Spotify (NYSE:SPOT) is one of the more interesting stocks in the market. The bear case for Spotify stock seems obvious: the company is losing money and facing intensifying competition. The bull case for SPOT stock seems almost equally obvious: the company already has 83 million paying users and continues to post impressive growth.
With SPOT down 43% from its highs, the bull case perhaps looks more intriguing. Spotify has years of growth ahead. Profitability will come at some point as the company leverages largely fixed costs. And at some point, Spotify should be able to raise prices, further boosting margins.
The big concern is competition. Giants are targeting the streaming music space. And it’s not clear that Spotify has the ability to fight them off. Increasingly, Spotify looks like a binary play. Investors choosing either side must do so with conviction.
The Bull Case for Spotify Stock
It’s too simplistic to argue that Spotify is overvalued simply because the company is posting negative earnings. For one, Spotify is generating positive free cash flow. And with a strong balance sheet (nearly $2 billion in cash and investments and no debt) the company actually announced a $1 billion repurchase program in November.
Meanwhile, earnings will improve over time. The company expects to end the year with roughly 200 million subscribers, nearly half of whom are paid users. The number of those premium subscribers should increase 30%+ this year. Each incremental subscriber adds more profit. And with the potential to grow worldwide (at least outside of Asia) both figures should rise for years to come.
There’s another key aspect of the bull case: pricing power. The longer a user sticks with Spotify, the better and more personalized the content. That in turn suggests that Spotify should be able to raise prices over time. Those incremental pricing dollars drop to pre-tax income at close to 100%; and a huge boost to earnings.
At the end of the day, Spotify already has a huge pool of paid users, which should only get bigger. Those users should be happy to pay more over time, as the service improves.
Assume paid users rise from 100 million to 300 million, and ARPU (average revenue per user) rises to $7 from a current $5.43. Ad-supported revenue rises to $1 billion from a current $600 million-plus. Revenue in this scenario gets to $26 billion – up from $6 billion this year.
Even flat gross margins suggest an incremental $5 billion in earnings. Even assuming operating expenses rise, a small current operating loss turns into $2-3 billion in net profit. And Spotify stock should at least double, assuming a still-healthy multiple with its growth runway intact.
The Competitive Problem for SPOT
However the numbers work out, if Spotify winds up dominating music streaming, SPOT is going to rise. We’ve seen with Netflix (NASDAQ:NFLX), even a sell-off of late, what investors will pay for long-term scale and pricing power. If Spotify can find a similar path in music, it, too, can stay elevated for years to come.
The counterargument to that is that Spotify is not Netflix, for a number of reasons. Music is not video: Spotify can’t develop content the way that Netflix does. Scale doesn’t benefit gross margins to the same extent because of royalties. Spotify has to pay artists for every listen, something Netflix doesn’t have to do with licensed content (it usually pays a flat fee) or its own offerings.
The biggest difference is that Netflix seems to have established a huge competitive advantage. Spotify, at least so far, can’t quite say the same thing.
Apple (NASDAQ:AAPL) surpassed Spotify in the U.S. this year. Amazon.com (NASDAQ:AMZN) continues to push Amazon Music Unlimited. Sirius XM Holdings (NASDAQ:SIRI) is acquiring Pandora (NYSE:P). Tencent Music (NYSE:TME) just went public and could prevent Spotify from expanding into Asia.
Spotify likely will turn profitable at some point. But even near the lows, SPOT stock still has a market cap near $20 billion. If it doesn’t wind up winning in streaming music, that figure will fall. Pandora, after all, is selling itself for just $3.5 billion.
SPOT Looks Intriguing
From here, the bull case for Spotify stock actually looks rather intriguing. Even if Pandora seems a disappointment, it’s still selling itself for about $500 per paying subscriber. The same figure would value the Spotify business at roughly $48 billion, and SPOT stock at almost $300 per share.
An acquisition seems potentially likely at some point, whether if Apple wants to expand beyond iOS or if another tech giant wants to expand into streaming music. For instance, could Facebook (NASDAQ:FB) or Alphabet (NASDAQ:GOOGL,GOOG) take a swing?
The competitive risk is one worth watching, particularly given the success of Apple Music. For big upside, Spotify needs to be the winner, not a winner. That seems far from guaranteed.
Still, SPOT is not just some ridiculously overvalued business simply because it’s unprofitable. And the sell-off does make Spotify stock more interesting.
Whether it’s interesting enough depends on whether an investor believes it can fight off the giants – or if it’s doomed to the same struggles that left Pandora no choice but to sell itself.
As of this writing, Vince Martin has no positions in any securities mentioned.