Spotify's Number One Business Problem (2024)

Jul 27, 2023

Spotify Technology SA (SPOT, Financial) is among the world's largest music streaming service providers, monetizing its user base through both a paid subscription model, the premium service, and an ad-based model. The ad-supported service has over 500 million users, as per the latest earnings report released earlier this week. Revenue from premium and ad-supported services represented 87% and 13% of 2022 total revenue, which is where the problem lies. Spotify has not been able to transform its premium service revenue into net profits, having a negative annual net margin for the period between 2015 and 2022.

While I have tried both of Spotify's services in the past and enjoyed them, its performance and investment prospects are another story. Based on its most recent financial report, the stock presents more risks than opportunities.

Brief review of second-quarter results

On Tuesday, Spotify reported second-quarter revenue that grew 11% to 3.18 billion euros ($3.51 billion), below the average estimate of 3.21 billion euros. Further, sales for the third quarter are expected to be 3.3 billion euros, which is below the figure of 3.42 billion euros analysts are forecasting. A light outlook and a miss on revenue were key reasons for the sell-off, sending Spotify’s U.S.-listed shares down nearly 14% to close at $140.38 on July 25.

The company reported an all-time high for monthly active users at 551 million, a 27% year-over-year increase and 21 million above guidance. It also saw the strongest quarterly net addition performance in its history at 36 million users. On a global basis, Spotify noted all regions outperformed, resulting in higher net additions compared to the previous year.

The number of premium subscribers grew 17% year over year to 220 million, 3 million above the company’s guidance. However, Spotify posted a net loss of 302 million euros, which was much wider compared to the loss of 125 million euros in the year-ago quarter.

Now my main concern is that with this record subscriber growth, profitability was not reached, but became worse compared to the same quarter last year as average revenue per user has continued to decline. Something is fundamentally flawed in Spotify’s business model.

Strategic decisions and competition

In an effort to lower costs, the company cut down its management staff by 2% in June and plans to reduce its headcount further this quarter.

Spotify also increased its prices in the U.S. for the first time. The standard premium plan now costs $10.99, which is the same as its primary competitors, Amazon Music and Apple Music. In a statement, CEO Daniel Ek said, “There will come a time when price increases become a more important tool in the toolbox.” I would argue that now is the right time for this decision to either work or fail for Spotify.

The music streaming market is becoming increasingly competitive, with major players such as Apple Inc. (AAPL, Financial), Amazon.com Inc. (AMZN, Financial) and Alphabet Inc.'s (GOOGL, Financial) YouTube Music vying for market share. If its competitors decided to lower their prices, Spotify could be at risk of losing a significant portion of its subscribers. On the other hand, if it decided to implement a price cut as well, then revenue would take a big hit. As such, I find the decision to increase its prices now very bold and risky since it has lost its competitive advantage of having cheaper audio streaming services.

Other challenges

Apart from competition, some key concerns include high royalty costs and local regulatory challenges. Spotify pays out a significant portion of its revenue to music rights-holders, which leaves less money for it to invest in growth and profitability.

The company is also facing regulatory challenges in some markets, such as India, where the government has imposed restrictions on its operations.

Additional challenges it is facing include the rise of ad-supported streaming, social media growth and the decline of physical music sales. Other ad-supported streaming services, such as YouTube Music and Sirius XM Holdings Inc.'s (SIRI, Financial) Pandora, are becoming increasingly popular, which is eating into Spotify's premium subscriber base. Additionally, social media platforms, such as TikTok and Meta Platforms' (META, Financial) Instagram, are becoming increasingly important for music discovery, which is reducing Spotify's role as a gatekeeper to new music. Further, the decline in physical music sales is reducing the amount of revenue it receives from music licensing.

Valuation

Spotify shares trade with a price-sales ratio of 2.51, a price-book ratio of 10.83 and a high price-to-free cash flow ratio of 595.88, which are underperforming versus its industry as well as its own history. The company's revenue growth has slowed down over the past 12 months, so the three-year Ebitda growth rate is -402.90%, the three-year free cash flow growth rate is -65.1% and the three-year earnings per share without non-recurring items growth rate is -39.5%.

However, the GF Value Line suggests the stock is significantly undervalued based on its historical ratios, past financial performance and analysts' future earnings projections.

Future prospects

Spotify is facing several challenges, but is a well-established company with a strong track record of innovation. It will be interesting to see how it adapts to the changing music streaming landscape in the years to come. Despite its apparent undervaluation, the stock does not present an appealing opportunity currently as profitability is still very far away.