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Down 40%, Is Now the Time to Buy Spotify Stock?

By Brett Schafer - May 19, 2021 at 8:15AM

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The audio streamer's stock is trading at a discount relative to its recent valuation.

Over the recent weeks and months, a lot of high-growth and historically unprofitable companies have seen their stock prices take quite the hit. This is especially true for any stock owned by Ark Invest, the popular investment management company founded by Cathie Wood. Spotify Technology (SPOT -0.92%) is no exception to this trend. The Swedish audio streamer's shares are down 40% from all-time highs, even though the underlying business is still humming along just fine. Is now the time to buy Spotify, with shares trading at a discount? Let's take a look.

A woman listening to music on her couch.

Image source: Getty Images.

Financials continue to improve

Since going public in 2018 through a direct listing, Spotify has consistently put up double-digit revenue growth. Last quarter, it grew sales 16% year over year to $2.5 billion, which is impressive considering management said the business saw a material uptick in the year-ago quarter due to the outbreak of COVID-19. Revenue is up 2.38 times since the first quarter of 2017, which was four years ago, demonstrating the power of sustained double-digit growth. 

Spotify is still in growth mode, so it hasn't generated any consistent profits yet. It also has a low gross margin (25.5% last quarter) due to the high payouts it is making to the music labels. However, gross margin has looked extremely weak lately due to Spotify's large podcast investments, bringing advertising gross margin close to breakeven (it was 4% last quarter). Once these podcast initiatives start generating meaningful gross profit dollars, expect Spotify's gross margin to expand closer to 30% in the near term and possibly higher over the long term if it can also renegotiate a better payout deal to the record labels.

Growth opportunities abound

Speaking of podcasts, the nascent and fast-growing entertainment medium should be a big growth driver for Spotify over the next few years. Its podcast strategy has a few different pillars. One is to get people to listen to podcasts on the Spotify app. As of last quarter, around 25% of Spotify's monthly active users (MAUs) listened to podcasts on the platform. It is going to try and grow that number by getting as many shows as it can on the platform and also signing exclusive deals with popular shows like the Joe Rogan Experience and Armchair Expert. After convincing consumers to listen to podcasts on Spotify, it can monetize that audience by dynamically inserting advertisements through its new audio advertising marketplace. 

Outside of podcasts, Spotify is also growing its discovery and artist services for the music side of the business. These tools, which are essentially ways to advertise new and existing music to users on Spotify, can help the company win back some of the gross profit dollars lost to the labels. It also keeps the musicians ingrained within the Spotify ecosystem, allowing the company to play a role similar to the radio stations before the internet went mainstream. Lastly, Spotify just bought live audio platform Locker Room for around $50 million. It is unclear what Spotify is going to do with Locker Room (the acquisition was barely over a month ago) or if the investment will pay off, but it shows the company's ambitions to change from just a music streaming service to a global audio platform.

These growth initiatives will take years to bear fruit at any meaningful size relative to Spotify's core business. But if they are successful, they will bring high-margin revenue dollars to Spotify while also increasing its value proposition both to consumers and creators alike.

No new competition

Spotify competes with Apple (AAPL -0.32%), Alphabet's (GOOG -0.39%) (GOOGL -0.39%) Google, Amazon (AMZN -1.17%), and even Tidal to a smaller degree. At first, this can look concerning since the three big tech giants all have more money to invest in audio streaming than Spotify. However, Spotify has been competing with all of them for several years now and is still the market leader even though Apple and Google have platform advantages with iOS and Android and Amazon can bundle Amazon Music with its other media services. No new entrants to the audio streaming race have emerged over the last few years, so there's no reason to believe Spotify will not keep or extend its lead as it tries to bring its music and audio service across the globe.

As of the latest reports, Apple Music has around 72 million paying subscribers, Amazon Music has 55 million users (it is unclear what percentage are paying compared with free users), and YouTube has around 30 million total subscribers to its music and premium video products. Even if you assume the Amazon and YouTube numbers are mostly from paying music subscribers, Spotify's big tech competitors don't have nearly as many paying subscribers as Spotify, which sat at 158 million as of the end of last quarter. Spotify also has a total of 356 million MAUs if you include its free tier, showing that it is the clear leader in audio streaming. Investors have a right to worry about the unit economics of Spotify's business. But right now, there's no evidence that competition has or is presenting a threat to the company.

But what about the valuation?

Spotify currently trades at a market cap of $42.5 billion, giving it a price-to-sales ratio (P/S) of 4.4. Management has guided for Spotify's long-term profit margins to hit 10% or slightly higher once it matures and expands its gross margin to 35% compared to today's 25% level. Taking Spotify's current P/S and applying a 10% profit margin would give the stock a price-to-earnings ratio (P/E) of 44.

This is not cheap, and does assume the company will be able to expand its gross margin (which is not a guarantee), but if you believe in Spotify's growth trajectory with its core music offering and the potential of all the ancillary investments it is making, a market cap of $42.5 billion could look cheap three to five years down the line. If you've wanted to invest in Spotify but stayed away due to valuation concerns, now looks like the time to buy with shares down 40% from all-time highs.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Brett Schafer owns shares of Spotify Technology. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and Spotify Technology. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon, long March 2023 $120 calls on Apple, short January 2022 $1,940 calls on Amazon, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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