Spotify: Growing In Size Needs To Tune Up To Growing In Value (NYSE:SPOT)

Investment Thesis

Strengths and Weaknesses

Founded in 2006 in Luxembourg and maintaining a principal operating office in Stockholm, Sweden, Spotify (NYSE:SPOT) is a digital platform for audio streaming services including music, radio, podcasts, and audiobooks with true global reach. As it originated from Luxembourg, the company not only dominates the European market but also achieves similar status in the US and Latin America. In total, it currently provides services in 184 countries and territories worldwide. It has an uncomplicated business model: growing subscription and advertising revenue while maintaining a large free user base.

Spotify’s production process relies on building a two-sided market for content creators such as musicians, podcasters, etc., and for the content consumers, the listeners. It either home-grows or acquires the content by paying for the licensing. The home-growing here really means it provides the tools and analytics for podcasters to create their content, while Spotify streams them free of the additional cost paid to the creators. Both the content creators and Spotify earn shares of income from monetizing the content from the listeners or ads. Although it reports earnings as a whole segment, the company does provide data on its two types of services, Premium Service (“PS”) and Ad-Supported Service (“AS”).

A quick glance over Spotify’s annual report for 2023 shows the company has fulfilled or done better than its guidance for the year. The company generated more monthly active users and premium subscribers than given in guidance, while its financial results are in line with or above.

By region, Spotify’s users’ growth is healthy in all major regions worldwide, with the rest of the world excluding North America, Europe, and LATAM growing slightly faster than the total.

The company measures its business growth with several essential metrics, such as monthly active users (“MAUs”), Premiums Subscribers, and Ad-Supported MAUs. Over the past six years, they have all grown by almost 3x. When measured with Premium average revenue per user (“ARPU”), the trend is declining from $4.81 to $4.39. Note that Spotify actually has been increasing its monthly subscription fee. The fees were $9.99/m for the individual plan and $4.99 for the student plan in 2018, and now it is $10.99/m and $5.99, respectively. It also has a Premium Duo plan that costs $14.99 per month, the Premium Family plan costs $16.99 per month. It usually rolls out a promotion for 2 to 3 months free upfront for anyone who subscribes to the service and then starts to charge the appropriate monthly fee. Such a program goes on a few times a year. For Premium ARPU to be about half of the individual plan, our guess is either the majority of subscribers are students or there are about half of them are on the free promotion, and the conversion rate to becoming a paid subscriber is much less than 100% or a combination of both. It typically does not release the composition of subscribers by type.

For the whole year of 2023, PS provided 87.3% of revenue while AS provided 12.7%. PS’s net margin is not only consistently in the high twenties, but also improved compared to in 2018. On the contrary, AS has seen its net margin declining dramatically over the past six years, and it hasn’t been stable either. Although both types of services have been generating more revenue annually, where PS has doubled and AS has almost tripled since 2018. During the Q4 earnings call, AS’s relatively small share in revenue was discussed. AS’s share was about 10.3% in 2018 and Spotify has set up a goal of growing AS to 20%+. The management said it was satisfied with the growth so far and the share of AS could have been overshadowed by the rapid growth of PS. We think there is more than just the share of AS needs growth but also the margin.

There is a divergence between its free cash flow margin and its EBITDA margin. Its revenue is still growing fast, but its EBITDA has been stagnant. In fact, its net margin, operating margin and EBITDA margin are all headed toward the negative, a territory that it has tried hard to escape since 2022. The strong growth of free cash flow came from the equally strong growth of operating cash flow. Its net income was a loss of $532 million in ’23 after losing $430 million in ’23. With that as the base, the key supply to the operating cash flow has been other items, such as share-based compensation expense, depreciation, finance cost and increase in trade and other liabilities. In the end, the Op. cash flow came out as positive $680 million ending ’23.

On the other hand, its operating cash flow has been growing to the highest but CapEx has shrunk to a minuscule level. The results are an exceptionally strong free cash flow. With its embrace of AI in targeting listeners based on their favorites in generating genres, song lists and recommendations, plus the heavy data storage requirement for audio pieces, it is hard to understand why its CapEx would drop to almost none, and we suspect its sustainability to stay at that level for long. In short, we see the high free cash flow more as a reflection of the business operating costs than positive income and are not certain it can sustain this high.

Financial Overview & Valuation

Spotify has increasing negative return on invested capital since its IPO. Its ROIC was negative 20.46% in 2022, and again double-digit in ’23. Yet, its stock price has essentially doubled from its bottom in ’22. The literal meaning of this metric being negative is as it grows, the company destroys value. Although it sounds a bit harsh, Spotify is an 18-year-old company with revenue in the billions. It needs to figure out a way to actually make profits for its investors instead of postponing it into the future. Until it does so, we believe it is overvalued at this time.

Conclusion

A dive into Spotify’s growth metrics and its margins reveals that the company’s revenue growth has not been as strong as it seems, and its free cash flow reflects even less of the income it lost. Although as one of the truly multinational audio streaming platforms, it carries weight in the music industry and in revolutionizing how artists can derive income from their content, we feel the experimental period has been long enough and the losses need to be lessened if not halted in order for its stock to measure up to its current lofty valuation. We recommend a sell at the current price.