There's no doubt that customers love music and podcast streaming service Spotify (SPOT 0.20%). The company just reported record user growth as the platform continues to enjoy strong uptake in international markets such as Southeast Asia, India, and Africa. That's in addition to steady growth in its more mature markets like North America and Western Europe.
However, even with global scale and hundreds of millions of users, this business still isn't profitable. In fact, its operating margin has actually gotten worse in recent quarters and sits at negative 7% over the trailing twelve months.
Bears point to these losses as evidence that Spotify's music streaming business model is flawed, while bulls think the company is reinvesting to tackle a gigantic market opportunity and will eventually turn profitable if it wants to. So who is right? Will Spotify ever turn a profit? Let's investigate.
Data by YCharts.
Accelerating user growth in Q2
In the second quarter, Spotify put up impressive growth in both active users and paying subscribers. Global monthly active users (MAUs) grew 27% year over year to 551 million, while premium subscribers (the customers paying for ad-free access) grew 17% year over year to 220 million. Both numbers were significantly higher than the previous guidance for 530 million MAUs and 217 million premium subscribers in the quarter. Clearly, Spotify is seeing better adoption globally with a lot of growth coming from its newer markets in Asia. The service looks well on track to reach 1 billion users by 2030, a long-term goal management has laid out for investors.
However, if user growth is firing on all cylinders, then Spotify's financials are sputtering. Over the long term, management thinks the company can expand its gross margins to above 30% through podcast advertising and high-margin promotional tools for music labels. It also believes it can get to 10% operating margins at scale. So far, there has been very little progress on both these initiatives. Spotify's gross margin was yet again around 25% in Q2 (24.1%, to be exact) and hasn't moved materially higher in years. Operating margin was negative 7.8%, again well off of management's long-term goal.
Executives at the company claim that profitability is just over the horizon as the business works through major investments in podcasting, advertising, and other projects. However, it looks like most investors are losing their patience with shares of Spotify falling over 10% on the day of the earnings announcement.
Profitability problem has an easy fix, but will management act?
Some of Spotify's Q2 expenses were one-time blips and should be fixed in future quarters. There were around $150 million of expenses in the quarter related to layoffs and its real estate optimization plan. However, even if you add back these expenses, Spotify would have still lost $123 million in the quarter.
So why can't a company with over 500 million users generate a profit? It's simple -- there are too many employees for its gross profitability. Even after laying off a total of 800 employees this spring, Spotify still had around 9,500 full-time employees and generated $3.2 billion in gross profit over the last 12 months. In contrast, Netflix had 12,800 full-time employees at the end of 2022 and generated $12.5 billion in gross profit over the last 12 months. That is 4 times the amount of gross profit but only 1.3 times the number of employees. This is why Netflix has an operating margin close to 20% while Spotify continues to lose money quarter after quarter.
While a difficult move, Spotify is going to need to lean up its employee base in order to get to break-even profitability and then eventually hit its goal of 10% operating margins.
Data by YCharts.
Is the stock expensive?
Spotify has a market cap of $29 billion as of this writing. At its long-term operating margin guidance of 10%, the company would have generated around $1.3 billion in profits over the last 12 months. For a business growing revenue at a consistent double-digit rate and an opportunity to continue growing for the next decade, the current stock price doesn't look crazy expensive, as long as the 10% margin guidance is reached.
However, there's no evidence that Spotify's executive team has the willingness to be more disciplined and reach this operating margin target. This is a huge risk for any investor thinking of buying the stock today.
