Company / Analytics

Analytics, 07 July 2020

Spotify could be the next big Tech Stock

Spotify, the audio-streaming giant, is rapidly becoming something of a monopoly in the audio industry, with all the elements of a future growth stock. Despite Spotify’s leading market position, rapid growth, and huge addressable market, the investment community largely doubted the company’s prospects, primarily because it relied on major music labels and its highly variable cost structure due to music royalty payments. Thus this is rapidly changing as Spotify expands beyond music to encompass all forms of audio content and entertainment, including original podcasts content, in a move that will potentially pave the way for higher margins as the cost structure incrementally shifts from variable costs to fixed costs.

Spotify is doing what Facebook did with social media, what Amazon did with online shopping, what Google did with online advertising, or Zoom has done with video-conferencing and has seen its shares spike 80% year to date. We unpack why Spotify could be the next big tech stock, just like Netflix, and what investors can consider going forward.

The situation

Founded in 2006, Spotify made its debut IPO in 2018 on the New York Stock Exchange with an opening price of $165.90. The opening price gave the company a market valuation of $29.5 billion, higher than in the private markets where it was trading for as much as $132.50 a share before the IPO.

After trading in a flat range for the first few years following the IPO, Spotify shares have spiked over 80% year to date. Most analysts believe that Spotify’s business today resembles Netflix in 2012 when Netflix began to step up its game and transition to the original content. If you invested $1,000 in Netflix in 2013 when it first aired the political drama, House of Cards, you would be sitting on a position worth nearly $20,000 today.

Similar to Netflix’s early days, Spotify has been highly doubted by the investment community, despite its potential to provide explosive gains for investors, an enormous opportunity for future growth and profitability. Spotify is valued much higher than Netflix in 2012, and investors are beginning to see its positive future outlook.

With more than 286 million active monthly users, Spotify is the leader in audio streaming. Just as Netflix essentially created the market for on-demand video streaming, Spotify has a big growth opportunity by expanding its original content, primarily with podcasts. While we can’t predict whether Spotify will be able to recreate Netflix’s stellar returns, its future in podcasts looks very promising based on market research.

Not many had envisioned the explosive growth Netflix would experience, mainly because the wave of demand for original video content hadn’t arrived yet. Before 2013, Netflix revolved around its DVD-by-mail rental business and streaming video content from third-party studios and distributors. Even as Netflix began to invest in originals ahead of the launch of House of Cards in 2013, its market value was still just under $5 billion at the end of 2012. Some investors believed that original content would not be a viable strategy, because people might subscribe to watch new episodes and then cancel.

But after a splendid first decade for streaming, investors are much wiser to the potential rewards of investing in original content. That’s one reason why Spotify already has a market value of $50 billion, even though it hasn’t earned much yet in profits.

The significance

Spotify is following the original content playbook, and its podcast strategy will reward shareholders. The stock’s 80% surge year-to-date is a big vote of confidence in this strategy. Netflix’s growth in the last decade has shown the significant impact of quality content in the world of entertainment, and investors are anticipating a strong decade ahead for Spotify.

The stock’s surge is linked to Spotify’s content strategy, where the company is quickly assembling an impressive roster of original content, which management believes will attract more users, fuel increased user engagement, generate faster revenue growth, and grow profits through higher margins. That sounds very similar to what happened at Netflix.

Some of Spotify’s recent big deals include the signing Joe Rogan to a multiyear exclusive podcast deal, which sent the sent the stock up 19% in May, the signing of Kim Kardashian and the DC Comics universe to exclusive podcast deals, and AT&T’s Warner Bros. to create exclusive podcasts around popular superheroes like Batman and Wonderwoman.

These deals are important because they will attract even more users to Spotify’s platform. And the more users Spotify has in the future, the more its scale and market power should ensure strong future profitability. Why? First, a larger number of users should naturally maximize the number of Premium subscribers. Not only will that boost revenue and profit, but the larger Spotify becomes, the more critical it becomes to the major music labels. And that should incrementally improve its bargaining power when it comes time to renegotiating music royalty rates.

Second, the more users Spotify has, the more ad impressions it will sell on Spotify-owned podcast content. That should generate high-margin advertising revenue and should create the “Netflix-like” operating leverage that’s been elusive for Spotify with its core music streaming business thus far.

Finally, a greater scale will help the company leverage its corporate overhead expenses, including selling and marketing, general and administrative, and research and development expenses. As revenues rise, these expenses won’t have to rise as much, which should contribute to greater profitability.

Bottom line

The market for content is booming, and Spotify has emerged as the leading podcast service across the world, with more than one million podcasts on its platform, three times more podcast content than it had just a year ago. The company reported growth in paid subscribers of 31% and total revenue growth of 22% year over year in the first quarter. Research indicates that the total podcast audience is growing by about 20% per year and is expected to double by 2023. Spotify has a strategic future vision, outlined through its CEO Daniel Ek, of expanding Spotify beyond just music to encompass all forms of audio content and entertainment. Investors are excited about this strategy since original podcasts don’t carry the same types of royalty burden as licensed music does, so the move will potentially pave the way for higher margins as the cost structure incrementally shifts from variable costs to fixed costs.

The company is successfully tapping into the double-digit growth of the overall podcast market, and it should remain a rewarding growth stock. Industry insiders also suggest Spotify will eventually end up under the ownership of one of the big technology corporations.

How the stock moved?

Spotify is currently valued at $50 billion. Shares have been on a massive tear since they bottomed around $118 per share in March during the initial COVID-19 panic. Since then, they have more than doubled to $260.26 per share as of this writing.

However, the stock got mixed reviews from two-leading Wall Street Analysts on Monday, Jul 6. In a research note to clients, J.P. Morgan analyst Doug Anmuth raised his one-year target on Spotify to $305 from $185 and kept his overweight rating on the company’s stock amid what he expects to be positive momentum from the company’s efforts to secure exclusive podcast content and also beef up its premium offering.

On the flip side, Bernstein analyst Todd Juenger downgraded Spotify to underperform from market perform, noting in his note that his team does not see Spotify’s recent move to bolster its podcast offerings generating as much in the way of earnings as other analysts and investors expect.

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