Spotify (NYSE: SPOT) thinks it can grow its business to become much larger than it thought just a few years ago. CEO Daniel Ek said the company made a key change in 2019, shifting from music distribution to becoming a platform for all of digital audio.
As a result, a lot of its outlook during its 2018 investor day requires some revisiting. And management gave a very optimistic forecast for the business over the next decade at its analyst day earlier this month.
The key future numbers are: 1 billion listeners, $100 billion in annual revenue, 40% gross margin, and 20% operating margin. On the top line, that represents nearly 10 times where it is today.
Here’s how Spotify says it gets there.
1 billion listeners
Spotify has done an excellent job of penetrating the markets in North America, Western Europe, the Nordic region, and Australia and New Zealand. Management claims 32% of the total addressable market of digital audio streaming in those markets.
But in the rest of the world, it claims just an 8% share. And those markets are much bigger. Spotify’s established markets represent a total addressable audience of 600 million people. The emerging markets present an opportunity to serve 2.7 billion people.
Importantly, the developed markets also exhibit better churn. What’s more, that churn rate is improving, dropping from 3.6% to 2.4% since 2018. Some markets have churn rates as low as 1% to 2%. The great news is that emerging markets are following the same path. And as churn rates decline, net additions become easier.
It’s important to remember Spotify is still relatively new in many markets. It expanded from 65 countries in 2018 to 183 countries today. And if it follows the same playbook as it did in its established markets, it should be able to reach its goal of 1 billion users by 2030.
$100 billion in annual revenue
This goal is broken down more simply as $100 in revenue per user per year, which is around four times its current annual revenue per user (ARPU).
The path toward that ARPU requires Spotify to expand into new verticals and monetization strategies. Management sees the market for music streaming, live-events sales and promotions, and podcasting growing four times over the next decade. Based on its current monetization methods, it believes it can double ARPU just from participating in the expanding market.
Adding audiobooks and other verticals like news, sports, or education will allow Spotify to grow ARPU by four times. Adding more a la carte purchasing options (which it already does for podcast subscriptions) could be a major catalyst for ARPU.
40% gross margin
When Spotify unveiled its long-term expectation to reach 30% to 35% gross margin at its investor day in 2018, it seemed like a high target. And after three years of gross margin barely budging from the mid-20% range, management is raising its outlook to 40%.
CEO Daniel Ek wasn’t afraid to address investors’ disappointment in the company’s gross margin results. The fact is, the underlying gross margins of its various verticals are progressing as expected. Music gross margin was 28.5% in the first quarter, expanding at an average rate of 75 basis points per year since 2018. Meanwhile, podcasts remain a drag on gross margin and will continue to be in 2022.
But podcast profitability is near, and chief financial officer Paul Vogel expects the verticals to become accretive to gross margin in one to two years. In other words, podcasts will have higher margins than the music business in just a couple of years and will represent a significant share of listening on the platform.
Long term, management sees podcast margins reaching 40% to 50%. Other verticals, like audiobooks, could have a gross margin of 40% to 80%. Adding these verticals is key to Spotify reaching its new outlook, but it will require patience from investors as new verticals might start off as a drag on margins.
20% operating margin
Not only does Spotify expect to expand its gross margin significantly over the next decade, it also expects to exhibit some operating leverage as it scales. While management will continue to invest heavily in research and development — about 10% to 13% of revenue — it doesn’t expect it to reach the level in its original long-term outlook from 2018. Sales and marketing will account for 6% to 7% of revenue. General and administrative expenses are projected to be less than 3%. Both represent about half of what Spotify’s spending on each expense relative to revenue today.
Gaining operating leverage, spending around 20% of revenue on operating expenses, combined with expansion to 40% gross margin, will result in the 20% operating margin Ek is forecasting.
At that level of profitability, Spotify will be worth a lot more than it is today. Even if it doesn’t quite achieve that outlook, it could dramatically grow earnings before interest, taxes, depreciation, and amortization (EBITDA) over the next decade, producing meaningful returns for investors.
The company appears to be on the precipice of its big bet on podcasts paying off. Its goal is to repeat that playbook two or three more times over the next decade. Management’s long-term growth mindset makes Spotify a great growth stock to consider for your portfolio.