Spotify stock (NYSE:SPOT) has rallied by 115% over the past year, yet the market is ignoring a major risk attached to the company’s investment case: a continuous lack of meaningful profits with no apparent signs of a turnaround. Despite being the favored music-streaming platform for over 570 million monthly active users, Spotify’s growth is paralleled by increasing losses. This raises concerns about the sustainability of its business model and the stock’s valuation. Consequently, I am bearish on the stock.
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Wall Street is Overlooking Spotify’s Lack of Profits
In my view, Wall Street appears to be overlooking Spotify’s lack of meaningful profits. Moreover, there’s a notable absence of a clear roadmap toward achieving sustainable profit margins. In fact, I would argue that Spotify’s business model is, to some extent, broken. On the one hand, Spotify’s innovative platform enriches the experience for listeners and helps artists grow their audience. On the other hand, narrow profit margins hinder the company’s potential to maximize shareholder value.
At the crux of Spotify’s cost structure are the substantial royalties paid to artists and record labels, significantly chipping away at the company’s revenue and leaving behind meager gross profits. The company’s most recent Q3 results once again underscored this challenge, with Spotify’s gross profit margin reaching a modest 26.4%. While the bulls might point to an improvement from last year’s 24.7%, the reality is that the margin is still far from the level required for meaningful profit generation.
Evidently, when we factor in Spotify’s substantial expenses for R&D, marketing, and administrative costs – a staggering €853 million in the most recent quarter – it becomes apparent that these costs erode almost all of the company’s gross profit of €885 million for the period. Consequently, Spotify essentially broke even, posting an operating profit of just €32 million in Q3. This translates to an unimpressive operating profit margin of 1%, easily susceptible to being wiped out by any inflationary impact on expenditures.
Reaccelerating MAU Growth is Only Half the Picture
One point often raised by optimistic Spotify enthusiasts to explain the recent surge in the stock is the evident acceleration in the company’s monthly active user (MAU) growth. Yet, this perspective seems to capture only part of the story, particularly when considering that the heightened pace of MAU additions hasn’t translated into a corresponding boost in revenue acceleration. Let’s examine.
In Q3, Spotify’s monthly active users (MAUs) came in at 574 million, recording a year-over-year increase of 26%. In particular, Premium MAUs grew by 16% to 226 million, while ad-supported MAUs grew by 32% to 361 million. These growth figures compare to 20%, 13%, and 24%, respectively, in Q3 2022, clearly signaling that there should’ve been a reacceleration in growth. However, revenue growth in Q3-2023 came in at 11%, significantly decelerating from last year’s revenue growth of 21%.
Premium subscriber growth rose by 16%, but revenue from premium subscriptions only increased by 10% due to a 6% decline in average revenue per user (ARPU). The company attributed the decline in ARPU to a tough product and market mix, along with FX headwinds. Spotify also noted that price hikes offset these challenges. Still, this makes me wonder whether these price hikes provoked a negative reaction from users (hence the “challenging product and market mix”). This may explain the higher growth in ad-supported accounts compared to the growth in the premium ones.
Examining Spotify’s ad-supported revenues reveals a less optimistic picture as well. While the company did show a resurgence in ad-supported MAUs), the growth in Ad-Supported revenue slowed down from 19% the previous year to 16%. Additionally, Spotify’s Ad-Supported gross margin stood at 8.3% in Q3. This suggests that considering all other operational expenses associated with the Ad business, such as R&D and marketing, Spotify is likely operating at a loss in the Ad segment.
The Valuation Makes No Sense
Based on Spotify’s persistent challenges in achieving noteworthy profit margins and the evident deceleration in its revenue growth, I find the stock’s current valuation puzzling. This is particularly true following Spotify’s prolonged rally in recent months.
To begin with, Spotify’s EPS for the current year is expected to be negative, mainly attributable to significant losses incurred in the first half of the year. But even when considering Wall Street’s forward estimates, the valuation remains rather inflated.
To elaborate, projections indicate Spotify is anticipated to report EPS of $1.26 in FY2024, implying a forward P/E of approximately 139x. Despite any optimistic scenarios in which earnings might escalate rapidly, a prospect I find dubious given the ongoing deceleration in revenues, I struggle to perceive how this valuation multiple is reasonable by any means.
Is SPOT Stock a Buy, According to Analysts?
Regarding Wall Street’s view on the stock, Spotify Technology has sustained a Moderate Buy consensus rating based on 16 Buys and nine Holds assigned in the past three months. At $188.39, the average Spotify stock forecast suggests 7% upside potential.
If you’re wondering which analyst you should follow if you want to buy and sell SPOT stock, the most profitable analyst covering the stock (on a one-year timeframe) is Mark Mahaney from Evercore ISI, with an average return of 32.79% per rating and a 67% success rate.
The Takeaway
While Spotify’s stock has experienced a remarkable surge, the market seems to overlook the critical issue of sustained profitability. The company faces challenges stemming from slim profit margins, hefty royalties, and hefty operational costs, which make me doubt its business model’s viability.
Further, despite an uptick in MAUs, revenue growth deceleration and questionable pricing strategies contribute to skepticism. Simultaneously, the stock’s current forward valuation appears disproportionately high, given the persistent hurdles in achieving substantial profits. Considering these concerns, I believe that a cautious stance towards Spotify’s investment case is warranted. Therefore, I remain bearish on the stock.
