Can Spotify Stock Overcome Its Latest Controversy?

Joe Rogan's exclusive podcast on Spotify (SPOT -1.16%) has been getting a lot of attention lately, and not necessarily for good reasons. Recording artists like Neil Young and others have pulled their music from Spotify's streaming subscription service in protest over what they believe is misinformation regarding COVID-19 being discussed by guests on Rogan's podcast. The situation has investors wondering about the company and the stock.

Spotify has not pulled the podcast episodes in question, but it has included content warnings on the episodes containing discussion of COVID-19. Rogan has apologized for the controversy and said he will make more effort to educate himself about topics discussed and fact-check guests that speak about controversial topics. Spotify CEO Daniel Ek defended Rogan's podcast, which is top-ranking in 90 of Spotify's markets, and he said on the fourth-quarter earnings call, "We don't change our policies based on one creator, nor do we change it based on any media cycle or call from anyone else."  

Spotify investors may have differing opinions on Rogan and his guests, but at the end of the day, it's still a high-level controversy and they have to make the same decision: Is Spotify worth investing in?

Image source: Getty Images.

Ad-supported users are growing faster -- but there's a catch

The company just released fiscal 2021 fourth-quarter earnings results, which include some telling numbers about the state of the business. Spotify has two usage options for its platform, which is home to more than 82 million tracks and 3.6 million podcasts. It offers a free platform that restricts some features and inserts ads every so often the listener must play. To get rid of ads and unlock the platform's full capabilities, Spotify offers a premium subscription for listeners who want the best possible experience.

In Q4, Spotify's premium subscribers grew 16% year over year to 180 million from 155 million. Ad-supported subscribers grew even quicker at a 19% clip year over year, to 236 million from 199 million. Spotify's main business plan is to convert free users into paying ones, as it makes more money from its premium model.

The chart shows how each usage option contributes to gross margin. 

Data source: Spotify.

While investors may be spooked by ad-supported users growing faster than premium ones, they should be delighted in how it is monetizing them. In 2020, Spotify made a measly 6 million euros in gross profit from its ad-supported base. This year, it increased its gross profit by 1,850% to 117 million euros. Improving its ad-supported revenue model drove overall revenue growth.

Data source: Spotify. 

While ad-supported users will likely never be worth more to Spotify than premium ones, monetization improvement is a welcome development.

Spotify is within inches of turning a profit

Even though Spotify is considered a tech stock, its margins are far from its software-as-a-service (SaaS) counterparts. With a 26.5% gross margin during Q4, there isn't much room for expenses above the bottom line. In both Q4 and the full fiscal year, Spotify lost 39 million euros and 34 million euros, respectively. Higher costs in research and development (R&D) and sales and marketing (S&M) drove the larger-than-average Q4 loss. However, at a mere negative 0.4% full-year net income margin, investors shouldn't be worried about its profitability.

From a free cash flow perspective, the business is profitable. Over the full year, Spotify generated 277 million euros in free cash flow, and 37% of it came from Q4's 103 million euros contribution. The main difference between net income and free cash flow is the addition of share-based compensation to the net income number. Spotify racked up 223 million euros in share-based compensation this year, which also increased the share count by 3%. While this isn't insignificant, investors shouldn't be too concerned about this cost.

Using the price-to-sales (P/S) ratio to value the business, the chart showcases Spotify's deteriorating valuation, as has been the case with many other tech stocks.

SPOT PS Ratio data by YCharts

Because of its low gross margin, Spotify stock trades at a much lower P/S ratio than many other tech companies. However, 3 times sales is likely too low for this business, as it last reached this level during the height of the pandemic sell-off in March 2020, despite significant business improvement since then. Investors looking to get in can do so without fear of overpaying for Spotify.

When a company runs a social platform that allows its users or contributors to speak freely, there will always be controversy. Investors in these companies must know the risk going in. If they can ride out any headline-induced volatility, these stocks can make a good long-term investment.

However, Spotify's low margins are just too much of an issue for me to invest. With its rising ad-supported revenue, the stock may reach a point where it enters my portfolio, but there are just too many better investments available. Additionally, if a lot more artists remove music from Spotify's catalog, the company could have major issues. This likely won't happen, but it is wise to understand every risk when investing in a company.

Spotify's stock may do well, but it just isn't right for me at the moment.