Spotify SA (NYSE:SPOT), the European digital music streaming service, has finally come down to earth. I wrote about this in late March last year, showing that SPOT stock was simply too high, especially in a comparison with Sirius XM Holdings (NASDAQ:SIRI).
As of mid-day March 8, Spotify was trading down around 56% at $132.18 from the peak on Nov. 1 at $300.95. And year-to-date (YTD) the stock is down 41%.
In effect, SPOT stock has had a major deflation event. It’s no longer at a huge premium, in terms of price-to-sales (P/S) compared to Sirius XM.
Moreover, the company ended the year with strong results, putting it on a good footing going forward.
Where Things Stand at Spotify
On Feb. 2, Spotify reported impressive results for Q4 and 2021. Its total monthly active users (MAUs) were up 18% during the quarter on a year-over-year (YoY) basis. In addition, its premium subscriber base grew 16% vs. its ad-supported base, which grew 19%. There are now more ad-supported users than premium subscription users, but most of the revenue comes from the latter.
Spotify’s quarterly revenue was up 24% YoY, driven primarily by a 22% growth in premium subscription revenue.
But more importantly, its free cash flow (FCF) is solidly profitable. Spotify is one of the growing numbers of firms that directly report their FCF in their results. It said that Q4 FCF was 103 million EUR, or $114.33 million. That puts it at 3.83% of its 2.689 billion EUR ($2.985 billion) in revenue.
That is not a very high FCF margin, but analysts hope that it will grow exponentially as revenue rises. However, last quarter the company made 99 million EUR in FCF on 2.5 billion EUR in revenue or 3.95%. That means that the FCF margin actually fell during Q4, even though the actual FCF rose slightly.
This year analysts forecast that revenue will rise to $12.66 billion, up 18% over the $10.73 billion in sales during 2021. With this higher sales level, there is a good chance that cash will rise substantially during the year.
Where This Leaves Spotify
For example, let’s assume that the company can double its FCF margin over the next year or so to 7.5%. That would raise the annual FCF to close to $1 billion, (i.e., 0.075 x $12.66b = $950 million).
We can use that to help derive a price for Spotify. For example, a typical 3% FCF yield (for tech stocks) would bring the forecast stock market value to $31.65 billion (i.e., $950m/0.03=$31,650m).
This is 22% over today’s market capitalization of $26 billion. That implies that SPOT stock should be priced at 1.217 x $132.18, or $160.86 per share, i.e., 22% higher than the price of SPOT stock as of March 8.
This is a reasonably good return for SPOT stock owners, especially now that the stock has fallen so far and the company’s outlook is still strong.
Analysts are also positive about the stock as well. For example, Seeking Alpha’s survey of 27 analysts shows that their average price target is $231.03. This implies a potential 75% upside in SPOT stock.
In fact, 25 analysts covered by Refinitiv, as seen on Yahoo! Finance’s site, have an average target of $235.05. That also represents a huge upside of 78% from March 8’s price level.
In other words, analysts are now very positive about the stock, even much more than I am.
What to Do With SPOT Stock
This leaves investors with the feeling that the stock may have fallen too far. Just keep in mind, however, that Spotify is in a very competitive arena.
As one analyst put it, Spotify had to find a business that’s more profitable than music hosting. The reason is that it pays out 2/3rds of revenue to the rights holders. This could be one reason why it is now specializing in podcasts and why it paid up to $200 million for a three-and-a-half-year exclusivity deal with Joe Rogan.
If that investment ends up paying off, despite the controversy and losing some of its existing talent contracts that protested about the Rogan podcasts, investors will be better off.
Investors in SPOT stock should keep their focus on the bottom line. If the company can raise its FCF margins as I have shown, the stock could rise up to 22% over March 8’s price, at $160.86.
On the date of publication, Mark Hake did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.