Layoffs Signal Positive Catalyst

Spotify (NYSE:SPOT) made headlines on November 4th when they announced layoffs impacting 17% of their workforce. At first glance, this seems like bad news for investors. But after taking a closer look at their announcement and strategy, we think this could be a pivotal moment that kicks off major growth for Spotify’s stock. We will illustrate this in the following sections.

Comparing Spotify and Netflix

When you compare Spotify and Netflix (NFLX), they have a surprisingly similar number of paying subscribers – around 226 million for Spotify and 223 million for Netflix globally. When freemium ad support users are taken into account, Spotify’s total user base surpasses that of Netflix.

And they charge pretty comparable monthly rates too, with Spotify at $14.99 in the US versus Netflix at $15.49 for their standard plan.

Spotify maintains operating expenses totaling 25.4% of revenues, quite close to Netflix’s operating cost ratio of 19.9% of revenue.

Yet despite having a smaller revenue base (about 40% of Netflix’s), Spotify’s market valuation is dwarfed at just 1/5th the size.

Investors give Netflix a much higher valuation seemingly because of its stronger gross margins. Netflix has a higher gross margin at 42.2%, while Spotify has a lower gross margin at 26.4%.

The belief is that Netflix has way more leverage with film studios, while Spotify lacks bargaining power compared to big music labels. So Netflix can keep more of its revenue as profit. Spotify has had to give a huge chunk of its earnings to the major artists and labels.

Content Costs and Bargaining Power

But we think Spotify’s growing marketplace of podcasts, audiobooks, and less mainstream artists is starting to change the power dynamic. Right now, megastars like Taylor Swift and Joe Rogan capture a ton of the revenue shares. However, as Spotify expands into more content beyond just music’s biggest names, it increases its leverage in negotiations bit by bit.

We’ve already seen gross margins steadily rising in recent years after huge podcast investments in 2022. This signals that the marketplace flywheel is kicking into gear finally.

There’s a good precedent for this with Netflix’s rise too. In the early days, Hollywood had them over a barrel with very little original content on the platform. But fast-forward to today after years of developing their in-house studios and talent, and now A-list movie stars are flocking to work with Netflix.

Premium Subscriber Margin

Spotify compares pretty favorably right now if we just look at premium subscriber gross margins rather than blending in the early-stage ad business. Margins for premium members hit a new high of 29.1%, a 170bps increase over last year, compared to a 42.2% margin, flat growth, at Netflix.

Management specifically called out the increasing profitability of music streaming itself as a key driver, thanks, especially to the growth of Spotify’s marketplace and a focus on other cost efficiencies.

To us, this affirms that the marketplace flywheel is starting to kick into gear. And it shows the potential for further expansion of margins over time if they can keep optimizing the premium subscription business model.

We believe that Spotify’s marketplace has the potential to list the company further through a very similar evolution to that of Netflix. Spotify’s vision has always been about getting more music and artists in front of more listeners. If the company can become the dominant global marketplace connecting those two groups, the leverage dynamics shift hugely in Spotify’s favor over time. Just comes down to the intelligent execution of the vision.

As Wall Street begins to appreciate the secular profit growth story emerging here, we’d expect valuation multiples to steadily re-rate closer to parity with Netflix. Spotify has proven it can drive margin expansion while simultaneously growing subscribers – that’s an alluring combination that big investors will reward handsomely once recognized.

AI Initiatives and Operational Efficiency

On the last earnings call, the management team talked about a few cost-cutting initiatives being driven by the adoption of AI to streamline workflows, improve decision efficiency, and optimize resources. This includes using AI DJ tools and AI voice translation.

The AI DJ tools should allow for more personalized experiences. By increasing user engagement, these tools can help lower customer retention costs. The AI voice translation into other languages expands our addressable market, similar to how YouTube’s transcript translation feature works. This expands the utilities of its products and can further increase profit margins.

…now coming through a personalized DJ for you. I think that nicely scales what AI can do. It can personalize things. It can contextualize things. It can provide this thing at a scale that would be impossible to do by humans…

….the AI voice translation thing is amazing, both for creators and consumers. For consumers, especially in non-English language content, they generally have a lot less content to consume. And for many other creators, this is an ability for them to be able to go with their content through many more geographies that they currently aren’t able to penetrate at all.

Additionally, the management mentioned how the company is leveraging AI and machine learning to improve advertising efficiencies. For instance, using generative AI to automate some of the voice advertisement production could lower those creative costs.

You can use the same voice actor, but instead of producing one or two ads, you can have 1,000 or 10,000 or even 100,000 ads that are individually created to each user that gets to hear this. So there’s lots of possibilities that lowers the barrier to entry for marketers on the ad side using generative AI.

We think the growing use of AI has reduced the use of labor forces and helped Spotify to relocate resources to focus, even though the CEO subtly cited optimizing costs as the primary reason for the layoffs.

“However, we now find ourselves in a very different environment. And despite our efforts to reduce costs this past year, our cost structure for where we need to be is still too big,” added Ek.

Ek noted that a reduction of this size would feel surprisingly large seeing the recent positive earnings report and the company’s performance.

Hence, we don’t think the layoffs signal failed product investments or a pessimistic economic outlook. Rather, this can be seen as Spotify making a strong move to kick off a multi-year expansion of its margins.

Competition risk

We know some investors see companies like Apple or Amazon Music as huge competitive threats to Spotify given they are backed by strong giants. But looking at the numbers over the past few years, Spotify has been gaining ground compared to its tech giant competitors.

Despite Apple’s (AAPL) broader ecosystem of devices and services, Spotify has maintained its dominant market share of music streaming while growing subscribers at a much faster clip than Apple and Amazon (AMZN)of the world.

To us, this signals how strong consumer brand loyalty is for Spotify, even against those formidable challengers. On top of that, management recently noted they were able to implement price increases without much user churn or backlash. That demonstrates pretty solid pricing power too.

So while we’ll keep an eye on subscriber trends, we are just not overly worried about competitive displacement based on the track record so far. Spotify’s execution has been superb as the still undisputed global leader in streaming music.

Gross Margin Risk

There’s a risk to our thesis that Spotify will struggle to expand margins over time if these new podcasts, audiobooks, or other products end up having lower profit profiles that dilute margins overall. We’ll have to closely monitor how gross margins for premium subscriptions and ad-supported tiers trend going forward. If we stop seeing steady margin lift after the initial podcast investment payoff, it could signal challenges monetizing some of these new growth avenues at scale or just hitting a ceiling on music profits. We believe the market potential exists for Spotify to keep widening margins for years to come. But we don’t want to be overly optimistic if the data starts going in the other direction. We’ll watch these key premium user and ad gross margin metrics closely in each earnings report to ensure the profit growth story remains on track.

Valuation

Spotify’s shares are up 49% since we first pounded the table back in April saying this was a buy. Even with that nice run, we still see tons of upside from current levels.

Spotify has a similar number of premium subscribers as Netflix and way more free users than them.

Spotify’s other products like podcasts, audiobooks, and their marketplace also help reduce their reliance on music labels, which has improved their profit margins over time.

The recent 17% layoff and their investments in AI for features like personalized playlists and lyrics translations could also boost earnings quite a bit by increasing margins.

We think Spotify can expand margins like Netflix did as it grew. And with revenue growth rates much higher than Netflix (Spotify user growth was still 26% last quarter!), Spotify should be valued at an even higher multiple given its greater growth potential. Yet its P/S ratio is currently just 2.8x, way under Netflix’s 6.15x. So we believe Spotify’s stock valuation is extremely attractive from a long-term perspective. Applying a valuation multiple of 6x to Spotify’s metrics suggests the potential for its market capitalization to reach $80.8 billion in the long run, implying a future share price of around $402.

However, we’d likely rethink our bullish stance if Spotify struggles to keep growing its user base over time. There’s always some risk that layoffs go too deep and end up damaging customer support or the pace of product innovation. And if bad PR around the cuts causes lots of subscribers to get upset and quit the service, that could certainly slow growth. If user base growth slows down, we would likely become less positive about the stock because it would lower the growth stock valuation.

Conclusion

As the dominant global leader in music streaming, we believe Spotify has carved out an extremely durable competitive position.

And we’re increasingly seeing evidence that Spotify’s profit margins are on track to reach parity with Netflix over time. Growth in marketplace offerings and AI efficiency moves will continue shifting bargaining power and margins higher in Spotify’s favor. Looking closely, Spotify has a similar premium subscriber base as Netflix along with a massive free user pool on top of that.

Yet despite all this, Spotify still trades at just 1/5th the market cap of Netflix. To us, it’s only a matter of time before the market wakes up and awards Spotify a similar premium multiple.

We believe that the layoff made Spotify stock even more appealing, even after it had already increased by 49%. As a result, we are raising our recommendation from Buy to Strong Buy.