The past year has been tough for high-growth tech companies as investors adjusted to the changing macro-economic environment, including higher interest rates. Spotify Technology (SPOT -0.79%), like many of the growth stocks on the market, experienced a huge decline in its share price -- around 66% from its 52-week high set in October 2021.
The lower share price has attracted the attention of potential bargain buyers (like myself). After spending some time digging into the company, here are two things that I learned about Spotify that might help investors better understand the stock and its prospects for future growth.
1. Spotify's business model involves a two-sided marketplace
Founded in 2006, Swedish-based Spotify created a platform for users to find and listen to music (and eventually podcasts and audiobooks) on an ad-supported or (ad-free) subscription basis. It is one of the largest music streaming providers in the world, with 406 million monthly active users (MAUs) and 180 million paid subscribers across 184 markets.
Spotify is a two-sided marketplace that connects users to artists and content creators. The company serves consumers by helping them discover music in a personalized and seamless manner. Users can easily find their favorite music or podcasts -- there are 82 million tracks to choose from on the platform -- or receive a personalized recommendation from Spotify. They can access the platform on various electronic devices -- phones, computers, tablets, etc.
Meanwhile, content creators can leverage Spotify's 406 million MAUs to distribute and monetize their creations. They can also build a direct relationship with fans, analyze their behaviors using software and data, and manage their business (such as subscription services) on Spotify.
As the number of users and artists on its platform grows, Spotify monetizes its service through two main avenues. The bulk of its revenue is from premium subscription services where users pay a fee for access to ad-free music -- accounting for 86% of revenue in 2021.
The rest is from its ad-supported service where users have to listen to advertisements in return for free access to a limited number of tracks. While smaller, this part of the business expanded rapidly in 2021, up by 62% year over year. Comparatively, the subscription business grew by "only" 19%.
2. Spotify's future is full of opportunities ... and challenges
Spotify has had great success scaling its business in the last few years. In the past five years, revenue more than tripled from 3 billion euros ($3.23 billion) to 9.7 billion euros as MAUs more than doubled from 123 million to 406 million.
Spotify's rise is due to its flywheel of ever-growing user base and content. On one end, it constantly adds new content to improve user engagement. There was only music at first, then came podcasts and now audiobooks -- via the acquisition of Findaway.
An ever-expanding content pool appeals to old and new users, explaining how Spotify touches millions of users. A growing user base, in turn, provides more opportunities for content creators to target a larger audience group and generate more income. Artists can then reinvest even more of their time and resources to create even better content, further improving the user experience.
In short, Spotify has the potential to grow revenue for many years as the flywheel gains momentum. It can convert its hundreds of millions of unpaid users into premium users, monetize its podcast business via advertising, and expand into newer services -- like audiobook services. Besides, it can also attract new streamers (globally) to join its free and paid services. With "only" 406 million MAUs, Spotify has a long way ahead of it.
Spotify has a proven model of growing content and user over time, but it is not free from issues. One thing is that while Spotify welcomes all artists, the top artists still get the bulk of user time. As artists' compensation correlates to the number of times their songs get played, small and independent artists (those less well-known) might find it difficult to survive on the platform. While this issue is not new in the competitive music industry, the tech company needs to find ways to compensate these smaller artists or risk losing them (and their content).
The other challenge that Spotify has to deal with is the strong bargaining power that top content creators have over it. The Joe Rogan incident earlier this year highlights the risks where top artists can leave the platform at their will, which will impact the user experience. Similarly, the incident demonstrates how much Spotify is depending on top creators like Rogan to grow its business. In other words, Spotify has to find ways to retain top artists or risk losing subscribers.
On top of that, Spotify has to face competing services like Apple's Apple Music, Alphabet's YouTube Music, etc. And despite generating billions of dollars in revenue, Spotify is still unprofitable -- it could remain so for a while as it invests in growth and also until it can better monetize its newer services like podcasting. Fortunately, the company can afford to invest heavily. It already generates positive operating cash flow and has 3.5 billion euros of cash and cash equivalents and short-term investments on its balance sheet.
A quick word on Spotify's long-term target
In the first-quarter earnings report, Spotify reiterated its long-term goal of reaching 1 billion users, growing revenue 20%-plus on an annual compound basis, and reaching a 30% to 40% gross margin.
If the company can continue to add high-quality content, users will naturally come. As more users join, Spotify can sustain its revenue growth trajectory. Besides, operating leverage can kick in to help the company reach its targeted gross margin (which was at 27% in 2021).
Still, investors should keep a close eye on the abovementioned risks since they can derail the company from its long-term ambition.