- Alphabet (GOOG, GOOGL) has said it will allow Spotify (SPOT) to offer its own billing in a new Spotify Android app.
- That should increase Spotify’s revenue and significantly enhance or leverage Spotify’s free cash flow growth (FCF) outlook.
- Growth investors will find that SPOT stock is now much more attractive as its value is higher.
On March 23, Spotify (NYSE:SPOT) won the right from Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) to direct bill its subscriptions in a new Android app. This will have a great result on the company and could push SPOT stock significantly higher.
The reason is that it will have a leveraged effect on Spotify’s free cash flow (FCF) as well as the value of SPOT stock. The marginal increase will flow straight down to FCF, pushing it much higher than the increase in revenue. In financial analysis, this is called operating leverage. This article will describe how that effect will play out.
| SPOT | Spotify | $146.04 |
How the Deal Will Have a Leveraged Effect
Let’s look at a practical example. As I explained in my last article on Spotify, the company made 103 million EUR ($114.33 million) in FCF on revenue of 2.689 billion EUR ($2.985 billion). That works out to a 3.83% margin. Moreover, analysts now expect Spotify to make $12.18 billion in revenue this year.
I estimate that the company will naturally have a 50% higher FCF margin this year than in the fourth quarter, so its FCF margin will rise to 5.75% from 3.83%. That puts its forecast for 2022 FCF at $736.6 million.
But now we can factor in an increase due to a higher take rate split with Alphabet. Normally, Google Play normally takes 30% of the Spotify subscription revenue gained from its downloads. I estimate (not knowing for sure) that the new split is probably now close to 80/20 (Spotify to Google Play).
So, if we assume that at least half of its revenue flows through Google Play, the increase in revenue will be 14.286% higher. That is because its 80% “take rate” is now 10 percentage points higher than the previous 70% take rate (i.e., .10/0.70=.14286).
Therefore, the revenue gain to Spotify is 14.286% of 50% higher (the portion of Google Play to total revenue): 14.286% x 50% x $12.81 billion in estimated 2022 revenue. The works out to: 7.1432% x $12.81 billion, or $915 million.
Here is where the operating leverage comes in. The $915 million gain in revenue is just 7.14% but it has virtually no cost, or maybe a little, let’s say 20% cost. This leads to a $732 million gain to the previous $736.6 million FCF forecast, or +99.4%. But the revenue gain was +7.14%. So you see the operating leverage here: a 7% gain in revenue leads to a 100% gain in FCF.
What This Means for SPOT Stock
So going forward we can now forecast a doubling in FCF to $1.469 billion (i.e., $736.6 million + $732 million). We can use that to value SPOT stock.
For example, in my last article, I used a 3% FCF yield metric to value the stock. This is also the mathematical same as multiplying FCF by 33.33 (i.e. 1/.03 = 33.33).
Therefore our new estimate for SPOT stock is this: 33.33 x $1.469 billion = $48.96 billion. That target market capitalization is 74% higher than the company’s existing $28.136 billion market cap, according to Yahoo Finance.
That also implies that SPOT stock is worth 74% more than its price as of Friday, March 25 ($146.04). That puts the target price per share at $254.11.
This is also close to other analysts’ target prices. For example, Refinitiv (Yahoo Finance) analyst surveys of 26 analysts is an average of $236.15 per share. In addition, TipRanks reports that the average of 23 analysts who have written on SPOT stock in the last three months is $242.91 per share. That is 66.3% over today’s price and is close to my $254.11, 75% higher price target.
As a result growth investors will be very pleased with this new Google Play deal, especially if it leads to a higher take rate for Spotify. The result will have an outsized or leveraged effect on Spotify’s forecast free cash flow, and hence its target value.
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.
