In this episode of Industry Focus: Tech, Dylan Lewis and Motley Fool analyst Brian Feroldi take a deep dive into Pinterest (NYSE:PINS) and Spotify (NYSE:SPOT) and go through their recent earnings results. They discuss their subscriber numbers, ad-based and subscription revenue model to understand the recent performance of these stocks. Discover how they are growing their business for the future, what management is saying and much more.

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This video was recorded on October 30, 2020.

Dylan Lewis: It's Friday, October 30th, and we're talking about recent results from Pinterest and Spotify. I'm your host Dylan Lewis, and I'm joined by Fool.com's permanent pinner of pre-published positivity, Brian Feroldi. Can you unpack that a little bit, pinner of pre-published positivity?

Brian Feroldi: Sure. Pinterest, you said you liked how I worked Snapchat [Snap][laughs] into my title last week, tried to do the same thing this week, Dylan. Everything I do here is just to make Dylan Lewis happy.

Lewis: [laughs] Our listeners can't see it, but I'm grinning ear-to-ear; I always enjoy that part of the show. And I love it when we can sync up with what we're going to be talking about. The focus of today's show is going to be earnings results from Pinterest and Spotify. Anyone who listens to the show knows that Brian is Mr. Pinterest. He's been following this basically since the stock debuted, and has enjoyed some pretty nice returns, [laughs] as a result of that.

Before we get into the earning releases though, Brian, I feel like -- just due the nature of our show, we should probably touch on the fact that things are not going particularly well in the market today; I don't know about you, but I think my portfolio is down about 4.5%.

Feroldi: I haven't checked my portfolio; I would assume it would be down somewhere similar. And, Dylan, who could have possibly predicted that there will be volatility leading into an election? I mean, who could have seen that coming?

Lewis: [laughs] Yeah, I think the only certainty we have is that there's uncertainty. I think that's got to be kind of the MO for the next couple of weeks, and that is why we are emphasizing the long-term focus. If you're one of the lucky people that didn't wind up with some major red today, you know, for the week, the market is down a little bit. But I think it's important, even in a year with a pandemic, with an economic screech to everything that's happening, the market is still basically flat, which is pretty unbelievable.

Feroldi: Yeah, the S&P 500 is up about 2.5% for the year, if you include dividends; the Dow Jones is down about 6%, if you include dividends; the Nasdaq though, saving the day, up [laughs] 27% even after this week. So, depending on what index you're invested in, you're either extremely happy or treading water; either way, given what's happened in the state of the world, that's not that bad of an outcome.

Lewis: It's not. And I'm assuming that a lot of the listeners to the show are Fool members and Fool followers and probably people that lean a little bit more tech and have been able to probably outperform the market this year. I know I have with my portfolio, thankfully, because I'm more focused in the tech sector; just what I know better. But a lot of the businesses that we tend to focus on have actually performed incredibly well this year, because they are very physically light, they are digital delivery.

And I guess that might be the perfect tee-up to a company like Pinterest, Brian, [laughs] who, I think has performed pretty well; I think that's a safe way to put their 2020 returns. Does that feel right to you?

Feroldi: Yeah, this stock has really caught fire in 2020. It had kind of a rough initial rookie year. And during the depths of the March decline this stock was down to, I believe, around $10/share, really, in my opinion, undervalued. The company has since come roaring back. It is now a 6-bagger [laughs] off its low, currently trading for about $60/share. And as we dig into the numbers for the quarter, I think people will understand why.

Lewis: Yeah, a lot of positive stuff here. And I think what's encouraging is, one of the big question marks from me, looking at Pinterest was, OK, are they going to be able to bring more people on to the platform? You know, this is in a lot of ways, it's kind of an older social media company, it's not like something that just came out of nowhere like TikTok over the last couple of years, Pinterest has been around for a little while, and there was a little bit of concern, for me, that they, kind of, have the audience that they're going to have. And what we see, and what we've seen over the last couple of quarters, but we definitely continue to see this quarter is, that's not the case, they're still adding users.

Feroldi: That's a completely fair, I would think, worry about this company that they have a niche offering, there's a lot of people that do not use Pinterest for whatever reason; this company was really on my radar because of my wife, she was just been in love with Pinterest for years and years and years, ever since she first discovered it. And I know that all of her friends also are regular Pinterest users. And we saw that shine through with some of the numbers. So, the company grew its user base this quarter 37% year-over-year to 442 million. That included 13% growth in the U.S., its most mature market, to 98 million users. International growth is really the star of the show, up 46% on a year-over-year basis to 343 million. So, yeah, that's almost 100 million users in the U.S., Dylan.

Lewis: And that's impressive. I mean, we've talked about this so many times in the show with the different ad-based businesses, but those North American users are crucial, because the Average Revenue Per User that they're able to command, because of the ad market in the United States is just so outsized compared to the rest of the world. You want to see growth everywhere, but if you can continue to build momentum in the U.S., that's going to be really great when it comes to actually monetizing the audience and having that flow through to your financials.

Feroldi: And we saw exactly that. So, again, the metric here that we're going to talk about is ARPU, Average Revenue Per User, this is a key metric to look at with any subscription or even ad-based business. So, Pinterest's ARPU this quarter grew 15% to $1.03 globally, but as you pointed out, that number is bifurcated based on the U.S. and international. The U.S. is the dominant portion of revenue now. They got $3.85 per user in the U.S., but only $0.21 internationally. But still, when you add that to the strength of their user growth, this company put up 58% revenue growth to $443 million, for comparisons, the markets were expecting $383 million, so they just crushed it on the top end. And their own guidance was only calling for 35% growth. So, they really knocked the cover off the ball this quarter.

Lewis: Yeah, those are great numbers. And I think what is encouraging to me is they are so, so early in the monetization efforts for this platform. The international segment was basically a rounding error for a while, they weren't even really considering their advertising efforts there too seriously. And what's kind of cool about a company like Pinterest is, as a consumer you can see it first-hand, you can really look at what they're doing in terms of ad load and see that there's probably room for more, and that's where you start getting those guidance numbers in the 30% range. And one of the easiest things, if you're just looking, kind of, for a visual test is, go to a platform like Facebook, go to a platform like Twitter, look at the ad load that you're being given, and then spend some time on Pinterest and compare. You're probably going to find that you're getting way more ad impressions on the likes of Facebook than you are Pinterest. There's a certain point where they're going to make some user experience decisions around that, but it also means that they're going to be able to increase the number of ads people are seeing. If those ads are effective, the prices for those ads are going to go up, all that translates into more money for Pinterest.

Feroldi: I think that's exactly right. And the other thing that I was particularly excited about on the user front was, Pinterest said that they saw a particular user strength from people that are aged 25 and younger, and they said that this has been happening for a couple of quarters. What's interesting is they pointed out that the iOS 14 update drove more than [laughs] 4 million incremental users as people would go to Pinterest to find new backgrounds or customized backgrounds for their phone. So, I think it's wonderful that the Pinterest platform is having particular appeal with those under age 25; that's something that companies like Facebook, for example, are struggling with.

Lewis: And we typically see that called the Snapchat generation, [laughs] so it's interesting that Pinterest is hopping in there as one of those, kind of, older social media businesses. We often think, OK, that's Snapchat and that's TikTok's domain.

Feroldi: Yep, and Pinterest is clearly exceeding there. Now, for those that have been following me at all, you know that the next thing I always look at with revenue is gross margin, and I am happy to report in this case that higher revenue translated into 440 basis points of increased in this company's gross margin, it's now topping out at near 75%; that's a very healthy number.

Lewis: That's an impressive number. I worry we shouldn't get used to that kind of expansion, that kind of growth. At a certain point when you're getting into the 70%s, you only have so much room there, but if they can consistently be around that point, Brian, that's a very healthy margin to be working with.

Feroldi: And it gives them plenty of space to continue to invest in their employees, in their suppliers, and still show outsized growth on the bottom-line; we saw exactly that during the quarter. So, while their revenue grew 58%, their GAAP expenses only grew 31%. And that includes a healthy amount of stock-based compensation as well as the company's decision to terminate one of its big leases as a result of more of its workers working remotely. So, on a non-GAAP basis their expenses only grew 27%, so when you combine 58% revenue growth, gross margin expansion, and only 27% expense growth, we saw their bottom-line just sore. $87 million in non-GAAP net income this quarter; that was a 20% margin, huge growth.

Lewis: Huge growth, and more topline growth to come based on what management is saying about this business. You always have to, kind of, pause and tense up a little bit when you start talking about guidance with everything that we've got going on right now. This is a case where the guidance looks really good for the business, you don't have to worry too much.

Feroldi: They're guiding for revenue growth in the upcoming quarter to be 60%; that would be an acceleration from the growth that they saw this quarter, and the guidance on Wall Street was only for 35%. So, when you tick through everything we just talked about, it's understandable why this stock soared [laughs] 28% on the day that the report was announced.

Lewis: Yeah, those are stellar numbers, [laughs] and I can understand the market's reaction. This is kind of an interesting company, Brian, because it is, in terms of platform, established, you know, I think it passes the snap test of, if it disappeared, people would notice. And it's a big enough player, it has a critical enough base of users that it's cemented its spot in social media. The financials and all the monetization efforts, for whatever reason, just didn't happen up until the last couple of years, and so you're able to take this playbook of ad-based monetization on social media, that we have seen work so many times and apply it to a business that is already fairly established and seems to be somewhat insulated from a lot of competitive pressures that we've seen other social media platforms fall to.

Feroldi: Yeah, that's one of the reasons I like this company, as we've noted numerous times, it does stand out from the others, in that, people don't go there to chat or, you know, there's no hate speech issues here, people go to Pinterest for inspiration and it's a positive platform. The other thing that I like about this is that Pinterest is spending their money in ways that I really approve of, they're really doing everything they can to make their platforms even more useful for creators and, importantly, advertisers. So, for example, this quarter they launched a new automatic bidding feature for ads that allows their small- and medium-sized businesses, for example, to quickly have automatic bids on ad spots on their platform. Within just 90 days they said that more than half [laughs] of their conversion revenue came from this automatic bidding program. They're also rolling out new features that are specifically designed for merchants to have storefronts on there to make shopping easier, all these things are combining to make Pinterest a very attractive place to advertise.

Lewis: Yeah, and those movements, Brian, create a lot more growth potential for their ad business. What one thing that we have seen as a lot of these different players, whether it's Facebook or Snap or Twitter, start rolling out advertising solutions that scale a little bit better is, it can do some funky things to the ad revenue dynamics. What it winds up generally doing is dramatically increasing the number of impressions, what it can also do is drive down the cost of those impressions. And so, what you're doing when you're setting yourself up for saying it's programmatic or more of an auction-based system that scales really well is saying, we're going to bring in a ton of players, we're going to create a lot of volume, and then over time they are going to see the ROI and the numbers are going to, kind of, work themselves out. And so, as they go through this process, you might see some funkiness with some of their numbers. But long-term, if they're trying to dramatically expand ARPU, and there's a lot of room for them to do that, that is the step that they need to take.

Feroldi: And they know that, and that's what to me is so exciting about this business. Pinterest's management team knows that there's a lot of room for them to grow that ARPU, they're investing now to do that. And they also believe that there's big room for them to grow in international business, they said that they've recently opened up new sales offices in Western Europe where they're seeing a lot of success, for example.

But to give you a sense of how much room there could be for them to grow. So, this quarter, globally, Pinterest Average Revenue Per User was $1.03. For comparison, Facebook was $7.89. Twitter was $4.32. And Snapchat was $2.73. I think that in a couple years, Pinterest will be in at least second place on this list.

Lewis: Yeah. If you're saying, OK, they're going to become their worst peer in terms of ARPU; that's still basically them sitting on a double in terms of their monetization efforts.

Feroldi: Correct. Not to mention whatever kind of user growth they get on top of that. And I could also see gross margin continuing to shoot a little bit higher over time as they continue to scale. So, I think that the good times are here to stay for Pinterest.

Lewis: I like that; I like that, Brian. You know, positive company, positive take on a business, positive all around. Like, what's wrong with that?

Feroldi: That's exactly right. That's why I'm Mr. permanent pinner of pre-published positivity today, Dylan.

Lewis: [laughs] Even you can say it. See, it's not challenging enough, Brian. If we can both get it out cleanly, I think you need to try a little bit harder. [laughs]

Feroldi: Obviously, the answer there is yes, and I do need help, so please send me direct messages on Twitter.

Lewis: @BrianFeroldi. I'm really setting myself up for a whooping, I know one day you're going to come at me with something that I simply cannot handle, and I will have asked for it, I think it's fair to say, at that point. [laughs]

Feroldi: We can only dream, Dylan.

Lewis: The second story I want to talk about, Brian, is earnings from Spotify. The company posted $2.3 billion in revenue in its most recent quarter, up 23% year-over-year. Probably a little bit of a relief for people that have been following this business, because it was a company that got bit a little bit earlier in the year with some slowing growth; that year-over-year revenue number had dipped down to about 12% in Q2 of 2020. It seems like the growth story is back on track here with this business.

Feroldi: Yeah, particularly, they're growing their monthly average users very nicely. So, for this quarter their total monthly average users were up 29% year-over-year to 320 million, of those, importantly, the number that are actually paying subscribers, that grew 27% to 144 million. So, while that did translate into 23% revenue growth, that did come in a little bit shy of what Wall Street was estimating. So, this stock, unlike Pinterest, actually fell about 8% when they announced earnings.

Lewis: Also, unlike Pinterest, Brian, slightly different gross margin profile for this company. 75% is not something that everyone gets to enjoy, in Spotify's case, it's about a third of that.

Feroldi: Yeah, this is a company with a gross margin of 24.8%, so that is in another world than what a company like Pinterest or Facebook is. And I was disappointed that even when you dig into that number a little bit more, their premium subscribers, their gross margin on that business is still only 27%. Their ad-supported business was 0.06% gross margin. So, for the quarter they were basically breakeven on a gross margin basis on their ad-supported customers. The story here is to really get as many of those ad-supported customers to become premium customers as soon as possible.

Lewis: Yeah, I think the ad-supported business is effectively a loss leader for them or, you know, a way to get people in the door and then create such a good experience that they upsell into those paid models. And what's unfortunate with a company like Spotify -- fortunate/unfortunate, I guess, depending on what part of the music industry you're in -- they have to pay out such a large chunk of their revenue as royalties, it's a sizable amount of money. And what we've seen them do over the last couple of years is start investing in operations that get them outside of being so beholden to that with their financials. And so, that has looked like them acquiring a bunch of podcast properties, that has looked like them slowly creating dynamic ad-tech that they are able to layer into their online exclusives, all of those things point to them possibly being able to have more control over that gross margin figure in the future, but until that's a really big part of the business, basically it's going to be dictated by music royalties and there's not going to be a lot of expansion there.

Feroldi: Yeah, one would hope that this company's move into the podcasting world, over time, can gradually help that [laughs] gross margin number to get up, but when you're working with a 25% gross margin versus, again, some other ad companies are much, much, much higher, it's so much harder to drive profitability. Now, on the good side, they were actually able to generate a whole bunch of free cash flow during this quarter, $103 million, however, that's just a cash flow basis. When you look at the expenses of this company, operating expenses actually grew 37% this quarter. As a reminder, revenue grew 23%, so that's operating leverage working in the wrong direction. As a result of that, the bottom-line results were not pretty, also coming up short of expectations.

Lewis: Yeah, and this company, you know, I don't think anyone is expecting them to be profitable anytime soon, but they are losing money both on the bottom-line and when it comes to their operating income. And that just makes it harder. They are pretty aggressively investing in R&D and SG&A; those are kind of the two big line items that are taking away from the money that's coming in. And to some extent, they kind of have to do that, because they're in a spot where they are the pureplay in a spot where all of these other companies offer the same service as a nice-to-have add-on. And, [laughs] you know, when you're going up against the likes of Apple and Amazon, they have a lot of cash to throw around, the R&D budget for Spotify is a lot smaller than that [laughs] for the other two.

Feroldi: Yeah, I think you're exactly right there. And it's going to be hard for them to compete in the music business. So, to combat that, they are investing in their podcast, and they did note that they have launched or acquired a number of really great hit podcasts this year. So, they just launched the Michelle Obama Podcast that became the No. 1 show globally on the company's platform in a matter of months. The Joe Rogan Experience is now exclusively on their platform, that is also the No. 1 show in their English-speaking markets. They've also have a number of other podcasts that they've launched that are going to grow and be very pop with users. So, that is the long-term strategy. I do see that as a differentiator for this company, but it's going to take them a while to really establish that business.

Lewis: Brian, in that rundown you left off perhaps the most important podcast.

Feroldi: I did, didn't I? [laughs]

Lewis: [laughs] Industry Focus, of course, available on Spotify, though maybe not to the same acclaim as some of the other shows you mentioned, but you know, we can pretend. [laughs]

Feroldi: [laughs] It's obviously going to be Industry Focus and then the Joe Rogan Experience in just a couple of years, Dylan.

Lewis: [laughs] We can dream. Yeah, I think that there are some really interesting things going on with this business. In addition to all the podcasts that we've talked about, we've kind of been following that story for a while, and I think it's a natural progression for them. I'm not a shareholder, but I'm rooting for them to pull this off, because I think this is a business that creates really wonderful user experiences, and just a company that I'm rooting for, because I'm a user of.

But one thing that I'm kind of curious to watch in the coming quarters is, based on this comment that Daniel Ek dropped in the conference call talking a little bit about pricing power, and this question came up about, you know, is there going to be some effort to increase your subscription prices over time? And Ek said, our primary focus remains user growth based on maturity in certain markets and the increasing value-per-hour to our subscribers, including, of course, enhanced content. We see engagement, and more specifically, value-per-hour grow substantially over these last few years. And I believe, an increase in value-per-hour is the most reliable signal we have in determining when we're able to use price as a lever to grow our business. And so, they go on to say basically that, it's still early, there are some initial results that indicate, based on some tests that when they have increased prices, users believe that Spotify is still an exceptional value, and that's really what you want to see.

You know, if we rewind the clock a couple of years, Brian, and look at a company like Netflix deciding to start increasing their monthly prices, I think everyone that followed that stock, [laughs] kind of, crossed their fingers and waited to see what would happen with their user numbers. They were able to pull it off because the value proposition was there, they were able to create all these awesome originals that kept people in there. It's a tough question for Spotify, because it seems like they're offering access to a commodity, and that's basically music, they aren't allowed to gatekept songs or albums on any music services that are exclusive to those services. With all these other things that Spotify is bundling in, it seems like they're creating a unique experience and that eventually should become something that they can try to raise prices on.

Feroldi: Yeah, they're essentially trying to become the Netflix of audio. And I'm sure they have the data that shows them that. They are right now, I'm sure, pricing their product at a very low price to get as many people into their paying prices as possible. If they can do that, and if you get used to it, I could easily see them adding a $1 or $2 on to the price every single year, and if they can do that, gross margin would certainly go up, and the financials would look drastically different than they do today. That's also a strategy that Disney is following today with Disney+. If you look at the cost of Disney+, I think it's like $60/year, I mean, that is dramatically lower than the price of Netflix, and I think it's one reason why they have blown out their subscriber numbers this year. There's no doubt in my mind that Disney is going to raise its Disney+ price each and every year for, say, the next five, +10 years. If Spotify could do the same thing, there's lots of room for its stock to grow.

Lewis: Yeah, and there's a good reason for them to adopt that strategy. You know, we go back to those user numbers that we threw out there earlier, Brian, they're very low, you know, they're in the hundreds of millions. But if you think about the global music streaming audience and the potential there, it's scratching the surface. And I think that they are probably rightly looking at this market, and saying, we are in huge greenfield space right now and we need to bring as many people on this platform as we possibly can, because if we can get them here, we're going to probably have them as customers for, like, the next 15 years.

Feroldi: I think that's exactly right, and if you look at their guidance for the upcoming quarter, they are saying that they believe they're going to get to about 340- to 345 million monthly active users, they think that about half of them are going to become and paying subscribers, and that's going to give them some decent revenue growth. They're also calling for their gross margin to be stable to actually expanding, the midpoint of their guidance says that they're going to gain some basis points in their gross margin. If they can grow and if they can continue to raise prices and expand their gross margin, there is certainly a bull case to be had here.

Lewis: Yeah, I think that this is a business that probably is bigger in two to three years than it is now. It isn't as easy as a lot of the software companies that we look at, Brian, where they throw off 60%, 70%, 80% gross margins, they have these ridiculous dollar-based net expansion numbers or retention numbers. It's a little bit trickier, because it's a more competitive space and the financials aren't as appealing, but people have been very successful in buying companies that deliver an awesome user experience, I think Spotify is one of those businesses.

Feroldi: I'm not a user, so I can't speak to it the same way that you can, but I trust your opinion there. But to me, my problem with Spotify is that I have a hard time seeing audio companies work out. I would much rather invest my money into video companies, such as Disney, such as Netflix, but this is a business I certainly wouldn't bet against.

Lewis: Yeah. So, don't hold that judgment against us Spotify, [laughs] when it comes to the podcast rankings. Just ignore everything Brian Feroldi said there at the end. [laughs]

Feroldi: [laughs] Come on, Tim Sparks come through for us.

Lewis: Maybe we'll channel the power of editing, maybe we won't, who knows, we'll see, that's the beauty of this. We're going to ship this off to Tim, and he can decide what ultimately makes it into the episode, and I love the mystery and the fun of that. I also love chatting with you, Brian, thank you so much for hopping on today's show and talking Pinterest and Spotify with me.

Feroldi: Anytime, Happy Trick-or-Treating, Dylan!

Lewis: Happy Trick-or-Treating. What's the plan with the kids this year? You have several young kids, how are you approaching Halloween?

Feroldi: We are approaching it the same way we always approach Halloween; we'll be dressing up, we'll be keeping our distance. And if a household is giving out candy, we will be taking it. To me, Halloween is the one holiday that is the most COVID-friendly, and we plan on taking full advantage of it. But the listeners want to know, one, is Dylan getting dressed up, and two, are you going trick-or-treating?

Lewis: So, I am not going trick-or-treating, but I am arranging a socially distant movie viewing with my friends. And so, you know, I have a lot of friends and have left DC over the last couple of years and are in a bunch of different cities. And so, what we're doing is we are doing a Big Lebowski costume and Zoom screening. And so, it's going to be, you know, oversized sweaters, White Russians, and we're going to watch the movie, kind of, enjoy it in all of its cult fun and then have a group Zoom afterwards to, kind of, like just hang out talk about the movie and catch up. And so, that is my Halloween plan, no trick-or-treating for me. There are some kids in the neighborhood that I'm going to drop-off some bags of candy to, because I'm not going to be giving out candy on Halloween; that's kind of the way that I've approached it. But, yeah, it's definitely a little bit of a different holiday tradition this year, but I think, you know, the joy of it is that you can, kind of, create your own and create something fun.

Feroldi: That sounds like a wonderful holiday tradition that you are setting up, Dylan. This Dude abides.

Lewis: [laughs] This Dude abides. I love that, maybe that's the motto for the Friday show from here on out, Brian. Thanks again for hopping on with me.

Feroldi: Anytime, Dylan.

Lewis: Listeners, that's going to do it for this episode of Industry Focus, if you have any questions or you want to reach out and say, "Hey!" shoot us an email at IndustryFocus@Fool.com or tweet us @MFIndustryFocus.

And you know what, aside from just the standard show stuff there, if you're doing anything fun for Halloween, hit us up, IndustryFocus@Fool.com or tweet us @MFIndustryFocus. We want to see how members and how our listeners are enjoying the holiday. This is a different year, and if people are doing anything fun like The Big Lebowski thing or Brian and his socially distant Halloween trick-or-treating, we want to see it. I think we need to enjoy some fun holiday stories this time of year with everything that's going on.

And of course, if you want more of our stuff, back to the actual show notes, subscribe on iTunes or wherever you get your podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for all his work behind the glass today. We are basically putty in his hands; he can do whatever he wants with us as our editor. Thank you for listening, and until next time, Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.