Stock splits have been in vogue lately. Big tech companies like Amazon, Alphabet, NvidiaAnd Tesla have split their shares after seeing their stock prices reach nearly $1,000 or more. This financial engineering tactic hasn’t changed the underlying business of these stocks, but it may make it easier for individual investors to buy a single stock.
One potential candidate for a stock split is Spotify (NYSE: SPOT). The audio streaming leader is up more than 500% since the start of 2023 and the stock is now approaching $500 per share, or stock split territory. Here’s why the stock has made a huge turnaround and whether you should buy shares of Spotify after the big gains.
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Many investors will know Spotify because it is one of the most popular music and podcast streaming services in the world. With 640 million monthly active users (MAUs), perhaps only YouTube has a greater reach around the world in this niche.
Spotify mainly makes money by selling commercial-free music through a subscription service. Premium subscription revenue has grown consistently since Spotify’s IPO in 2018, growing 24% on a currency-neutral basis last quarter. In US dollars, the segment is approaching $15 billion in annual subscription revenue.
Investors were never concerned about Spotify’s revenue growth. The problems were around profitability. In the third quarter of 2023, Spotify’s gross margin was a paltry 26.4%, not much higher than when it went public. The operating margin was only 1.0% and had been negative for many quarters before that. A year later, the story has completely changed. Gross profit margin was 31.1% in Q3 2024, while operating margin exploded to 11.4%.
Spotify was able to do this for a number of reasons. First, the company has reduced the number of full-time employees; the number of employees has decreased by more than 20% in the past year, while no effect on turnover growth was observed. Second, the company is seeing increased revenue from its high-margin promotional marketplace, leading to gross margin expansion. Third, the company has started raising prices for its subscription services, which – along with declining employee numbers – has led to double-digit operating leverage and operating margins.
Given the stock’s rally and the platform’s 640 million MAUs, investors may worry that Spotify will soon reach user saturation. This may be true in the most mature markets such as the Scandinavian countries (the first market the country entered), but in most countries in the world this is far from the case. Internet penetration in countries like India, Indonesia and Latin America will continue to grow in the coming years, which should lead to more MAU profits for Spotify.
You can see it in the company’s geographic user analysis. The ‘Rest of World’ segment – everywhere except America and Europe – represented 19% of total users in 2020. Last quarter it reached 33% of MAUs, which amounts to over 200 million MAUs. There are billions of potential customers in these countries, even if you exclude places like China, where Spotify doesn’t operate.
But will Spotify be able to monetize these users? They don’t have the wealth or income to pay the same subscription fees as a country like the United States, but it seems like there are people in most countries in the world who are willing to pay for commercial-free listening. Premium subscribers grew 12% year-over-year last quarter, which was faster than MAU growth.
In addition to new premium users, Spotify should be able to raise prices consistently in more mature markets. Prices in the United States have increased twice in the past two years, with minimal effect on churn rates. This indicates there is room for management to continue raising prices over the next decade, especially if the company continues to add new features like audiobooks to increase the value of a Spotify subscription.
Spotify might decide to split its stock in the future, but if you’re considering buying shares in anticipation of a split, here’s the candid truth: a stock split is pointless in the long run. Of course, a stock may rise in the lead-up to a stock split, but this has no impact on how the underlying company performs.
But earnings per share (EPS) and cash flow growth are important factors in a stock’s long-term return. Spotify’s free cash flow is rising to record highs as a result of the cost cuts, reaching approximately $2 billion in the last twelve months. The stock has a market cap of about $95 billion at the time of writing, meaning it’s trading at 48 times its free cash flow. And the valuation ratio rises even higher to almost 130 when we look at rolling earnings per share.
While Spotify has solid growth prospects over the next decade, this is an expensive stock after its incredible two-year rally. I recommend keeping this one on your watchlist.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, a director at Alphabet, is a member of The Motley Fool’s board of directors. Brett Schafer has positions in Alphabet, Amazon and Spotify Technology. The Motley Fool holds positions in and recommends Alphabet, Amazon, Nvidia, Spotify Technology and Tesla. The Motley Fool has a disclosure policy.
Stock-Split Watch: 1 Under-the-Radar Growth, Stocks Up 510% Since Early 2023 Originally published by The Motley Fool
