Music streaming leader Spotify (SPOT 11.41%) is joining a stampede of tech companies reducing their headcounts amid a tough economic environment. In a letter to employees on Monday, Spotify CEO Daniel Ek announced a restructuring that involves a 6% reduction in the company's workforce.
Spotify's costs have grown too quickly, with Ek pointing out that operating expenses grew at about twice the rate of revenue in 2022. While this wouldn't be an emergency for some highly profitable tech companies, it is an emergency for Spotify.
A low-margin business
Music streaming is a low-margin affair that doesn't get any better with scale. Spotify's gross margin hovers around 25%, and it hasn't meaningfully improved in years. To put that in perspective, Wayfair, an online furniture retailer that ships bulky products to customers, currently sports a slightly higher gross margin than Spotify.
The bulk of Spotify's cost of revenue comes from royalties and distribution costs. Agreements with record labels, music publishers, and other rights holders are complex, but the company generally pays royalties based on revenue earned, usage metrics, or both. What this means is that as Spotify grows its customer base or generates more revenue per customer, those royalty costs are going to rise just as quickly.
Through the first nine months of 2022, Spotify generated $8.56 billion in revenue and $2.13 billion in gross profit. Operating expenses totaled $2.55 billion, leading to an operating loss of about $430 million. That's a half-a-billion-dollar swing from the same period in 2021, when the company's operating costs were substantially lower.
With only 25% of revenue being converted into gross profit, Spotify has little room for error. Sales and marketing spending ate up more than half of that gross profit during the first nine months of 2022, and it will be difficult to cut that spending without negatively affecting customer acquisition. While layoffs and cost-cutting do lower costs, these actions don't happen in a vacuum.
Spotify seemingly has no leverage with those to which it pays royalties. If it did, its gross margin wouldn't be stuck where it is. And even if the company has some pricing power with its customers, royalty agreements will ensure that royalty payments will rise right alongside revenue. This is not a great situation to be in.
An expensive stock
The best-case scenario for Spotify appears to be eking out a small profit as operating costs are aggressively managed. Even after the stock plunged from its all-time highs, Spotify is still valued at around $19 billion. The company has greatly reduced its losses over the past few years, but positive quarterly net income has been a rare occurrence.
SPOT Net Income (Quarterly) data by YCharts
There doesn't seem to be a way for Spotify to materially boost its gross margin, and there's enough competition that the company probably doesn't have the ability to raise prices without losing customers. That leaves cost-cutting as the only path to profitability. As an investing thesis, that doesn't seem all that appealing to me.
