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Spotify upgraded at Wells Fargo as company comes off 'margin probation'

Spotify (SPOT) stock rose more than 2% early Monday after the music streaming giant received an upgrade from Wells Fargo analyst Steve Cahall.

"SPOT's commitment to margin improvement is picking up pace," Cahall wrote in a new note to clients, upgrading shares to Overweight from Equal Weight and increasing his price target to $180 from $121 a share.

Cahall added the company is now off "margin probation," writing: "When we upgraded SPOT to Equal Weight it was predicated on management showing progress against margin targets. ... [We] think SPOT will be break-even in 1Q24."

Investors have remained hyper-focused on Spotify's declining gross margins, which beat expectations of 24.5% in the fourth quarter to reach 25.3%, "due primarily to lower investment spending and broad-based music favorability," the company said.

Spotify guided a Q1 dip in gross margins to 24.9% amid "severance-related charges" after the company laid off 6% of its workforce last month. Gross margins are expected come in between 30% to 35% over the long term amid plans to further scale its podcasting and ads business, Spotify told investors.

London, UK - July 31, 2018: The buttons of the music streaming app Spotify, surrounded by Podcasts, Apple Music, Facebook and other apps on the screen of an iPhone.
London, UK - July 31, 2018: The buttons of the music streaming app Spotify, surrounded by Podcasts, Apple Music, Facebook and other apps on the screen of an iPhone.

In a modest surprise, Spotify company did not raise prices on its U.S.-based premium subscription plan, despite recent hikes at Apple Music (AAPL) and YouTube Premium (GOOGL).

According to Cahall, the possibility of future price hikes in 2023 should help drive margin upside.

"We think investors already expect a '23 price hike. What we think is being missed is that SPOT has held out with the labels for a 'win-win' arrangement, and this has implications," he wrote.

"For example, a price increase could be in conjunction with labels allocating more spend to SPOT's Marketplace. Labels get price increase benefits, SPOT gets Music gross margin benefits. We don't think margin improvement from pricing is in the stock."

Cahall said his firm's new target for Spotify suggests the company reaches a path towards being "sustainably profitable," but notes industry challenges hold him back from being a "perma bull" on the name.

"SPOT is a better business, but not yet a great business," Cahall wrote. "We see the path to our new target as SPOT largely proving it's sustainably profitable."

Spotify stock, which lost more than two-thirds of its value in 2022, has gained roughly 20% since last week's earnings report, which presented a mixed picture with a wider-than-expected loss and a beat on gross margins.

Total monthly active users topped expectations, coming in at 489 million against forecasts for 478 million with both premium and ad-supported subscribers surging past estimates.

"The next era of Spotify is one where we're adding speed plus efficiency — not just growth at all costs," Spotify CEO Daniel Ek said on the company's Q4 earnings call. "That's a big shift...but now we're going to have to live up to that."

Alexandra is a Senior Entertainment and Media Reporter at Yahoo Finance. Follow her on Twitter @alliecanal8193 and email her at alexandra.canal@yahoofinance.com

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