Spotify: Investor Fatigue to Exuberance Inside of Two Years
Is the stock still cheap?
From a long-term investor’s perspective, Spotify’s third-quarter results were gratifying. While the company’s robust trajectory for Premium sub and MAU growth has been visible for a long time, investors had been unaccustomed to seeing material improvements in Spotify’s financial performance. For example, investor fatigue relating to the lack of gross margin expansion may have reached a peak when I wrote this in May of 2023 (Spotify: A Compounding Effect).
Things have been changing though and the stock market has clearly taken notice. This quarter, gross margin was a standout at 31.1%, up 473 bps year-over-year. That was a 54.5% incremental gross margin. R&D, Sales and Marketing, and G&A each improved by 242 bps, 225, bps, and 103 bps year-over-year, respectively. Operating margin was 11.4%, an all-time high, up 1043 bps year-over-year. Daniel Ek has been delivering on his promise to transform Spotify from just a great product to a great business as well.
The stock has come a long way in a short period of time. After tanking in 2022 along with so many tech stocks, SPOT has climbed almost 6-fold since.
As a long-time Spotify shareholder, I am pleased but I also find it bittersweet to suddenly lack confidence that the stock is still undervalued. My partnership has been a shareholder since 2018. At some point, investments start to feel like “one of the family businesses.” From my perspective, the ideal outcome is for one of these business to continue generating robust performance, which causes the stock to do well over time but never quite as well as I think is justified or is needed to catch up to a more reasonably fair valuation. In those happy situations, the stock remains perpetually undervalued and I’m thrilled to hold those investments indefinitely. I’ve been doing that for six years.
But Spotify’s impressive financial improvements of late has caused investors to get excited. Excited enough that prospective long-term returns from $471 per share could be average or below average. I don’t like having to entertain the idea of selling off the last of my shares.
Scenario Analysis and Valuation
Here is the link to the PDF showing my scenario analysis and DCF work for Spotify. The Priced In scenario is a reverse DCF. The other five scenarios reflect plausible outcomes with varying degrees of optimism/pessimism.
Here is my valuation summary exhibit, first in Euros, Spotify’s reporting currency:
And here it is in U.S. dollars, in which the stock trades:
As you can see, Spotify’s current stock price sits between my Base case and my Bull case valuations. This is a drastic change from my last Spotify update from December 2023 (Spotify: The New Modus Operandi) when the stock was trading at a nice discount to even the low end of my valuation range, as you can see here:
To me, investment decision-making is much easier when a particular stock is trading well below my entire valuation range. Those instances alleviate the need to bank on a very specific long-term forecast. That is a much more comfortable position, in my view. I can continue to be an owner or buy more shares because I have a view that what’s priced in seems far too pessimistic, which is much easier to have confidence in than one particular outcome. That is how I viewed Spotify shares for most of the last six years.
But at $471 per share, which is a $98b equity valuation, it’s no longer obvious to me that that’s the wrong valuation. I don’t have a crystal ball. It could be discounting a perfectly likely outcome. Or maybe it’s still too cheap because I’m drastically underestimating the business.
The thing about the future is that it’s hard to predict. Do I know exactly how much cash flow Spotify will be generating for its owners in 20 years? No. So when the stock trades well into my updated valuation range, things get pretty murky for me. My confidence that the stock is necessarily undervalued declines. It might still be undervalued if I’m still materially underestimating things, but these updated scenarios I’m posting here reflect my best estimates today.
Assuming my Base case were to play out exactly from here (it won’t), then I’d say long-term owners of the business might be modestly disappointed with the long-term returns from $471 per share. But that’s the whole game—what’s really going to happen? At one extreme, we have Daniel Ek at the 2022 Investor Day calling for €100 billion of revenue within a decade. Certainly, my estimates are not in that ballpark. My decade-from-then revenue estimates for 2032 range from €29.1 billion to €36.8 billion! Could Daniel be closer to right than I am? Anything is possible, but I can’t imagine any close Spotify observer thinking his €100 billion number by 2032 is anything but a dream.
What’s Priced In at $471?
My Priced In scenario, which backs into that valuation, calls for 522 million Premium subs by 2043—up from about 260 million at the end of this year. Almost 1.3 billion total MAUs—up from 665 million at the end of this year. Revenue reaching €80 billion, which is a 9.0% 20-year CAGR from this year. Gross margins reaching 36%. Operating margin doubling from here to reach 22.5%. Most Spotify observers would undoubtedly call this a bullish outcome.
So am I going to pound the table that that future is far too conservative? That Spotify is likely to crush that scenario? I can’t with a straight face with my current understanding of the business. But I’d love to be convinced my scenarios are wildly off.
Do you think I’m drastically underestimating Spotify’s long-term pricing power? The higher priced “Superfan” tiers? Are Premium subs going to maintain a faster rate of growth for much longer than I expect? What gives you the confidence to say that? Is the Ad-Supported business going to take off and become 20%-40% of total revenue like Daniel once said and meaningfully improve its monetization? What new products or features am I failing to appreciate?
I should say I do assume Spotify’s revenue growth decelerates from 2024’s pace. I do not have the confidence to assume the company can achieve 20% revenue growth for a while longer. I just don’t know. And I have overestimated growth at other companies in the past and it is not something I’d like to repeat.
If you have thoughts on any of these long-term or big picture questions pertaining to Spotify’s future, please send me your thoughts at impliedexpectations@gmail.com.
Disclosure: Long SPOT
Disclaimer: This post is for entertainment purposes only and is not a recommendation to buy or sell any security. Everything I write could be completely wrong and the stock I’m writing about could go to $0. Rely entirely on your own research and investment judgement.