Investors Are Overreacting to Spotify's Guidance

Paid music-streaming leader Spotify (SPOT -4.62%) reported third-quarter results this morning. The company added 4 million premium subscribers during the period, bringing its total premium subscriber base to 87 million. Spotify remains the largest paid music-streaming service in the world. (Tencent Music has more total users, but less than 25 million paid subscribers.) Spotify now has 191 million total monthly active users (MAUs).

While the results were solid, investors were rattled by the Swedish company's guidance.

Spotify CEO Daniel Ek. Image source: Spotify.

Inadvertent margin expansion

Revenue in the third quarter jumped 31% to 1.35 million euros ($1.54 billion), with premium subscriptions naturally representing the bulk of that top line (nearly 90%). Average revenue per user (ARPU) continues to fall, which has been an ongoing trend, as subscribers are increasingly choosing family and student plans. Spotify has highlighted the strong retention of these plans, though -- churn declined 90 basis points from a year ago -- making it worth the ARPU sacrifice.

Operating expenses were 348 million euros ($397 million), leading to an operating loss of 6 million euros ($6.8 million). That loss is much narrower than expected, which Spotify actually considered a negative development. The company said the operating margin improvement was "largely due to shortfalls in hiring." Spotify is keenly aware that it needs to continue investing heavily in the business to remain competitive, and plans to accelerate the pace of these investments (mostly R&D and content) next year. Over 40% of new hires are related to R&D.

Spotify was actually profitable thanks to a tax benefit related to a mark to market adjustment regarding the value of Spotify's stake in Tencent Music. Net income was 43 million euros ($49 million), or 0.23 euros per share ($0.26 per share).

Overreacting to guidance

The real kicker, at least as far as the market's reaction is concerned, was guidance. Spotify walked back its guidance on premium subscribers modestly, but after raising its full-year subscriber forecast last quarter. In other words, Spotify is simply going back to its initial guidance provided in May.

Data source: SEC filings.

The tweaks to Spotify's subscriber outlook are very modest. Spotify's financial guidance actually improved, largely attributable to the aforementioned "shortfalls in hiring," which the company says have continued into the fourth quarter. The company had previously expected to post an operating loss of 20 million to 100 million euros ($22.8 million to $114.1 million) in the fourth quarter, but now believes it could post an operating loss of 35 million euros to an operating profit of 15 million euros (loss of $39.9 million to profit of $17.1 million).

Revenue outlook is unchanged at 1.35 billion to 1.55 billion euros ($1.54 billion to $1.77 billion). However, gross margin is going to take a hit of 50 basis points due to a new promotion announced yesterday in which Spotify is giving family plan account holders a free Google Home Mini, valid through the end of the year. Spotify prioritizing subscriber and revenue growth over profitability is still the right call for now.