A bull market is coming. It may not seem like it right now, with stocks steadily moving lower, but there is always light at the end of the tunnel in financial markets. The average bear market lasts just 1.4 years (compared to 8.9 years for bull markets), so with almost a full year since the 2022 bear market began, stocks are likely to start turning around sometime in 2023. This means now is the perfect time to start putting your investable cash to hard work, especially in technology stocks down large amounts this year.
Here's why Spotify Technology (SPOT -1.12%) -- down 70% in 2022 -- is a perfect stock to buy heading into 2023.
Steady growth
Spotify is the leading audio streaming service worldwide, known for its ad-free music subscriptions that let you listen to nearly every song in the world from your mobile device. Since launching a little over a decade ago, the service has steadily grown around the world and is now in virtually every sizable country outside of China. Last quarter, it hit 456 million total monthly active users (MAUs) compared to just 68 million at the start of 2015. In addition, premium subscribers, or those who pay a monthly subscription for ad-free music listening, hit 195 million as opposed to just 18 million in 2015.
People are clearly finding value in Spotify's music offerings, which has translated to steady revenue growth. Last quarter, revenue grew 21% year over year and was $12.2 billion over the past 12 months. In 2016, the service made around $3 billion in sales, meaning revenue has more than quadrupled over the last six years. With billions more internet users around the globe and a goal of reaching more than 1 billion users on the platform, there is still a long runway for Spotify to grow its business over the next five to six years.
The problem investors have with Spotify is its uncomfortable combination of low gross margin and minimal free cash flow, which likely hurt the stock in 2022. The gross margin has remained low at around 25% for the past few years, while annual free cash flow has only been a few hundred million dollars, a small amount for a business doing over $10 billion in revenue each year. But there are ways Spotify is looking to fix these issues.
SPOT Free Cash Flow data by YCharts
Plenty of optionality
With hundreds of millions of users, Spotify has looked to expand beyond just a music streaming subscription service into a wider audio platform. Its first venture outside of music was into podcasts, which has gone well so far. Spotify is now the market leader for podcasts in many countries around the world, including the United States, which I think is impressive considering it only started fully focusing on this product in 2018 and 2019. To monetize podcasts, Spotify is building a dynamic advertising marketplace similar to YouTube, but for audio. Last quarter, advertising revenue grew 19% year over year with podcast advertising outpacing overall growth. Investors should watch this metric closely as a sign that Spotify is succeeding with its podcast initiatives.
Spotify is a highly experimental company and intends to get a lot of shots on goal to expand its product offerings. Unfortunately, some of these experiments, like live audio and listening hardware, have been failures. But others -- like the aforementioned podcasts -- can be winners and make up for all the duds. One that has a lot of promise is its two-sided promotional marketplace, where music artists and labels can pay to promote their work to users on Spotify's service. This is a small part of Spotify's business today but has a high gross margin and should be able to drive consolidated margin expansion over the next few years.
It's not showing up in the financials today, but if Spotify continues to win in the podcast market while experimenting with new audio products, I think the company can keep growing revenue at a double-digit annual rate while eventually expanding its gross margin. This should lead to positive net profits and higher free-cash-flow generation a few years from now.
Cheap valuation
I think it is a disservice to Spotify to try to value the stock today on net income or free cash flow given how much it is currently reinvesting for growth. But what investors can do is take its market cap, revenue, and projected future margins and see what comes out the other side.
As of this writing, Spotify has a market cap of $14.4 billion. Over the next few years (the exact timeline is not specified), management believes its gross margin can expand to 30% to 35% withe th operating margin hitting 10%. Assuming a standard 20% tax rate, that would equate to a net income margin of 8%. At Spotify's current revenue level of $12.2 billion, an 8% net margin is just under $1 billion in annual net income or a price-to-earnings (P/E) ratio of 14.4 based on today's stock price.
For a company with a clear path to growing its users and revenue, this looks like a cheap valuation, and that is why I think the stock is a buy today.
