While the business of streaming content has been around for quite some time, it's no secret the COVID-19 pandemic contributed to the accelerated adoption of such services. While people sat at home and binged on video content, listened to audiobooks, or relaxed to music, streaming services became a natural component of their daily routines.

The Swedish company Spotify (SPOT 0.86%) specializes in music, audiobooks, and podcasts. While it faces competition from big-tech counterparts like Apple, Amazon, and Alphabet, Spotify remains the No. 1 streaming audio service.

The company has inked exclusive deals with several big-name podcasting hosts in an effort to gain market share in that space. However, even as the company has seen an uptick in its subscriber base (and, in turn, its revenue), its margins have also deteriorated over time. The company is struggling to achieve efficient operating leverage, and big-name investors like Cathie Wood have seen enough.

Let's dig into Spotify to see if it deserves a spot in your portfolio. 

How is Spotify different?

If you look at music streaming services overall, there is very little differentiation among them besides price. For movies and television, companies like Netflix have deals with production companies and distributors to be the exclusive provider of popular content. But what really sets Netflix apart from the competition is its original content. Subscribers can debate how much they enjoy original content from Netflix over Disney, for example.

But listening to a song or album from your favorite singer sounds the same on Spotify, Apple Music, Amazon Prime Music, or YouTube. So in an effort to differentiate itself, Spotify decided to invest heavily in the podcasting market. 

Podcasts have risen in popularity for several reasons. Some are episodic, like a TV show. However, unlike television, you have the luxury of listening to each episode on the go.

Some podcasts are less formal. Instead of scripted content, they are interviews. While this mimics radio, the same podcast benefits apply: The listener does not need to set aside a designated time to ensure they've listened to the entire interview.

Spotify has deployed a two-pronged approach to podcasting. First, the company has made a number of strategic acquisitions in podcasting networks in an effort to inspire its users to create their own content on the platform, much like YouTube has done. Second, it has signed exclusivity deals with high-profile podcasters. Both of these initiatives have come with a steep cost, which has weighed heavily on the streamer's financials.

Users are up, but margins are down

Two of Spotify's most notable deals were the takeovers of podcasting network Gimlet and recording platform Anchor at an estimated price of $340 million for the two companies.  

Spotify also acquired The Ringer, a sports and movie media outlet, for roughly $200 million, and The Joe Rogan Experience, for which it also paid about $200 million. The primary thesis behind these deals was the company would attract users away from platforms like YouTube and other music-streaming services and convert them to paying subscribers on its own platform.

The table below illustrates Spotify's subscriber base after the deals mentioned above. Also included are the company's ad revenue and margin profile to show how the growth from these acquisitions came with downsides.

Metric  Q3 2021  Q4 2021  Q1 2022  Q2 2022  Q3 2022
Monthly active users (MAUs) 381 million 406 million 422 million 433 million 456 million
Premium subscribers 172 million 180 million 182 million 188 million 195 million
Ad-supported MAUs 220 million 236 million 252 million 256 million 273 million
Premium revenue 2.18 billion euros 2.3 billion euros 2.38 billion euros 2.50 billion euros 2.65 billion euros
Ad-supported revenue 323 million euros 394 million euros 282 million euros 360 million euros 385 million euros
Gross margin  26.7% 26.5% 25.2% 24.6% 24.7%
Operating margin 3.0% (0.3%) (0.2%) (6.8%) (7.5%)

Data source: Spotify.

It's clear Spotify has been able to attract more users to its platform, and more importantly, some of these users have become premium (paying) subscribers. However, the company's gross margin and operating margin have declined significantly over the past year, indicating that the cost of these deals have taken their toll. In that light, it's no surprise that some on Wall Street have decided to move away from the company.

What does Wall Street think?

Cathie Wood is the head of asset management firm Ark Invest. Her firm once owned over four million shares of Spotify. But since April, she has gradually sold the bulk of her position. 

While Wood has moved on from Spotify, not all on Wall Street have given up on the company. Several banks have cut their price targets for the stock but still give it a buy rating. For example, Citigroup currently has a price target of $140, which implies 87% upside from the current share price. And while Goldman Sachs has a neutral rating on Spotify, its price target of $114 is 50% higher than where Spotify trades as of this writing.   

Companies typically enjoy increased profitability as their business scales, but in the case of Spotify, rising revenue and users haven't been able to offset declining margins. Management's fourth-quarter guidance indicates gross margin will shrink to 24.5%, while operating losses grow to over 9% of revenue. Even so, Wall Street seems to believe the stock is currently undervalued and carries some upside. If you're still bullish on the streaming service's potential to turn podcasts into a lasting competitive advantage, now could be an opportunity to lower your cost basis if you already own shares or to initiate a small position.