In 2022, investors are impatient with companies that are investing for growth and not showing any current profits. Many of these fast-growing technology and consumer internet stocks have gotten clobbered this year, down 50% or more in just a few short months. Spotify (SPOT +0.97%) is one of them. The audio platform just reported strong growth in its Q1 earnings results, but investors decided to sell off the stock because of a lack of progress in expanding gross margins and generating meaningful profits. As of this writing, the stock is down a whopping 60% year-to-date, and hit an all-time low of approximately $97 a share at the close today.
A huge drawdown is never fun to go through, but is part of the process sometimes when holding an unprofitable stock. Here are three reasons investors shouldn't panic about the recent drop in Spotify stock.
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1. User growth continues
Spotify is still showing no signs of slowing down the growth of its user base around the globe. In Q1 2022, total monthly active users (MAUs) hit 422 million, up 19% year-over-year. Excluding an estimated double-count of 3 million MAUs during a service outage in March, MAUs were 419 million for the period. Both numbers beat Spotify's previous guidance for Q1 of 418 million. This outperformance was led by growth in Brazil, Mexico, and Indonesia, according to the Q1 shareholder letter.
User growth is vital for Spotify's business, as it is the top of the funnel for users to trickle down toward eventually buying its ad-free premium subscription service. In Q1, the number of premium subscribers grew 15% year-over-year to 182 million. This was below its guidance for 183 million subscribers, so not a highlight for the period, but average revenue per user (ARPU) grew 6% year-over-year, which was likely a plus for most investors. It should also be noted that Spotify pulled out of Russia entirely due to its invasion of Ukraine. This will have a negative impact of 1.5 million subscribers for the premium business in 2022.
2. Advertising revenue growth
Second, we have the sustained outperformance of the advertising business, which grew revenue 31% year-over-year in Q1 to $297 million. Revenue would have grown around 35% without the disruptions of the Russo-Ukraine conflict. Advertising is only 11% of Spotify's overall revenue right now, but growing quicker than the premium business, which grew revenue by 23% year-over-year in Q1.
Spotify's advertising business is growing so quickly because of its launch of the Spotify Audience Network (SPAN) last year. The marketplace lets advertisers dynamically place targeted audio advertisements across podcasts and music, a big improvement over Spotify's old advertising model. Management hasn't given out any specifics, but continues to say it is outperforming expectations. Investors should expect SPAN to become a bigger portion of Spotify's overall business over the next few years.
3. Podcast engagement
Since advertising is how Spotify monetizes its podcast business, its most important metric for success is not necessarily MAUs but the number of hours spent listening to podcasts on the platform. In Q1, Spotify continued to make progress in this regard.
There are now 4 million podcasts on Spotify, up 53% year-over-year. According to CEO Daniel Ek on the conference call, growth in the number of podcasts is coming from emerging markets like Latin America and Asia, which is a good sign that podcasts are becoming a truly global business. There are now 1,150 original and/or exclusive shows on Spotify, which is a key way the company is trying to differentiate itself from other podcast listening services. Lastly, and probably most important, podcasts' share of overall consumption hours reached an all-time high last quarter. With a music business that is not growing slowly, this indicates to me that podcast listening hours are growing at a rapid rate on Spotify right now, which is fantastic news for a company trying to build a robust advertising marketplace.
Concerns with gross margins
User, advertising, and podcast growth are highlights of Spotify's business right now. But investors are getting increasingly skittish about a lack of performance below the revenue line. Gross margin in Q1 came in at 25.2%, down year-over-year, with podcast investments weighing on cost of revenue right now. For the last few years, Spotify executives have claimed that over the long-term its business can achieve gross margins of up to 40% once it scales its discovery tools and advertising marketplace. However, so far very little progress is showing up in its financial statements. With investors less willing to take on a stock that isn't showing current profitability, it is no surprise that Spotify's share price has hit an all-time low.
This isn't to say that Spotify is hemorrhaging money. It consistently generates positive free cash flow, although in Q1 it was a measly $23 million compared to its $18.6 billion market cap. There's no risk of Spotify going bankrupt, but it is still not generating substantial profits.
It will be important for investors to watch gross margins, operating margins, and cash flow margins over the next three to five years. But if you're a believer in the long-term growth of the music, advertising, and podcast business and are not worried about what gross margins look like today, now could be a great time to start a position in Spotify stock.
