Shares of Spotify (SPOT +1.16%) recently shot higher in response to better-than-expected third-quarter results. Investors were encouraged by operating earnings that turned positive after several quarters of heavy losses.
A majority of Spotify users are on the free ad-supported plan, but a weakening economy has pressured advertising revenues across the media industry. Is Spotify's ability to drive profits during a difficult time for its industry a sign the stock can outperform over the long run?
Image source: Getty Images.
What happened
Spotify saw total revenue climb 11% year over year or 17% if we adjust for the effects of currency exchange. The growth came from a healthy combination of premium and ad-supported users.
The platform grew its ad-supported user base by a whopping 32% year over year. Ad prices are down significantly, but there were enough new users to push ad-supported revenue up 24% year over year at constant currency.
In Q3 alone, Spotify converted enough free users into paying members to raise its premium subscriber count by 6 million. The company finished September with 226 million premium users. That's all the more impressive when you consider it raised subscription prices in the U.S. and other big markets for the first time this June.
While increasing membership and higher prices raised Spotify's top line, a round of layoffs and other cost-cutting measures helped slash operating costs by 8% year over year at constant currency.
SPOT Operating Income (Quarterly) data by YCharts.
Spotify reported frighteningly large operating losses in recent quarters. With revenues and costs moving in opposite directions, though, the heavy operating losses it's been reporting turned positive during the three months ended in September.
Beyond just music
Spotify's attempt to drive membership levels higher with exclusive podcasts hasn't worked out as hoped. That said, its early lead as an all-encompassing audio-streaming platform can still give the company an enduring advantage.
For a couple of years now, the Spotify Audience Network has been helping advertisers buy podcast ads at scale. This makes Spotify an especially lucrative platform that creators of all sizes want to be on. Spotify is also the first and only audio-streaming platform to offer audiobooks right next to music and podcasts.
Premium subscribers won't tolerate ads between songs, but Spotify gets to serve podcast advertisements to paying users without complaint. Unfortunately, this dynamic isn't showing up in the company's results.
SPOT Gross Profit Margin (Quarterly) data by YCharts.
Spotify's Q3 gross margin of 26.4% was an improvement year over year, but it's still lower than the company reported a few years ago. I'm going to go out on a limb and predict further gross-margin expansion now that the company is spending far less to acquire new, exclusive podcast content.
Building a significant moat
Podcasts and more recently, audiobooks, probably won't be the huge profit drivers that investors are hoping for. That said, they are making the Spotify app stickier by the day.
Non-exportable lists of favorite songs, artists, and albums take time to build. Now that it's the streaming app its users use for music, podcasts, and audiobooks, Spotify probably has a lot more pricing power than it displayed with its latest increase.
Spotify's moat isn't a wide one, but it could allow the company to remain profitable and grow its bottom line for at least a decade.
A buy now?
Spotify has been trading at about 35 times annualized free cash flow based on Q3 results. While I expect profits to continue growing, investors should understand that this is a high multiple that comes with big expectations.
If the improved profitability metrics Spotify just reported don't continue through the next several quarters, its stock price could come crashing down. This is a stock to buy now, but only for investors who can tolerate a lot of risk. For most of us, it's probably better to wait for a more attractive valuation.
