Popular investment management firm Ark Invest is home to nine different exchange-traded funds (ETFs), all designed to craft exposure to various trends. The largest of these ETFs is the ARK Innovation ETF (ARKK -0.18%), which touts more than $18 billion in assets. Due to its sheer size, the performance of this fund can often closely resemble the performance of the underlying stocks in its portfolio. And one of those stocks is Spotify (SPOT -2.10%).
With the ARK Innovation ETF now down roughly 40.8% from its 52-week highs set in February, Spotify has seen a similar decline -- down 41.7% during roughly the same time period. But while the stock has sold off, the company has continuously delivered strong financial performance. Let's see why this recent weakness could present a good buying opportunity for investors.
Spotify by the numbers
Spotify is the world's largest audio streaming platform. After first launching in 2006, the company flipped the music industry on its head by introducing a first-of-its-kind "freemium" model. With Spotify, users can get unlimited access to a massive library of audio through either a free, ad-supported experience or an ad-free monthly subscription.
Needless to say, this model has been remarkably successful and the company now expects to surpass 400 million total monthly active users by the end of this year -- a roughly 17% increase from the year prior.
But it isn't just the number of users that should intrigue investors. Spotify's customer engagement seems to be superior as well. On Spotify's second-quarter conference call, CEO Daniel Ek stated that "we have more than 2x or even 3x the amount of engagement per user than some of our competitors do." While this might not initially sound like a huge deal, it in fact bodes quite well for Spotify's pricing power. This was evident during the second quarter when Spotify's overall churn declined versus the quarter prior, despite the company increasing prices in several of its more mature markets.
Thanks to this growing and engaged user base, Spotify estimates that it will generate just under $11 billion in revenue for the full year.
Advantage of scale
The biggest knock Spotify often receives from investors is that it only gets to take home a small percentage of its overall revenue. Since the company relies heavily on content owned by independent artists and labels, it's required to pay out a sizable chunk of its sales to those respective rights holders. This, in turn, has diminished Spotify's overall gross margin to just under 30%. However, it's beginning to improve.
Though Spotify has yet to express any intention of owning the music on its platform -- like Netflix has done with its content -- the company has other ways to increase its take-rate, most notably, through discovery. Spotify leverages its listener data to curate different types of playlists for its users. These include algorithmic playlists like Discover Weekly and Release Radar, which are designed specifically for each individual user, as well as editorial playlists such as Rap Caviar and Rock This, which cover a specific genre.
Artists who want exposure to millions of potential listeners can apply to have their songs included in these playlists. And one way to improve their likelihood of being included is to reduce their required royalty. This process serves as a win-win for both parties as Spotify is able to boost its gross margin, while artists get access to a potentially much bigger fan base.
Spotify's hidden revenue stream
Music isn't the only avenue driving growth for Spotify. Unsurprisingly, since Spotify's premium business has historically accounted for around 90% or more of revenue, most investors have focused on the growth of the company's subscriptions. However, thanks largely to the recent push toward alternative forms of audio -- primarily podcasts -- Spotify's advertising business is becoming increasingly important.
Through the recent acquisitions of Megaphone and Anchor, Spotify has built a unique, all-in-one audio platform for advertisers, called the Spotify Audience Network (SPAN). Advertisers can select the type of advertising inventory they'd prefer, whether it's podcasts, music, or potentially audiobooks, and use Spotify's listener data to target their ideal customer. With this new advertising strategy, Spotify is already seeing robust growth.
In the latest quarter, Spotify's advertising revenue grew 75% year over year to $365 million and accounted for 13% of overall revenue versus just 9% a year ago. CEO Daniel Ek even expressed his optimism for the advertising segment on the conference call by stating that he thinks it could account for up to 40% of revenue within five to 10 years.
At its current enterprise value (market cap minus net cash) to gross profit ratio of roughly 15 times, I believe Spotify looks fairly cheap. As the company grows its advertising business and unlocks slightly greater profitability within its premium segment, its gross profit growth should eclipse that of its revenue.