Spotify is still losing money. Should investors be worried?

Fall earnings season is upon us, with many tech and consumer internet stocks reporting their third quarter results at the end of October. Spotify (PLACE 1.98%)the world leader in audio streaming, published its results on October 25. Wall Street was unhappy with the report, send shares down more than 10% the next trading day.

Spotify again failed to increase its gross margin and generate profit in the third quarter of 2022. Should investors be worried about the future prospects of the music broadcaster? We’ll take a look.

3rd quarter results: strong growth in the number of users

Before we get into the troubling aspects of Spotify’s third quarter results, let’s take a look at the areas where the company is performing well, namely the growing popularity of its platform. In the third quarter, Spotify’s monthly active users (MAUs) reached 456 million, up 20% year-over-year. This is an increase of 23 million from the second quarter, a record net addition. The growth came primarily from its Rest of the World segment, which includes everything other than North America, South America and Europe. Rest of the world users now represent 26% of all MAUs, up from just 11% in 2018.

If this pace of MAU growth continues, Spotify should have no problem reaching its 2030 goal of having 1 billion users on its platform. Typically, 40% of all these new MAUs will result in premium subscribers for Spotify’s ad-free tier. In the third quarter, the number of premium subscribers increased 13% year-over-year to 195 million. Premium music subscriptions now account for the majority of Spotify’s revenue, with the segment generating €2.65 billion in revenue last quarter, and are expected to continue growing as long as MAUs also increase.

In the long term, Spotify plans to make money in many other ways, including advertising on podcasts and selling audiobooks. However, these investments are only in their infancy and are not significant for the company today.

Margins continue to weigh on the title

Investors are increasingly frustrated with Spotify due to the lack of gross margin expansion. In the third quarter, the company had a consolidated gross margin of 24.7%, which is essentially the same as 2018. Its premium gross margin has increased slightly over the past few years due to its song and music promotional tools. artists, reaching 28%. % at Q3.

But the advertising gross margin fell to just 1.8% in the third quarter. Although it represents only a small part of the overall turnover, the advertising gross margin has weighed heavily on the consolidated gross margin in recent years.

Why is advertising gross margin so bad? Because Spotify has invested aggressively to develop its podcast content, advertising and licensing strategy. This includes buying studios like Ringer and licensing flagship shows like The Joe Rogan Experience. These initial investments have led to significant market share gains in podcast listening (Spotify is now the #1 player in many markets) but weigh on gross margin in the short term.

Spotify promised that the gross margin would eventually reach the 30% to 40% range, leading to an underlying profit margin of 10%. To do this, it will need to increase the size of its ad revenue on its large fixed podcast cost base as well as grow its promotional market at a rapid pace. These two segments (additional advertising revenue and promotional tools) have higher gross margin and should be able to drive consolidated gross margin expansion if they become a large enough part of Spotify’s overall business.

What the future may hold

I believe there are two scenarios Spotify could go through in the next two years. Hopefully, if gross margin finally starts to pick up (management says this will happen in 2023), then Spotify could do well over the next decade. With its current market capitalization of $16 billion and with around $12 billion in global earnings, the stock could trade at a good price-to-earnings ratio (PER) of about 10 based on its current market capitalization within a few years if the net margin reaches 10%.

More pessimistic, if the promotional market and podcast advertising not scale to a much larger size, then Spotify will struggle to grow its gross margin, and likely its underlying net profit margin as well. That would be bad news for the title.

Going back to the title of the article, yes, I think Spotify investors should be worried about the company losing money and the lack of margin expansion. If this isn’t resolved within the next few years, as management says, then Spotify might not be a worthwhile investment to have in your portfolio.

Brett Schaefer holds positions in Spotify Technology. The Motley Fool holds posts and recommends Spotify technology. The Motley Fool has a disclosure policy.

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