Spotify is still losing money. Should investors be worried?

Fall earnings season is just around the corner, with many tech and consumer internet stocks reporting third-quarter results in late October. Spotify (point 1.98%)The global leader in audio streaming, released earnings on October 25. Wall Street was unhappy with the report, and shares fell more than 10% in the following session.

Spotify again failed to expand its gross margins and generate profits in the third quarter of 2022. Should investors worry about the future of music streaming? let’s see.

Q3 Earnings: Strong User Growth

Before we get into the troubling parts of Spotify’s third-quarter results, let’s take a look at where the company is doing 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 was an increase of 23 million from the second quarter, a record net increase. Growth came primarily from its rest of the world, which includes all regions except North America, South America and Europe. Users in the rest of the world now account for 26% of overall MAU, up from 11% in 2018.

If this MAU growth rate continues, Spotify should have no problem hitting its goal of 1 billion users on its platform by 2030. Generally, 40% of all these new MAUs will convert to premium subscribers on Spotify’s ad-free tier. Premium users grew 13% year over year to 195 million in the third quarter. Paid music subscriptions are a major part of Spotify’s revenue today, with the unit generating €2.65 billion in revenue last quarter, and it should continue to grow as long as MAU also grows.

In the long run, Spotify plans to make money in many other ways, including podcast ads and selling audiobooks. However, these investments are still in the early stages and not important to the business today.

Profit margins continue to weigh on stocks

Investors have grown increasingly frustrated with Spotify due to the lack of gross margin expansion. In the third quarter, the company’s consolidated gross margin was 24.7%, which was basically the same as in 2018. Its premium gross margin has risen slightly over the past few years to 28 percent in the third quarter, thanks to its song and artist promotion tools.

But advertising gross margins fell sharply, reaching just 1.8% in the third quarter. While only a fraction of total revenue, advertising gross margins have been a big drag on consolidated gross margins over the past few years.

Why are advertising gross margins so poor? Because Spotify invests aggressively to build out its podcast content, advertising and licensing strategy.This includes buying studios like Ringer and licensing top shows like Joe Rogan’s Experience. These upfront investments have resulted in a massive increase in podcast listening market share (Spotify is now the No. 1 player in many markets), but dragged down gross margins in the short term.

Spotify promises gross margins will eventually be in the 30% to 40% range, which would lead to a potential profit margin of 10%. To do that, it needs to scale its ad revenue on top of its massive fixed podcast cost and rapidly grow its promotional market. Both segments (incremental ad revenue and promotional tools) have high gross margins, and if they become a large enough part of Spotify’s overall business, they should be able to drive consolidated gross margin growth.

what the future might hold

I believe Spotify may experience two scenarios in the next few years. On an optimistic note, if gross margins finally start to expand (which management says will happen in 2023), then Spotify could do well over the next decade. At its current market cap of $16 billion and gross revenue of about $12 billion, the stock could trade margin at a cheap price-to-earnings (P/E) ratio of around 10% over the next few years if net worth is in the next few years.

Even more pessimistic, if the promotional market and podcast ads don’t want Scale to a larger scale, and Spotify will struggle to expand its gross margin, and possibly its underlying net margin. That’s bad news for stocks.

Going back to the title of the article, yes, I do think Spotify investors should be concerned about the company’s losses and lack of profit expansion. If this doesn’t work out as management says it does in the next few years, then Spotify probably isn’t worth investing in your portfolio.

Brett Schafer is with Spotify Technology. Motley Fool has a position in Spotify Technology and is recommended. The Motley Fool has a disclosure policy.

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