The market hated Spotify (SPOT -1.49%) in 2022. At some points, it felt like shares would never stop falling with the stock down 66% last calendar year.
But in 2023, fortunes for the audio streamer have started to change. The stock is up 55% year to date (YTD) along with an overall resurgence in growth stocks this year and after reporting strong user growth for the fourth quarter of 2022.
Investors are betting big on Spotify after its latest earnings result. Is the stock finally ready to bounce back for good? Let's take a look.
Strong Q4 results ... with a few concerns
Spotify reported its fourth quarter earnings on the last day of January. Its user growth was way above expectations with monthly active users (MAUs) growing 20% year over year to 489 million and premium subscribers -- those who pay for ad-free music listening -- up 14% year over year to 205 million. This led to revenue growth of 18% in the quarter, hitting 3.2 billion euros ($3.4 billion) in the last three months of 2022.
While user and revenue growth was great, Spotify is still struggling to generate an operating profit. Its operating loss totaled 231 million euros ($250 million), giving it a negative margin of 7.3%. Operating margin has declined as expenses rise faster than revenue.
For example, the company's research and development expenses were up 64% year over year during the quarter. In order to rein in this spending, Spotify announced in January that it was laying off 6% of its workforce. These cost savings will hopefully start showing up on its income statement in 2023.
Podcasts, advertising, and promotions as the path to profitability
The company also plans to achieve operating leverage by growing its podcast advertising business and promotional marketplace. Since 2018, podcasts have been a huge investment focus for Spotify with the company spending over $1 billion on production studios, distribution platforms, and licensing exclusive shows for its service. So far, the results of these investments have mainly been in listener market share with Spotify quickly dethroning Apple Podcasts as the most popular podcast platform in many markets around the globe.
Over the next few years, it wants to monetize its podcast audience by growing its audio advertising marketplace. Advertising makes up 14% of Spotify's revenue today, up from 10% a few years back, but management thinks that over time it can reach 20% or higher. With high incremental margins, a larger advertising business should lead to better overall profit margins at Spotify, making ad-supported revenue a key metric for investors to track over the next few years.
Within music, Spotify is planning to expand its gross margins through the growth of its promotional marketplace for artists. Through its discovery tools, music labels and musicians can promote their work to users across Spotify, paying lower royalty fees in return for gaining new fans. Spotify also earns higher gross margins on these streams.
If you squint, the stock could be cheap
Up 55% already in 2023, Spotify now trades at a market cap of about $24 billion. Over the next three to five years, management expects operating margins to expand to 10% due to the growth of the advertising and promotional marketplace segments.
Assuming revenue can grow at least 15% annually for Spotify over the next five years, it would reach $25 billion in 2027. At a 10% operating margin, that equates to $2.5 billion in annual operating profits. Compared with the current market cap of $24 billion, that's a valuation multiple of just 9.6.
There are always risks when buying a business that is not profitable today with the hopes it starts generating a profit tomorrow. But with a durable music subscription business and the new growth and margin-expanding strategies discussed, Spotify's stock could prove to be a bargain at current prices.
