The world's largest audio streaming company, Spotify (SPOT 0.20%), has seen its stock soar in 2023 along with the rise in tech stocks broadly. However, while the stock's performance has certainly been impressive, the company's underlying financial results have been a bit of a mixed bag. Let's see if this growth-focused tech stock still has room to run.
By the numbers
Spotify just reported its second-quarter financial results and there was plenty for investors to like. On the user front, the company drastically outperformed its own expectations by adding 36 million total monthly active users in the quarter, far more than in any other quarter in the company's history. This puts Spotify today at 551 million total monthly active users, which is 27% higher than the same period a year ago.
But that growth isn't just coming from Spotify's established markets. Its users outside North America, Latin America, and Europe now account for 30% of Spotify's total user base, versus just 15% four years ago. While it's certainly nice to see that kind of growth across emerging markets, the lower propensity to spend throughout many of those geographies helped contribute to a 4% yearly decline in Spotify's average revenue per subscriber.
To help offset this impact, two weeks ago Spotify announced that it will be raising prices by about 10% (depending on the plan) across more than 50 of its markets. Though this revenue boost won't appear in the next quarter's results, Spotify CEO Daniel Ek was clear on the company's second-quarter conference call that "we expect it to have a meaningful impact on Q4 and beyond."
Spotify's lack of profits
While the robust user growth has certainly been a positive surprise, there's still one big lingering question that the company has failed to truly answer: Can Spotify ever be profitable?
Since coming public, Spotify never posted a year of positive GAAP net income. One big reason for this is the massive royalty payouts Spotify provides to music labels and other rights holders. For every dollar Spotify generates in revenue, about two-thirds are given to the content owners or artists. Historically, this has left the company with around a 25% gross profit margin. While that's quite a low percentage relative to other technology platforms, it still leaves Spotify with more than $3 billion in annual gross profits to invest in its operations.
Unfortunately, though, it seems the company hasn't been very efficient with its spending. Since 2018, Spotify's gross profit grew at a rate of 21% per year. Meanwhile, its growth in operating costs significantly outpaced it. Research and development expenses grew by 31% annually, and sales, general, and administrative expenses grew at 24% annually.
Management instead often points to the company's positive free cash flow as an indicator of profitability. But this figure is down significantly relative to previous years and fails to account for the more than fourfold increase in stock-based compensation that's occurred over the last five years.
SPOT Net Income (TTM) data by YCharts
Is it time to sell?
Though Spotify's lack of profitability has been frustrating for shareholders like myself, investors should be wary about hitting the sell button too soon. Spotify is taking a number of steps to improve its cost structure that aren't being fully reflected in the income statement quite yet. In January, Spotify reduced its workforce by 600 people, then followed it up with another 200-person reduction in June, and is still incurring severance charges related to those actions.
Additionally, the company reduced its real estate footprint this quarter and shuttered a number of its unprofitable podcasting initiatives. Spotify's CFO Paul Vogel was quite direct about the impact this should have when he stated, "We expect all of these moves to have a positive impact on our rate of profitability."
At Spotify's previous investor day, management laid out a long-term target of 10% operating margins. While there are no guarantees Spotify will reach that number, that would imply roughly $1.4 billion in annual operating income at today's sales levels. At Spotify's current enterprise value of $26 billion, that means the stock is valued at potentially 18 times what the company could be earning. For a business that's consistently growing users and revenue well above 10%, that strikes me as a reasonable price to pay.
