The 2022 stock market slump has been particularly harsh on the technology sector. The market capitalization of Internet-focused, high-growth companies, such as Spotify Technology S.A. (NYSE:SPOT), has declined by more than 60% YTD. Although the company’s growth prospects seem to be more moderate, they are still appealing. However, Spotify is incurring losses and is not anticipated to have a profitable quarter in the near future. In this analysis, Spotify stock and financial performance are looked at, and the valuation attractiveness of the company is also examined in greater detail.
Expanding the Company
Since 2016, the size of the US music streaming market has tripled, and it is expected to be worth over $12B by 2021. Currently, streaming generates more than 80% of all music sales.
Despite fierce competition, Spotify has managed to hold onto its market-leading (33% approx. share) position in music and podcast streaming over the past few years. In market share, Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) lag behind Spotify. Other rivals include platforms like SoundCloud, YouTube, and Tidal. Future predictions predict an increase in the intensity of competitive pressures.
Additionally, since 2016 Spotify has experienced the highest subscriber growth. The company has also successfully diversified its user base geographically, with 26% of users coming from outside of North America, 22% from Latin America, and 31% from Europe (Spotify’s largest market). In the third quarter of 2022, SPOT saw a 20% annual user growth, slightly exceeding predictions.
The number of premium (paying) subscribers is also growing quickly. The most recent quarter saw Spotify outpace all geographic segments with 13% YoY growth. The developing world, particularly Asia, continues to offer the most significant potential for future growth. The company depends on recurring revenue streams from paying subscribers to increase profitability, deliver high margins, and generate shareholder returns. The company anticipates 7M new premium subscribers and 23M new users for Q4 2022.
Financial Results
Ad revenue from non-paying subscribers and subscription revenue from premium users are the foundation of Spotify’s business model. Over the previous few years, revenue increased at a 20.6% CAGR, and growth is anticipated to slow down. Since the company’s gross margins are only 25%, they remain its primary concern source. Spotify continues to post operating losses while maintaining disproportionately high SG&A and R&D costs in relation to revenue. Given that the company generates a sizable portion of its revenue outside of the United States, the impact of foreign exchange rates has also been significant over the past year.
A significant cash and equivalents balance of $3.6 billion (roughly 25% of market cap) and a current ratio of 1.3x on Spotify’s balance sheet assure no liquidity issues. The company’s $1.2B long-term debt balance is also relatively small. When examining Spotify’s financials, one issue that stands out is the rising share count. More specifically, the company has diluted current stockholders by adding more than 40 million shares to its share count since 2016 (193 million shares were outstanding as of the most recent filing).
The Present Valuation Situation
Spotify’s very low operating income and lack of net profits make it increasingly difficult to value the company on multiple bases. The company also generates a negligibly small amount of free cash flow (FCF), which results in highly high P/FCF and EV/FCF ratios, which are inherently unreliable valuation indicators. Compared to five-year average multiples, Spotify has become reasonably priced on a more reliable P/S ratio basis. When compared to a year ago, Spotify stock price was valued at about 6x P/S, and it now trades at a P/S multiple of 1.3. Of course, this valuation contraction has been brought on by the stock’s sharp decline in 2022. As the stock markets struggle to recover, it is unclear whether multiples across the technology sector are destined to remain lower.
It’s critical to keep an eye on the future despite Spotify’s significant valuation multiple declines. The Price/Sales ratio was chosen to conduct a forward valuation analysis due to the company’s growth prospects and current financial situation.
To embrace the uncertainty surrounding the company, I will project potential upside for the stock through the end of 2024 by using scenario analysis and focusing on the prices/sales ratio. In the scenarios, there were multiple expansion and contraction elements. With a $15.34B market cap, Spotify currently trades at a 1.3x forward Price/Sales multiple.
Bullish Case: The company grows revenue at a rate of 15-20% annually, exceeding growth projections. In the best-case scenario, the P/S ratio increases to 2.25x, and by the end of 2024, the company will be trading at a $40–47B market cap, representing a potential gain of 170–200%. If the P/S multiple remains at a more moderate 1.75x, Spotify will continue to have a market cap of $32-37B, which still denotes an overall expected 125% upside.
Base Case: Spotify grows its revenue at a rate of 10-15% annually and meets growth expectations. Spotify’s upside is still appealing, with a market valuation that will fall between 20 and 32 billion, especially if the business slightly increases its current valuation multiples. While a lower forward multiple of 1.25x at the end of the period offers a respectable, minimum expected 35% potential upside, the maximum potential upside, assuming a 1.75x multiple, sits at 105%.
Bearish Case: Although revenue growth is only 5%–10% annually, the company does not meet growth expectations. In this instance, there is still some room for growth in 2023 at a 1.75x or even a 1.25x P/S multiple, whereas downside potential begins to loom at lower multiples. It’s important to note that further downside for Spotify appears much worse if P/S multiples deteriorate.
To sum up, if Spotify meets growth projections, investors have a significant potential upside, assuming that the P/S ratio stays at current levels or even rises. Although the company’s current revenue projections seem reasonable and should be manageable to achieve, to win over investors, the company will need to demonstrate a more straightforward path to profitability.
Several Significant Risk Factors
Spotify faces a significant risk from sluggish subscriber growth. Competition and the struggle for market share both grow more intense. Stalled subscriber growth directly translates into revenue stagnation, making the road to long-term sustainability more challenging. It is simple to imagine a scenario where Spotify fails to fend off its rivals, especially when considering the platforms and businesses it competes with (Apple, Amazon, YouTube, and others).
Since consumer spending on apps like Spotify is mainly discretionary and cyclical, Spotify’s subscriber and revenue growth are in jeopardy, as many analysts anticipate a recession in 2023.
Spotify’s operating risk is also high because the company keeps raising costs while falling short of profitability. Valid sustainability concerns also surface over the long term.
Spotify Stock: Final Reflections
When everything is considered, the significant stock price decline for Spotify in 2022 has created a unique opportunity for prospective investors. Nevertheless, given the company’s struggles with profitability and other risk factors, I believe Spotify stock to be a high-risk investment. I would therefore assign the stock a hold rating.
Featured Image: Unsplash @ Thibault Penin
