Spotify Technology (NYSE: SPOT) reported strong earnings last week. Paying subscribers increased by 14%, monthly active users rose 19%, and revenue gained 20% year over year. Perhaps best of all, Spotify reported an operating profit for the quarter -- only 4.6%, but still better than last year's negative margins. And free cash flow (FCF) roughly quadrupled to $207 million.
So it's probably no great surprise that J.P. Morgan urged investors to buy Spotify stock on Wednesday, predicting the stock will go to $365.
Is Spotify stock a buy?
The investment bank had nothing but kind words for the streaming music company this week, citing growth trends in the music, marketplace, and advertising segments. It also praised Spotify for getting its costs under control, "helping to drive significant operating income growth," as The Fly noted Wednesday.
Best of all, though, was the improvement in free cash flow, which the bank thinks will be "significant" in Spotify's "Year of Monetization." But this raises a question for investors: Spotify grew quickly, and made a lot of money last quarter. But how fast must it keep growing to justify J.P. Morgan's $365 target price?
Assuming a fair price for Spotify would equal a price-to-FCF-to-growth ratio of 1, let's run the numbers: The $365 target price times roughly 200 million shares equals $73 billion -- that's the "price." Free cash flow for the last 12 months was $888 million. Thus, for a ratio of 1 I'd want to see Spotify growing free cash flow at 82% annually to justify J.P. Morgan's target price.
Now, the good news is that Spotify beat that growth rate, growing FCF 263% in the first quarter of 2024. The bad news is that this hypergrowth rate won't last forever. Analysts, on average, expect Spotify to grow profits at closer to 38% annually over the next five years.
I'm not saying Spotify can't exceed that growth projection. But until it proves it can, and that Q1's growth rate was no fluke, I won't be a buyer of Spotify stock.
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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Rich Smith has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase and Spotify Technology. The Motley Fool has a disclosure policy.
