Spotify Technology (SPOT -0.33%) has been one of the best-performing technology stocks in the world since going public in 2018. The journey has been bumpy, though. Shares have produced a 19% annual total return compared to 14% for the S&P 500 index, meaning that Spotify has beaten the market over the last seven years.
However, in 2021 and 2022, the Spotify story looked dire. The music and audio streaming platform had an 80% drawdown as investors worried about a lack of profitability with its business model. Since falling to $75 a share, the stock has rallied in the last two years in a remarkable comeback for the company, which is now worth close to $100 billion in market capitalization.
And yet, the stock is rarely talked about in investing circles, even after this run-up. Here's the generally overlooked story of Spotify's stock market comeback, and whether you should buy shares today.
A forgotten stock recovery
Late 2022 was a dark period for Spotify. This was the depths of the stock's decline. Wall Street was concerned about the company's deteriorating operating margin, which fell to negative 7% in the third and fourth quarters of that year.
Due to its ambitious expansion into podcasts, advertising, and other new segments, Spotify's operating expenses were growing faster than revenue. Gross margins were also slipping with increased costs for podcast content on expensive licensing deals.
In the two years since, Spotify's margins have made a miraculous turnaround. The reason for this improvement is simple: It got disciplined with expenses. Through layoffs and fewer content licensing deals, operating expenses have fallen from their peak, while gross margins hit an all-time high of 31.1% in the third quarter of this year. At the same time, revenue kept growing and was up 19% year over year last quarter.
Greater spending discipline has led to a big improvement in operating margin, which hit a positive 11.4% last quarter, surpassing management's previous goal of reaching a 10% profit margin that it set forth back at its Investor Day in 2022. This is fantastic progress for a business that many believed could never turn a profit, which is why the stock price is up by a multiple of 5 in less than two years.
SPOT total operating expenses (TTM), data by YCharts; TTM = trailing 12 months.
Pricing power, new segments, gross margin expansion
Revenue growth has accelerated in recent quarters, hitting 19% in the third quarter. Price hikes across the globe for its premium subscriptions were the main reason for this growth. The company has been able to implement significant price increases in places like the United States with little to no increases in customer churn, which indicates it is underpricing its premium music service.
Price hikes are great for shareholders, but Spotify can't implement them every year. Other sources of revenue growth will come from new user acquisition and new segments outside of music.
Monthly active users (MAUs) grew 11% year over year last quarter to 640 million, with strong growth coming from places like Southeast Asia and India. With billions of people in these emerging mobile phone markets, there is plenty of room to grow over the next few years.
Hopefully, these new customers will not just engage with Spotify's music service, but also with its other forms of audio content such as podcasts and audiobooks. The company recently launched audiobooks in some markets to great success, which has led to an acceleration of growth for the category.
Another thing to highlight -- and what should lead to further earnings increases -- is gross margin expansion. This metric hit 31.1% last quarter, up from 25% in 2022. Its promotional marketplace for music has helped earn better unit economics from the music industry. If this gross margin expansion continues over the next few years, the company will be able to let more earnings fall to the bottom line.
Should you buy shares today?
The big question for investors is whether Spotify is a buy after this monster run. As of this writing, the stock has a market cap of $97.5 billion.
Revenue over the last 12 months was $16.4 billion. If you believe in the pricing power, user growth, and new audio segment stories, I think it is plausible that Spotify will grow its revenue at a 15% annual rate for the next five years. Through increased scale and gross margin expansion, I think it is likely that its operating margin will expand to 15% over this five-year period.
Applying these estimates, revenue will be $33 billion five years from now, and earnings will be just under $5 billion. Using its current market cap of $97.5 billion, that is a five-year forward price-to-operating earnings of around 20.
There is no reason to sell your Spotify stock at this price, but adding to your position or starting a new buy today looks unwise. If the company keeps up this impressive growth, it will only be trading at an earnings ratio right around the long-term market average in five years. These are high expectations for the stock. Keep on the sidelines with Spotify (for now) after its monster 2024 run.
