Over the last 12 months, investors seem to have lost patience for companies investing heavily now in hopes of long-term profits down the road. One of the companies that has felt that change in investor sentiment at a sizeable level is Spotify (SPOT 0.72%).
Shares of the world's largest audio streaming platform have now declined by more than half over the last 12 months and are even sitting well below its initial public offering (IPO) price from four years ago. But with Spotify's investor day coming up in June, perhaps the event could provide the spark that shareholders are looking for.
A bit of background on Spotify
Before mentioning what investors should expect from the upcoming event, it's worth revisiting Spotify's journey over recent years.
Throughout Spotify's history as a public company, it has been somewhat notorious for having low gross margins. Since Spotify's catalog is primarily comprised of music from artists and music labels, the company pays out the lion's share of its music revenue to those respective rights holders in the form of royalties. Starting around 2018, the company set out to find additional sources of income and began pushing into alternative forms of audio, primarily podcasting.
Over the last several years, Spotify has poured more than $1 billion into podcast-related investments, including acquiring production studios like The Ringer and Gimlet Media and purchasing podcast distribution platforms like Megaphone and Anchor. With the revenue from these businesses not connected to royalty payouts, shareholders started getting optimistic that the gross margin from the company's ad-supported revenue could see a big rise.
Spotify's chief financial officer, Paul Vogel, even expressed this more directly during an earnings conference call last year when he stated, "We think having a fixed cost nature of the podcasting business and being able to grow that advertising will help margins." However, so far, it's been hard for investors to see that in the financial results.
Since Spotify accounts for all of the podcast-related content costs in its ad-supported cost of revenue line, the segment's gross margin has declined quite dramatically during the recent period of heavy investment. In fact, in the most recent quarter, the ad-supported gross margin came in at negative 1.5%.
What to look for at investor day
When pressed about the recent quarterly results on the conference call, Spotify's management team repeatedly expressed (eight separate times) that it would be providing more details during its investor day, now officially set for June 8.
And one thing in particular that investors will be on the lookout for is the ad-supported revenue mix. There are several drivers of Spotify's ad-supported revenue. Whether it's advertising revenue from owned podcasts, revenue from the advertising marketplace in its podcast distribution platforms, or even Spotify's original ad-supported music revenue, each possesses drastically different growth rates and profit margins. So, understanding each segment's progress and overall size is essential to assessing Spotify's future potential.
Yet, so far, the company has disclosed little to no information on that front and has even stopped reporting the specific percentage of its users who listen to podcasts. Though the company may be acting discreetly simply to deter competition, the lack of transparency also seems to be leading to a loss of investor excitement. For investors to continue buying into management's long-term vision, investor day is going to need to provide some context around the progress and profitability of Spotify's podcasting initiatives.
Spotify's valuation hits new lows
Fortunately, for investors today, Spotify's valuation has never been lower.
Spotify is currently valued at an enterprise value (market cap minus net cash) to revenue ratio of 1.6 times, which is well below any other point in the company's history. While valuing a company based on revenue certainly isn't perfect, it can provide a decent starting point. So, let's go a step further.
If Spotify does begin to see improved profitability thanks to its non-music initiatives and is able to realize higher overall gross margins, I believe the eventual path to a 10% free cash flow margin seems achievable. For reference, Spotify generated 3% over the last 12 months. At today's revenue level, that means Spotify would be generating over $1.1 billion in free cash flow.
Given that Spotify's entire enterprise value stands at about $18 billion currently, and the company has demonstrated the ability to consistently grow its already massive user base -- 422 million in total -- and revenue at a double-digit pace, that strikes me as a fair price to pay for the stock.