There's no sugarcoating it: 2022 has been rough for Spotify (SPOT -3.31%) shareholders. The audio platform's stock is down 39% year to date (YTD). At one point, it was down almost 50% in the first few months of this year. Investors have been skittish because of the controversy surrounding the Joe Rogan Experience podcast, revenue losses from pulling out of Russia, and perceived weak guidance for the first quarter of 2022.
If you're a long-term investor, whenever drops like this happen, it can be helpful to extend your time horizon and think about what a business will look like three, five, or 10 years from now. So where will Spotify be in five years? Let's find out.
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Increasing user penetration
At the end of 2021, Spotify had 406 million total monthly active users (MAUs), its preferred metric to track engagement with its service. This metric was up 18% year over year and almost 100% from three years ago, when Spotify had 207 million MAUs. Premium subscribers, which are the MAUs that pay for ad-free and downloadable music, hit 180 million in Q4 2021, growing slightly slower than overall MAUs at 16% year over year. Like total MAUs, premium subscribers have almost doubled from three years ago, when Spotify had 96 million people paying to use its service.
With a 6.5 billion global smartphone population (5 billion excluding China, where Spotify doesn't operate), I think Spotify has a chance to double both MAUs and premium subscribers within five years. Why? Because the vast majority of people around the world enjoy listening to music and audio content All of these people will be regularly using a digital audio platform like Spotify within the next decade. If Spotify can maintain its estimated 31% market share around the globe -- which is higher if you exclude China -- there's plenty of room for the service to get to 800 million MAUs and 360 million premium subscribers within the next five years.
Advertising revenue plus margin expansion
User growth is great, but what really matters for long-term stock performance is growth in revenue and profits. However, given that Spotify runs a simple subscription model for its premium business, growth in subscribers should correlate strongly with revenue growth.
In the fourth quarter of 2021, Spotify did $2.5 billion in premium revenue or $10 billion annualized for a full year. If we assume average revenue per user (ARPU) is stable over the next five years and Spotify can double its subscriber count, premium revenue will double to $20 billion as well.
On top of this revenue growth, Spotify will likely continue to expand its premium gross margin, which it has done over the past few years. In Q4 2021, the premium gross margin was 29.2% compared to around 27% three years ago. This has happened because of better payout deals with record labels and artists, along with the growth of Spotify's high-margin promotional marketplace, where artists can promote their work on Spotify's popular playlists and on the home screen. Five years from now, it is likely that Spotify's premium gross margin will continue to tick higher and fall between 30% and 35%.
The other part of Spotify's business is advertising. This used to be an afterthought for the company, mainly a division that would sustain its ad-supported MAUs while trying to convert them to premium users. But now, with Spotify's huge investments in podcasts and spoken-word content, it is trying to make advertising revenue the second big pillar of its business. In Q4 2021, advertising revenue was $434 million, up 40% year over year, and now makes up around 15% of Spotify's consolidated revenue.
What's most exciting about Spotify's advertising business is the Spotify Audience Network (SPAN), a dynamic advertising marketplace for audio content (both music and podcasts) that was launched around a year ago. With the rapid growth of podcasts and durable demand for music listening around the world, I think Spotify's advertising business can grow at 30%-plus a year or higher for the next five years. If this happens, Spotify's annual advertising revenue will hit around $5 billion within five years.
Where could Spotify's stock be in five years?
As of this writing, Spotify stock trades at a market cap of $28 billion. If combined advertising and premium revenues hit $25 billion five years from now and we assume the business will have an operating margin of 10% (we shouldn't assume much higher because of the low gross margins), Spotify will be generating $2.5 billion in annual operating profit.
Taking the market cap and dividing it by operating profit, we get a forward price-to-operating-profit (P/OP) of 11.2. This is well below the market average. What this indicates to me is that, unless the broad market goes into a deep downturn, Spotify's stock will be much higher five years from now. For long-term investors, this is what you should focus on when volatility starts to rear its ugly head.
