Spotify (SPOT) recently posted its Q2 results, showcasing strong user growth and an unexpected margin expansion. Despite already boasting over 626 million monthly active users (MAUs), Spotify keeps drawing paying subscribers and ad-supported members rapidly. This trend is expected to endure, which, along with Spotify’s pricing strength, is likely to lead to robust revenue growth and snowballing free cash flow. That said, the stock’s valuation appears too richly today. Thus, I am neutral on the stock.
User Growth, Pricing Power Drive Robust Revenue Growth
In Q2, Spotify reported a robust 20% year-over-year increase in revenues, which reached €3.81 billion. On a quarter-over-quarter basis, revenues were up 5%, suggesting generally strong momentum. This uptick was supported by continued user growth and Spotify leveraging its strong pricing power. Let’s take a look.
To begin with, Spotify achieved a 12% year-over-year gain in premium subscribers, totaling 246 million, along with an 8% year-over-year increase in average revenue per user (ARPU) to €4.62. The increase in ARPU was primarily driven by higher pricing. Spotify capitalized on the high switching costs associated with music streaming services, such as the inconvenience of transferring playlists and favorite songs, to drive revenues higher.
The MAU growth and higher pricing combined drove the Premium segment’s revenues by 20% to €3.25 billion. As you can see, the premium side makes up the largest portion of Spotify’s total revenues at about 85%. However, the Ad-Supported side also did well. Its revenues grew by 13% year-over-year to make the remaining €456 million. In this segment, growth was fueled by an increase in impressions sold and higher pricing in music advertising, alongside a rise in podcast advertising revenues.
Unexpected Margin Expansion Shifts the Profitability Narrative
In addition to Spotify’s impressive revenue growth, what truly captured investors’ attention was its surprisingly robust margin expansion. This has shifted the narrative significantly, offering a fresh outlook on the company’s profitability prospects.
Earlier, investors were skeptical about Spotify’s ability to achieve significant profitability. Many, including myself, doubted that margin expansion would be feasible, given that rising royalties—driven by increased listening times as members grew—would likely offset any of the additional revenue brought in. However, Spotify has defied these expectations.
More specifically, Spotify’s gross margin reached a record high of 29.2%, up 510 basis points year-over-year. Management attributed this jump to several factors, including improved profitability in music and podcast segments, favorable revenue costs, and the impact of lapping prior-year charges associated with efficiency actions. However, I think you can sum the gross margin to higher pricing, which drove margins higher.
In any case, this helped Spotify’s operating income for Q2 land at €266 million, implying a 7.0% operating margin, a substantial improvement from the previous year’s 4.6%. Cash from operations in total also came in at a record €492 million, aided by improvements in receivables, which, along with a measly €2 million in capital expenditures, free cash flow reached €490 million.
Strong Outlook, But SPOT Stock Seems Expensive
Moving forward, Spotify’s outlook seems bright, with management expecting further revenue and margin gains. In particular, for Q3, management expects revenues to reach a new record of €4.0 billion as total MAUs are anticipated to grow to 639 million, with paid MAUs reaching 251 million. Further, gross margins are expected to expand further to 30.2%, suggesting continued free cash flow growth.
That said, I find it somewhat hard to be bullish on the stock at its current valuation. Even with Wall Street forecasting free cash flow of €1.81 billion this year, along with a further increase to €2.33 billion next year, these figures still imply price/FCF multiples of 35.7x and 27.7x, respectively. Even if you want to adopt an even more bullish view and assume Spotify beats these estimates, the current and future price/FCF multiples appear too rich to offer extra compelling gains from where the stock is trading today.
Is SPOT Stock a Buy, According to Analysts?
Examining Wall Street’s sentiment on the stock, Spotify Technology has a Strong Buy consensus rating based on 22 Buys, five Holds, and one Sell in the past three months. At $392.80, the average Spotify stock forecast suggests 18.9% upside potential.
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The Takeaway
Spotify’s Q2 results were, without a doubt, impressive, boasting a notable 20% revenue increase and an unexpected margin expansion. The company’s ability to keep adding both premium and ad-supported accounts is commendable, while its record-high gross margins reflect the strong pricing power that its platform commands.
However, the stock’s current valuation complicates the picture. While Spotify’s growth prospects remain strong, the high present and future P/FCF ratios suggest that the stock might be overvalued today. This could potentially limit investors’ total returns, moving forward, which is why I remain neutral on SPOT stock.
