base of 1.6 billion, which would reflect a compound annual growth rate of approximately 15% throughout the forecast period—a rate slightly below the historical trend. On monetization, I believe a $45-45 ARPU is reasonable, which would approximately be equal to the weighted ARPU that Netflix is seeing in its global subscriber base, as of 2024 (I argue Netflix in 2024 is far ahead of the monetization vs. Spotify, as evidenced by the company’s price increases, crackdowns on password sharing and sophistication in subscription tier. In my base case thesis, Spotify’s monetization would catch up to Netflix’ over the next 7 years). Building on similar operating economics seen in Netflix, I’m projecting a 12% net profit margin. Moreover, while I maintain a terminal growth rate assumption at 3%, which is approximately 75-100 basis points ahead of nominal GDP growth, lower my cost of equity requirement by as much as 200 basis points, mostly as a reflection of a more accommodating interest rate environment on macro level, but also as a reflection of a maturing, and thus less risky, commercial outlook for Spotify specifically. Based on these revised assumptions, I now calculate that Spotify will generate a $7.7 billion annuity by 2030, which has a present value worth of $128 billion. When this figure is discounted back to early 2024 at a 9% rate and combined with $2.4 billion in net cash, the calculation yields an equity value of $72.4 billion, or $368 per share.

Below also the updated sensitivity table (columns = MAU; rows = ARPU)

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Risks

Relating to risk, I would like to point out what I have previously written — in my view, no major risk event has been notable since (September 2023):

Competition vs big tech companies is the main risk I see for Spotify: Notably, Apple (AAPL), Amazon (AMZN) and Google (GOOG) are competing for a share in the music streaming industries – and these players are not “nice” competitors to have. Specifically, and in addition to the competition for users, competition from pocket-rich players such as Apple and Google has the potential to drive increased content acquisition costs, as streaming vendors strive to secure exclusive music rights to remain competitive. Additionally, Spotify may face challenges in diversifying its revenue streams beyond subscriptions, as compared to Apple and YouTube, which have other profitable businesses supporting their music and video offerings. While Spotify looks like the winner in music streaming currently (for me), investors should watch competitive dynamics “like a hawk”.

Investor Takeaway

Heading into 2024, my outlook on Spotify is extremely bullish, marking it as my top recommendation for potentially explosive share price upside: In my view, Spotify’s positive growth trajectory is firmly anchored in robust product development, enhanced monetization, and improved efficiency. On a more structural note, I highlight the potential for user growth and revenue diversification that could imply $51 billion of sales by 2030. Considering updated valuation metrics for Spotify, I now calculate a fair implied target price of $368/share.