The fall earnings season is upon us, with many technology and consumer internet stocks reporting their third-quarter results at the end of October. Spotify (SPOT -4.62%), the global leader in audio streaming, released its earnings on Oct. 25. Wall Street was not happy with the report, sending shares down over 10% the following trading day.
Spotify again failed to expand its gross margin and generate a profit in the third quarter of 2022. Should investors be concerned about the music streamer's prospects going forward? Let's take a look.
Q3 earnings: Strong user growth
Before hitting the troubling parts of Spotify's Q3 results, let's take a look at where the company is executing well, which is the growing popularity of its platform. In the third quarter, Spotify's monthly active users (MAUs) hit 456 million, up 20% year over year. This was a 23 million increase from Q2, a record net addition. Growth is mainly coming from its Rest of World segment, which includes everything that isn't North America, South America, and Europe. Rest of World users are now 26% of overall MAUs, up from just 11% in 2018.
If this pace of MAU growth continues, Spotify should have no problem reaching its 2030 goal of having 1 billion users on its platform. Generally, 40% of all these new MAUs will translate into premium subscribers for Spotify's ad-free tier. In Q3, premium subscribers grew 13% year over year to 195 million. Premium music subscriptions are the majority of Spotify's revenue today, with the segment generating 2.65 billion euros of revenue last quarter, and should keep growing as long as MAUs grow as well.
Over the long term, Spotify plans to make money in many other ways, including podcast advertising and selling audiobooks. However, these investments are still in the early stages and are not material to the business today.
Margins continue to weigh on the stock
Investors have gotten increasingly frustrated with Spotify due to the lack of gross margin expansion. In Q3, the company had a consolidated gross margin of 24.7%, which is essentially the same as where it was in 2018. Its premium gross margin has ticked up slightly over the last few years due to its song and artist promotional tools, hitting 28% in Q3.
But advertising gross margin has plummeted, reaching only 1.8% in Q3. While only a small part of overall revenue, advertising gross margin has been a big drag on consolidated gross margin in the past few years.
Why is the advertising gross margin so bad? Because Spotify has invested aggressively to build out its podcast content, advertising, and licensing strategy. This includes buying studios like the Ringer and licensing top shows like The Joe Rogan Experience. These upfront investments have led to great market share gains in podcast listening (Spotify is now the No. 1 player in many markets) but are a drag on gross margin in the short term.
Spotify has promised gross margin will reach the 30% to 40% range eventually, which will lead to 10% underlying profit margin. To do this, it will need to grow the size of its advertising revenue over its large fixed podcast cost base as well as grow its promotional marketplace at a fast pace. Both of these segments (incremental advertising revenue and promotional tools) have higher gross margin and should be able to drive consolidated gross margin expansion if they become a large enough part of Spotify's overall business.
What the future may hold
I believe there are two scenarios that Spotify could go through over the next couple of years. Looking optimistically, if gross margin starts to finally expand (management says it will happen in 2023), then Spotify could do well over the next decade. At its current market capitalization of $16 billion and with around $12 billion in overall revenue, the stock could trade at a cheap price-to-earnings ratio (P/E) of around 10 based on its current market cap within a few years if net margin reaches 10%.
More pessimistically, if the promotional marketplace and podcast advertising do not scale to a much larger size, then Spotify will struggle to expand its gross margin, and likely its underlying net profit margin as well. This would be bad news for the stock.
Coming back to the article title, yes, I do think Spotify investors should be concerned about the company losing money and the lack of margin expansion. If this doesn't get fixed over the next few years as management says it will, then Spotify might not be a worthwhile investment to have in your portfolio.
