Spotify: A Valuation Reality Check Is On The Cards (NYSE:SPOT)

Spotify Expertise S.A. (NYSE:SPOT) reported respectable earnings for the second quarter yesterday, however the market was not impressed. SPOT inventory tanked greater than 14% as traders targeted on the income miss regardless of robust subscriber and consumer metrics. Three months in the past, I highlighted why profitability stays elusive for Spotify regardless of exponential development in month-to-month lively customers and subscribers within the final 5 years. After digesting second-quarter earnings, I imagine Mr. Market is being too harsh on Spotify, however I nonetheless want a wider margin of security to spend money on the corporate.

The Monetization Drawback

Spotify added 36 million internet month-to-month lively customers within the second quarter and 10 million subscribers to finish the quarter with 551 million MAUs and 220 million premium subscribers, each metrics above the corporate’s steering.

Exhibit 1: Q2 earnings snapshot

Subscription income grew 11% on the again of a 17% YoY subscriber development, however the firm booked a 6% decline in common income per consumer to EUR 4.27. In accordance with firm filings, ARPU was impacted by forex headwinds, product combine, and market combine. A better have a look at Spotify’s ARPU reveals the corporate has struggled to realize momentum for a number of years. In lots of cases, the corporate has attributed the regular decline in ARPUs to the expansion of its Household Plan, which permits as much as 6 individuals dwelling below one roof to make use of a subscription. The growing reputation of this subscription tier has certainly modified the corporate’s product combine through the years, negatively impacting ARPU. Nevertheless, traders mustn’t overlook that Spotify projected a reversal of this decline again in 2020 with no outcomes to indicate but, which makes this problem a basic barrier to income development.

Exhibit 2: Spotify premium ARPU

Spotify CEO Daniel Ek has repeatedly emphasised the corporate’s technique of specializing in constructing scale vs maximizing ARPU development within the quick time period. As an investor who has endorsed comparable methods of Netflix, Inc. (NFLX) and Uber Applied sciences, Inc. (UBER), it could not be justifiable if I had been to recommend Spotify do in any other case. Nevertheless, as I said in my earlier article, I imagine Spotify has already amassed sufficient scale to now deal with profitability, which is the catalyst that might transfer SPOT inventory increased from right here. In the course of the Q2 earnings name yesterday, CEO Daniel Ek mentioned:

So now let’s speak about income development. There are 3 ways for us to drive income development. We are able to develop our customers, we will create new enterprise with new income streams, and we will enhance income per consumer. Our choice amongst them is to deal with rising the general variety of shoppers on our platform as this provides us scale benefits and retains optionality for the long run. Nevertheless, we have additionally been clear that there’ll come a time when value will increase change into a extra essential device within the toolbox.

The significance of higher monetization might be understood by taking a look at a easy income metric. As illustrated under, subscription income accounts for the lion’s share of Spotify’s income (87% in 2022) however ad-supported customers account for greater than half of complete customers.

Exhibit 3: Spotify income by section

To enhance the monetization of its consumer base (which incorporates each premium and free customers), the corporate has embraced ads. To enhance the ARPU (not simply premium ARPU), Spotify can deal with just a few completely different methods.

1. Improve the share of premium subscribers.
2. Improve the price of premium subscriptions.
3. Enhance the monetization of ad-supported customers.

A monetization technique that mixes these 3 parts will assist Spotify understand a notable enhance in ARPU. The corporate has efficiently executed value hikes prior to now, and on Monday, introduced one other value hike that may see the costs of some U.S. plans growing by as a lot as 20%. It is a welcome transfer that may assist the corporate reverse the current developments in ARPU, however amid intensifying competitors and difficult macroeconomic circumstances, the corporate could need to accept an elevated subscriber churn as effectively. If some customers downgrade to the ad-supported plan, the general monetization will take a success as the corporate has struggled to realize momentum with advert income.

The approaching value will increase, alternatively, won’t incentivize ad-supported customers to tug the set off to change into premium subscribers. This can pose a problem to Spotify’s mission to extend the penetration of premium subscribers.

Coming to the monetization of ad-supported customers, the corporate is grappling with macroeconomic challenges which have dampened the outlook for the worldwide promoting sector. Though these challenges are prone to show short-lived, I imagine Spotify will proceed to seek out it tough to develop this enterprise on account of basic challenges. In contrast to Fb which might seamlessly combine adverts into our feed, Spotify adverts are available between music, which might have a significant impression on the expertise of customers. The corporate has accomplished a commendable job in taking issues sluggish to let customers familiarize themselves with ads, however I imagine the corporate’s skill to draw and retain advertisers is inherently low in comparison with social media platforms.

Product innovation is all the time a welcome signal, and Spotify’s foray into podcast streaming is an thrilling transfer on condition that podcast consumption is on the rise not simply in America however globally. Nevertheless, the corporate has confronted challenges in monetizing podcasts, primarily as a result of the corporate doesn’t have the rights to most of those podcasts. In accordance with Jake Barfield, founder and portfolio supervisor of Asheville Capital Administration, Spotify is unable to monetize greater than 99% of podcasts streamed on the platform.

General, I imagine the encouraging consumer development that we’re seeing as we speak will take years to be mirrored in Spotify’s monetary efficiency, if in any respect. I’m not within the least suggesting Spotify’s long-term focus is questionable. In reality, I want to spend money on firms that prioritize the sustainability of long-term earnings development over short-term profitability. In Spotify’s case, the trail to profitability stays unsure even in the long term due to the elemental challenges the corporate is going through as we speak.

A Valuation Actuality Test Is On The Playing cards

Within the best-case state of affairs, I imagine the worldwide promoting business will get well sooner than anticipated, paving the best way for Spotify to enhance the monetization of ad-supported customers. The corporate continues to develop MAUs at a stellar tempo, which units up the platform to learn from scale benefits sooner or later. Though an enchancment in monetization is a constructive growth, the corporate could endure from a valuation perspective. Within the final decade, Mr. Market has hooked up premium valuation multiples to subscription companies. In my view, traders want to spend money on subscription companies due to the diminished income volatility ensuing from recurring income streams. The anticipated development of Spotify’s advert enterprise will expose the corporate to the cyclicality related to the promoting business. Cyclical companies have traditionally traded at a reduction to subscription companies, and I imagine a valuation actuality test is on the playing cards for Spotify when the advert enterprise grows meaningfully to account for a sizeable share of complete income.

Takeaway

Spotify’s consumer development is encouraging, however the firm, as a result of inherent traits of its enterprise, continues to be discovering it tough to transform consumer development into tangible monetary outcomes. The corporate’s lack of profitability coupled with the expectations for rising advert income suggests a valuation actuality test is on the playing cards. Spotify is a real disruptor, however I’m not snug investing within the firm in gentle of the profitability challenges.