What happened
Spotify (SPOT 2.77%) stock tumbled more than 9% in October after a disappointing earnings report. The company narrowly exceeded internal forecasts and Wall Street's estimates for both revenue and user growth. However, Spotify's net losses were larger than anticipated. It's also struggling to drive growth in its advertising business, despite investing resources in that revenue stream.
So what
Spotify shares were having a good month prior to its earnings report. In fact, the stock had risen around 10% before tumbling. Many tech stocks had positive momentum as investor risk appetite ticked higher. Investors were also speculating that Spotify would have an opportunity to increase its subscription prices, with competitors Apple (NASDAQ: AAPL) and YouTube announcing price increases earlier in the month.
That narrative unraveled upon inspection. Spotify's advertising business, which is expected to be an avenue for increased growth, isn't living up to expectations. The company's profit margins are suffering, too. This all sows doubts that the streaming service will produce the amoubt of cash flow that previously seemed possible.
Image source: Getty Images.
Spotify's earnings weren't spectacular, but it's hard to see how the fundamental outlook for the business changed so dramatically from the news. October was a tough time for tech stocks and high-growth companies. Earnings season produced a lot of winners, but stocks with unimpressive quarterly results were punished by a volatile market. In these conditions, it didn't take much to trigger steep losses.
Now what
Spotify's management has indicated that many of its prominent challenges are short-term in nature, brought on by geopolitical events and a temporary pullback in advertising due to weak economic growth in Europe and Asia. That's certainly plausible, and the company could deliver accelerating revenue growth down the road when those challenges subside. With the stock down nearly 70% year-to-date, this could mark an attractive entry point for investors who want to capitalize on that potential bounce.
The stock's 1.29 price-to-sales ratio is attractive, but its narrow margins result in much higher valuation multiples on the basis of EBITDA and cash flow. While Spotify's growth is impressive, profit stability remains a long-term issue due its business model and the presence of fierce competition. The stock's valuation leaves plenty of room for long-term appreciation, but there are likely to be some bumps in the road ahead.
