Investors in Spotify (SPOT 0.20%) have gone on a rollercoaster ride in the last few years. Shares rallied more than 100% in late 2020 and early 2021, but went into a steep decline during the 2022 bear market after the company failed to reign in costs and reach profitability. Shares fell more than 80% from all-time highs in less than two years.
Meanwhile, 2023 has been a lot kinder to shareholders, with the stock up 85% year to date (YTD) as of this writing -- likely due to the general bull market, cost-cutting measures from management, and impressive first-quarter growth numbers for the music and audio streaming platform.
If you own Spotify, you're probably debating if you should sell the stock after this monster bull run. Let's see whether now is the right time to dump your shares.
Steady growth and a path to profitability
General market fluctuations aside, Spotify's stock has soared this year because its business is starting to look healthier.
In the first quarter, monthly active users (MAUs) grew 22% year over year to 515 million, adding 26 million new users to the platform in the first three months of 2023. Revenue growth has been a bit muted in U.S. dollar terms due to foreign exchange translations (Spotify operates in every major market outside of China) and a slowdown in the advertising market, but it has still hit $12.6 billion in revenue over the last 12 months, up over 100% in the last five years.
SPOT Revenue (TTM) data by YCharts
Users and revenue have never been the problem with Spotify -- it is the profitability (or lack thereof) that has gotten investors pessimistic about the business in the last few years.
Last quarter, Spotify had an operating margin of negative 5%, which is clearly not sustainable over the long term. Management has been working to fix this profitability issue by focusing less on high-dollar-value podcast deals and reducing its employee count.
The company laid off 600 employees early in 2023, and another 200 this week. These layoffs have not been reflected in the income statement yet, but should lead to operating leverage as long as Spotify can keep growing its topline.
How the valuation has changed
But where will Spotify's profit margins land once the business matures? Management thinks around 10%, which it hopes to achieve within the next three to five years. Compared to $12.6 billion in trailing revenue, that would equate to $1.26 billion in annual profits.
Earlier this year, when Spotify sported a market cap of just $15 billion, you could make the argument the stock was cheap even if it didn't grow its revenue much from current levels as long as it hit its 10% margin target. $1.26 billion in annual profits versus a market cap of $15 billion is a price-to-earnings ratio (P/E) of just 12, which is significantly below the market average.
Today, Spotify has a market cap of $29 billion, which would increase its P/E to at or above the market average of about 25 even if it reaches its 10% margin target. This makes the valuation math much more difficult than at the beginning of this year.
Why there's no reason to sell (yet)
I don't think Spotify is a screaming buy at these levels, but there's no reason for shareholders to trim the flowers and sell this winner early. The company looks poised to significantly grow its revenue over the next few years due to pricing power in music streaming subscriptions, podcast advertising, and the continuation of steady user growth around the globe.
If Spotify doubles its revenue over the next five years, it will hit $25 billion in annual revenue. At a 10% profit margin, that is equal to $2.5 billion in annual earnings for a fast-growing business. While this scenario is not guaranteed to occur, it would likely mean Spotify's stock is higher five years from now even after its explosive performance to start 2023.
A big mistake many investors make is selling their winners early. Don't make that mistake in 2023 with Spotify just because it feels like the safe move right now.
