Spotify Technology S.A. (NYSE: SPOT) has successfully met market expectations with its Q1 FY24 results, leading to a rise in stock prices following the announcement. During the quarter, Spotify implemented its first price increase in the U.S. since 2011 and undertook a workforce reduction to optimize its cost structure.
In Q1 FY23, Spotify employed 9,646 individuals, a figure that decreased to 7,721 in Q1 FY24, marking a 20% year-over-year decline. During the earnings call, management acknowledged that the workforce reduction created more business disruptions than anticipated. However, they emphasized that operations are now back on track. This cost optimization initiative is viewed as a positive step, as it is expected to enhance productivity and foster an entrepreneurial spirit within the company. Additionally, the layoff could contribute to improved operating margins in the near term.
Spotify’s recent price increase contributed to a 7% year-over-year growth in ARPU. As illustrated in the chart provided, the total number of monthly active users increased by 19.4% year-over-year, while the number of premium subscribers grew by 13.8% year-over-year. Notably, the price increase has not yet affected subscriber growth.
Ad-supported revenue currently accounts for approximately 13% of Spotify’s total revenue, but it has been outpacing overall revenue growth recently. Spotify has experienced significant growth in Ad-supported MAUs, as depicted in the chart. Ad-supported services offer a different business model, charging no subscription fees while generating revenue from advertising. This type of service is not uncommon in the streaming industry, with companies like Netflix (NFLX) and Disney (DIS) introducing similar offerings to expand their potential customer base.
In February 2021, Spotify launched the Spotify Audience Network (SPAN), an audio advertising marketplace that connects advertisers to listeners. SPAN is considered an efficient and effective platform for targeted marketing within the audio/music industry. Spotify possesses a vast amount of data on its subscribers, including their preferred music genres and artists followed. As a result of multi-year investments, Spotify’s advertising business has experienced robust revenue growth in recent quarters, increasing by 17% in Q4 FY23 and 19% in Q1 FY24 on a constant currency basis. It is anticipated that the Ad-supported business will continue to outpace overall business growth in the foreseeable future.
Spotify’s total revenue increased by 21% in constant currency in Q1 FY24, and the company anticipates revenue growth of over 22% in Q2 FY24. A key takeaway from the quarter is management’s confidence in improving margins and cash flow from operations. Spotify achieved a record-high gross margin of 27.6% in Q1 FY24 and projects it to reach 28.1% in Q2, as indicated in the provided slide. This improvement is attributed to disciplined content spending, as discussed during the conference call. Spotify utilizes various revenue-sharing models, including direct revenue share, per-user model, and per-hour model, which allow it to optimize content costs using data analytics.
Spotify generated €207 million in FCF in Q1 FY24, a significant improvement from the €57 million reported in Q1 FY23. This growth in FCF is primarily driven by margin improvement and revenue growth. As the company continues to prioritize cost management, its cash flow generation has the potential to improve further in the near future.
In terms of FY24’s growth, several factors need to be considered:
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Industry Growth:
BusinessWire predicts that the music streaming market will grow at a CAGR of 13.57% from 2022 to 2026. Spotify’s dominance in the market, with 239 million premium subscribers and a market share of approximately 31%, according to the Musical Pursuits report, makes it well-positioned to benefit from this growth. The market transition from physical records to digital streaming is considered a primary driver of industry growth. Additionally, Ad-supported music streaming is attracting new listeners to the market.–
Price Increase:
The $1 price increase represents a 10% increase year-over-year. Spotify’s ARPU growth will receive a boost in FY24 due to this recent adjustment. However, investors should not anticipate similar additional growth in the near future, as the price increase is a one-time event.–
Advertising Growth:
Ad-supported revenue contributes approximately 13% to Spotify’s total revenue. Assuming a 20% growth rate, it could contribute 2%–3% of growth to the top line. Factoring in an estimated 7% ARPU growth, 11% growth from subscriber growth, and 2% growth from advertising, Spotify’s combined revenue growth is projected to be around 20% in FY24. For FY25 and beyond, the ARPU growth rate is adjusted to 2% to align with overall inflation, resulting in a projected revenue growth of 15%.–
Valuation:
My operating margin considerations include:– Sales and marketing expenses: Spotify reduced its marketing expenses in FY23 due to macroeconomic uncertainties. It seeks a balance between marketing expense growth and revenue growth. They intend to increase some marketing spending in Q2, but not to the extent seen before FY23.
– Gross Margin: Spotify continues to optimize its content cost structure and is on track to expand its gross margin. With its advantage in data insights, Spotify is well-positioned to manage content costs effectively.
– Price Increase and Layoff: The ARPU increase and layoff could positively impact Spotify’s gross margin in FY24, although the latter is a one-time event. I assume a 100bps margin expansion for gross profits, 20bps leverage from R&D, and 30bps leverage from sales and marketing. Calculations indicate that the total operating expense will grow by 13.3% annually.
Based on these considerations, I estimate that the free cash flow from equity will grow at a CAGR of 12.5% from 2024 to 2029. I calculate the cost of equity to be 14.4%, resulting in a one-year price target of $392 per share.
In terms of risks:
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New CFO:
Christian Luiga, the new CFO announced on April 4, 2024, plans to join Spotify in Q3 FY24. Given his background in the defense and security industry, it is expected that he will need time to familiarize himself with Spotify’s business model.–
Competition:
While Spotify holds the largest market share in the music streaming market, Apple (AAPL) and Amazon (AMZN) are formidable competitors. Apple has a vast smartphone user base, while Amazon can leverage its Prime subscriber base.–
Licensing Agreements:
Spotify has agreements with Universal Music Group, Sony Music Entertainment, and Warner Music Group, which account for 74% of audio content streams. During contract renewals, pushback from these music companies could pose risks to Spotify’s streaming services in the near term.In conclusion, I am optimistic about Spotify Technology S.A. due to its leadership position in the music streaming industry, ongoing cost optimization initiatives, and potential for further margin expansion. Therefore, I initiate a “Strong Buy” rating with a one-year price target of $392 per share.
