With hundreds of millions of users around the globe, Spotify (SPOT -2.36%) is one of the most well-known stocks out there. And while the company continues to grow its user base and revenue, the stock has disappointed investors over the past year. Shares are down around 20% in the past 12 months while the S&P 500 is up about 30%. This might indicate to investors that Spotify is struggling as a company, but that couldn't be further from the truth. If anything, this is a great buying opportunity for those with a long time horizon.
Here are four reasons why Spotify belongs in your portfolio.
Spotify started out in 2006 as a music-streaming service. This is still the majority of its business today. In the second quarter, 88% of the company's revenue came from premium music subscriptions. For this service, users pay a flat monthly bill to access tens of millions of songs. The good news is that the music-streaming industry as a whole is poised to continue growing over the next decade, with projections for a 10% compound annual growth rate (CAGR) from now until 2027. If Spotify can maintain or expand its market share, this industry tailwind can help boost its music-streaming revenue.
In February, Spotify announced it will move into over 80 new markets in 2021, representing over 1 billion potential new customers around the globe. If music streaming gains traction in these new markets, that could help Spotify gain market share globally in the next decade.
Outside of music, Spotify's second-largest audio category, podcasts, is growing even faster than its core streaming business. Some estimates have the industry growing at a 30% rate or higher from now until 2028, which would make it one of the largest entertainment categories in the world. Spotify is going after this market aggressively, investing hundreds of millions each year into the format. One of its initiatives, dynamic podcast advertising, is what investors should be most excited about.
Spotify has made tons of podcast investments over the past few years. This includes starting its own podcast studio (Spotify Studios); buying up popular studios like the Ringer, Gimlet, and Parcast; signing exclusive contracts with the most popular shows in the world like The Joe Rogan Experience and Call Her Daddy; and buying out two podcast distribution companies (Megaphone and Anchor). All these investments were made for one reason: dynamic podcast advertising.
The Spotify Audience Network, which utilizes dynamic ad insertions (like YouTube ads), lets advertisers target specific listeners across podcasts on Spotify, Anchor, and Megaphone. This has only been in the U.S. since its launch in the spring, but is slowly being rolled out around the globe. This advertising network also takes the advertising burden off of the podcast hosts while paying them more per listen (targeted advertisements get higher payout rates).
While they have required a lot of up-front costs, these investments have started to pay off. Last quarter, inorganic podcast revenue (which includes acquisitions) was up 627% year over year, and organic podcast revenue was up 200% year over year. While still early days, if Spotify can continue these impressive growth rates, podcast revenue will become a large part of this business rather quickly.
A small but growing part of Spotify's business is its music promotional products, which it calls the two-sided marketplace. This is where artists and music labels can pay, through reduced royalty rates, to have albums and songs promoted on users' Spotify apps. This will help Spotify grow its notoriously low gross margin, which is only projected to be in the neighborhood of 24.1% to 26.1% in Q4 of this year.
While some people may think these promotional products are predatory by forcing artists to "pay for play," it is no different than a business promoting itself on Facebook or Alphabet's Google. Millions of people around the globe use Spotify regularly, and if the company can help grow an artist's audience through pop-up notifications and dynamic playlist insertions, it will be beneficial to both parties over the long run.
In its Q2 earnings release, Spotify shared that artists who use Discovery Mode (one of its promotional tools) had 40% more listeners on average than before using the tool. On top of that, 44% of the listeners had never listened to the artist before. Because most artists make money outside of music streaming by doing concerts and selling merchandise, growing a fanbase is vital for artists to make a living. If Spotify can help them do this, that makes its service very valuable in the eyes of artists.
The last reason investors should like Spotify is the stock's reasonable valuation. It has a market cap of $42 billion, and over the last 12 months, the company has brought in $10.22 billion in revenue. Since it is investing heavily for growth and has low gross margin, Spotify is not yet profitable. However, with such a big growth opportunity in front of it, a $42 billion market cap seems cheap, especially if you think the company can expand its gross margin over time.
Spotify isn't a perfect company. But with big industry tailwinds, the growth of podcast advertising, Discovery Mode, and its reasonable valuation, there are plenty of reasons to own Spotify stock right now.