Did you hear the news? Recently, the world's leading audio-streaming business disappointed investors with a less-than-glowing quarterly earnings report. Despite already falling by more than half this year, shares of Spotify Technology (SPOT 1.14%) fell by more than 11% overnight in response to a bottom line that moved a little further away from positive territory.
Spotify shareholders have seen their investments fall a terrifying 76.3% from a peak the stock reached in early 2021. Is the company's disappointing third-quarter report a sign that it's finally time to cut and run?
Why Spotify stock tanked
Spotify's a relatively young business in a high growth phase. Investors are generally nervous about this and other growth companies these days. That's because soaring interest rates will raise their cost of capital and make positive profit margins far more difficult to achieve.
In the third quarter of 2021, Spotify reported a significant operating profit that disappeared this year. During the third quarter of 2022, Spotify reported a $228 million operating loss that was even larger than the company's operating loss in the second quarter of 2022.
Spotify is mostly a subscription business, but it does earn ad revenue from hundreds of millions of users who aren't subscribers yet. As investors have seen from digital advertising giants Meta Platforms and Alphabet, general spending on digital advertising is contracting due to fear of a recession.
Why I'm not selling
Profit margins that have moved in the wrong direction aren't particularly troubling for some important reasons. First, Spotify's enormous user base keeps growing by leaps and bounds. Total monthly active users in the third quarter rose 20% year over year to a whopping 456 million and premium subscribers rose 13% year over year to 195 million.
Over the past two years, Spotify has successfully managed 46 price increases worldwide. In the near term, investors can expect a big bump in the always-important U.S. market to help push the company toward profitability again. Spotify's biggest competitor in the music streaming space, Apple, recently raised U.S. prices by $1 for premium users. With a growing roster of exclusive podcast content that its subscribers can't access on Apple Music, Spotify will have no problem raising U.S. subscription prices by $1 per month as well.
Why I'll be buying more
When Spotify went public in 2018, it told investors to expect a gross profit margin at around 30% to 35% of total revenue. The company approached this goal in 2021, but heavy investments in its future have pushed it further away this year.
Big moves like jumping into podcasting and audiobooks have dented profitability this year but this is most likely temporary. Music streaming is a generally low-margin business because artists expect to be paid every time their content is heard. Podcasters, on the other hand, gladly distribute their content for free because they can fill that content with lucrative advertisements. For this reason, Spotify believes its podcasting business has a 40% to 50% gross margin potential.
It's been just three years since Spotify began incorporating podcasts into what was just a music streaming app. It's already the No. 1 platform podcast listeners use in the U.S. and other developed markets. Its competitors haven't even begun to enter the lucrative space, which means Spotify's already excellent customer retention rate will more than likely grow stronger.
Spotify's highly successful podcast venture proves that its platform is a powerful machine capable of going after new verticals. The next vertical Spotify's aiming for is a market for audiobook delivery it estimates at around $70 billion annually. The new integration is pinching profitability at the moment but Spotify thinks its audiobook business can maintain a gross margin above 40% once it has a chance to mature.
If Spotify were still just a music streaming business, the wider-than-expected loss it reported in the third quarter would be a reason to sell and or avoid the stock altogether. A well-executed investment in podcasting and a more recent push into audiobooks, though, puts Spotify miles ahead of its nearest competitors.
It won't happen in 2022, but higher margins from podcasts and audiobooks will help this relatively well-run company post a reliable profit. Adding some beaten-down shares of Spotify to an already well-diversified portfolio looks like a sensible idea right now.