Spotify (SPOT) stock could be undervalued

Spotify (SPOT) had huge volatility in the share price in the last 1.5 years, so I decided to take a look at the business, understand how they make money, analyze their historical performance, and lay down some assumptions to assess its intrinsic value.

Below are the outcomes:

Spotify adds value to the users by providing content in the form of music/podcasts and it is definitely a disruptive platform. Fundamentally, they have two types of users:

  1. Ad-supported users – those that are paying for the content with their time (by occasionally having their content interrupted by an audio/video advertisement). In this case, Spotify gets advertisement revenue, but this represents only 10% of the total revenue. Of course, as the users get access to the content, 90% of all of this revenue goes to the owners of the music/podcast, so Spotify is left with a gross margin of 10%. In fact, this segment of their business is not profitable, but it serves as a stepping stone as it targets a wider audience and if they’re happy with the platform and decide that it adds value, they can become premium users.
  2. Premium users – those that do not want their music/podcast to be interrupted and are willing to pay a monthly subscription for that. This is 90% of their revenue and the gross margin is at around 29%. Same as in the previous case, the cost of the revenue is the royalty and distribution costs related to content streaming that is paid to certain record labels, music publishers, and other right holders, for the right to stream music to the users. This is the part that is key for their business.

The revenue growth in 2017 was close to 40%, then in 2018 and 2019 it was close to 30%, now it is close to 20%. Even though the company is growing the total revenue, these are declining growth rates.

The # of premium users has increased from 71m in 2017 to 172m reported in the last quarter (Q3-2021). However, the average monthly revenue per user has been declining from €5.32 to €4.25 in the same period. Is it worrying? It depends. I see two reasons that can justify this decline in the average revenue per user:

  1. The plan chosen by the users – Spotify offers many different plans (Student plan, standard plan, duo plan, family plan…). The plans that involve more users are more expensive on an absolute basis but are cheaper per user. If more users opt for group plans, then it is not a surprise that the average revenue drops.
  2. Expansion in lower-rate markets – Same as Netflix, the pricing differs between countries. If Spotify is expanding in LATAM, then the marginal revenue is lower than the average revenue.

So, we have two types of users that bring revenue to the company and a gross margin that’s at around 27%. Once they cover the cost of the content, they need to cover the SG&A, R&D, and Sales/marketing expenses. Currently, they’re at a point where they’re covering that and they have an operating margin of close to 0%. So, looking into the future, as the economy of scale kicks in, I expect them to have a positive operating margin. How high? My assumption is 13% and here’s why:

I can see them improve the gross margin and get it as high as 30% and over time, the Sales/marketing expenses and SG&A should be lower as % of the revenue. For the R&D, it could be that they remain to pour funds into that for a longer period. Of course, if you disagree with me on this assumption, at the end of this post I have a table that shows the valuation based on different scenarios (revenue growth / operating margin)

From a balance sheet point of view, there’s nothing worrying. About 60% of the balance sheet (amounting to €4.3bn) is cash/cash-equivalents, short-term investments, and long-term investments. They have only €1.2bn in long-term debt and about €600m in capital leases.

If you are confused about why I am using Euros, Spotify is a company based in Sweden and it reports all the financial numbers in Euros. So, I’ll be valuing the company in the same currency and once I have the value, I’ll convert that to USD to compare it with the market price.

So, here are my assumptions about the future:

Revenue growth – 20% in the next year, then 17% for the following 4 years and then slowly declining to the euros risk-free rate.

Operating margin – 0% for the next year, then improving overtime to get to the 13% in the next 6 years

Reinvestment ratio – 4 (Sales to capital) – Mainly in acquisitions as they have a lot of cash that they need to put in use and possible opening a few more offices around the world

Tax rate – 25% – although as they have €2.2bn in tax credits, they won’t be paying any for quite some years.

WACC – 9.5%

Based on these assumptions, with a DCF model, the outcome is €174.26 or in USD – $193.43

I personally didn’t see any fundamental change in what they’ve been doing or how they were growing over time that justifies the share price increase in the last 1.5 years so the decline was pretty much expected from a fundamental point of view.

Below is an overview of the value of the company based on different assumptions related to revenue growth (in 10 years) and operating margin:

Revenue / Op. margin10%13%15%
180% (€25.7b)$121.6$158.7$183.3
214% (€28.8b)$133.1$193.4$201.7
250% (€32.0b)$145.3$190.9$221.4
300% (€36.7b)$161.6$213.1$247.5

This article was written by u/k_ristovski.