The start of 2023 has been strong for digital audio platform Spotify (SPOT -7.28%). Shares are up 69% year to date (YTD) and popped just under 10% this week after reporting strong user growth in the first quarter. Exclusive podcasts, refined marketing strategies, and new platform features are driving more people around the world to sign up and engage with Spotify's audio service, which has investors bullish on its prospects at the moment.
Here's the skinny on Spotify's Q1 earnings.
Q1 earnings: Record user growth
The highlight of Spotify's first quarter was clearly its user and subscriber numbers. Last quarter, management told investors the company would reach 500 million monthly active users (MAUs) and 207 million paying subscribers in Q1 of 2023. Actual results blew the estimates out of the water, with Spotify hitting 515 million MAUs and 210 million premium subscribers in Q1. A record 26 million MAUs joined Spotify to start 2023, making Q1 the fifth straight quarter of accelerating year-over-year growth.
Why is Spotify's user growth accelerating? A few reasons. First, the company is growing rapidly in its "Rest of the World" demographic category, which is every country outside of North America, Latin America, and Europe.
Countries like India and Indonesia have gigantic populations that are all getting internet-connected devices, providing a long runway for Spotify to grow its user base in these regions. Rest of the World made up 28% of overall MAUs in Q1 of 2023 compared to just 13% in Q1 of 2019.
Second, Spotify is seeing improved MAU churn because of its exclusive podcasts and new product features like its recently launched AI DJ. These shows and listening tools differentiate Spotify from competing services like Apple Music and Amazon Music, which convinces people to switch to Spotify for their audio-listening needs.
Will profits arrive this year?
If user growth has consistently impressed investors with Spotify, profitability has consistently underwhelmed. In Q1, Spotify posted an operating loss of $156 million and a gross margin of just 25.2%.
These were around what management expected in the period, but it's still an issue the company needs to resolve over the next few years. Gross margins are low at the moment due to huge investments into podcast content and exclusive deals, which are driving Spotify's advertising gross margins close to zero. Management claims advertising gross margins (and therefore Spotify's overall gross margin) will improve throughout 2023 as it scales its podcast advertising marketplace.
Investors should be watching gross margins closely in the coming quarters. If Spotify can finally expand gross margins on a consolidated basis, it will likely start generating a positive bottom-line profit as well.
Valuation is uncertain but could provide an opportunity
Spotify's valuation is a bit of a mystery, considering it currently does not generate a profit. Classic metrics like a trailing price-to-earnings (P/E) ratio have no meaning for a money-losing business.
But I believe we can make some rough estimates on what Spotify can earn a few years from now, assuming management is right in saying that gross margins will start to expand in 2023.
If revenue grows by 15% a year from its 2022 level of $12.3 billion, it will be doing $18.7 billion in revenue in 2025. Over the long term, Spotify expects its business to generate a profit margin of 10% once its gross margins expand to 30% or higher. A 10% margin on $18.7 billion in revenue equates to $1.87 billion in profits.
Comparing $1.87 billion in profits to Spotify's current market cap of $27 billion, Spotify could be (emphasis on could) trading at a cheap forward P/E of just 14.4. For reference, the S&P 500's current P/E is 22.
If you believe Spotify can reach these profitability hurdles within a few years and that the stock will trade at an earnings multiple at or above the market average, there still could be plenty of strong returns left for Spotify shareholders even after its meteoric rise to begin 2023.
