Earnings season is upon us. Over the next few weeks, companies will be releasing updates on how they performed through the second quarter of 2021. One well-known stock, audio music streamer Spotify (SPOT -7.28%), is set to release its Q2 report before the market opens on July 28. Should you buy shares before the Q2 release? Let's dive deeper and find out.
The business is steadily growing
The majority of Spotify's revenue comes from its ad-free music subscription service. Since subscription revenue is inherently recurring, Spotify is able to reliably grow its revenue base along with the number of subscribers it adds to its service. In Q1, revenue grew 16% year over year (22% excluding foreign currency fluctuations) to $2.5 billion, in conjunction with premium subscribers growing 21% year over year to 158 million.
Image source: Spotify.
Spotify recently announced price increases in some of its mature European and North American markets. If the company can slowly increase prices as it continually improves the value proposition of its service, revenue growth could even outpace subscriber growth in future quarters. However, this may be buoyed by entrances into less wealthy markets like India, Southeast Asia, and Africa. This winter, Spotify announced it would enter over 80 new markets in 2021, most of which are countries where citizens have less spending power than in Western Europe or North America as it pushes to get over 1 billion users on its platform.
With only 356 million total monthly active users at the end of Q1, Spotify has a clear path to grow subscribers and subsequently grow revenue for the foreseeable future.
New initiatives showing promise
One pushback with Spotify is that its gross margins are structurally low due to the high royalty payouts it makes to the music labels and other music rightsholders. In Q1, the gross margin was a measly 25.5%, which tracks pretty closely with the overall numbers the last few years. Within its core music subscription offering, Spotify will likely struggle to raise gross margin much, if at all, over time.
However, to help alleviate these margin issues, Spotify has multiple new initiatives, including:
Podcasts
Spotify has invested hundreds of millions in podcast studios, exclusive licensing deals, and distribution platforms over the past few years to help drive listeners and podcast creators to the Spotify platform. Right now, podcasts bring in minimal revenue compared to what Spotify has spent acquiring shows and content. But if it can build out its advertising network for podcasts, this could start bringing in tons of high-margin revenue within three to five years.
Two-sided marketplace
This is Spotify's promotional marketplace for labels and artists. Through sponsored recommendations and insertions on Spotify's popular playlists, this marketplace can help the company capture gross margin dollars back from the labels.
Live audio
Recently, Spotify acquired Locker Room, a live discussion mobile application like Clubhouse that is focused on sports-related content. It rebranded the app as Spotify Greenroom and is looking to push it to broader audiences, especially musicians and podcast hosts who are already popular on the core Spotify app. It is unclear how Spotify plans to make money off of Greenroom, but it provides optionality for Spotify over the next decade and could eventually turn into another high-margin revenue source.
The valuation remains reasonable
With a market cap of $46 billion, Spotify has a trailing price-to-sales ratio (P/S) of 4.8. This might seem cheap compared to many other fast-growing consumer internet businesses, but investors should remember that Spotify has low gross margins, generating only $2.45 billion in gross profit over the last 12 months. Again, this will limit free cash flow and profit generation. Considering these factors, it still looks like Spotify is trading at a reasonable valuation, depending on how bullish you are on the growth of its core music business and its other bets in podcasting, the two-sided marketplace, and live audio.
Time to buy?
Spotify isn't a bargain at these prices, even with the stock down 22% year to date, but it looks like a great opportunity for anyone bullish on the long-term growth of music streaming and podcasts. If you believe the company can keep up its double-digit growth in premium subscribers while also rapidly growing its other initiatives, Spotify stock looks like a buy heading into its Q2 earnings report.
That's not to say I know what will happen to the stock in the short term, but if you are confident in management's plan over the long term, this could be a perfect time to start a position in the Swedish audio streamer.
