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Spotify Technology: Profitability Concerns Remain


Spotify Technology (SPOT) is the biggest music streaming service provider worldwide, counting more than 406 million monthly active users (MAUs). Of these, 180 million are active premium subscribers.

With a prominent position in a growing market, Spotify exhibits some exceptional characteristics, such as a foreseeable revenue expansion path ahead.

However, I cannot get over the fact that the company’s tight net income margins deteriorate the stock’s investment case. Spotify’s profitability prospects remain too thin, despite its consistent revenue growth. Therefore, there is significant uncertainty regarding Spotify’s ability to produce strong future shareholder returns.

Spotify shares have corrected substantially from their 52-week highs of ~$387. However, there could still be more room for the stock to decline, considering the overall risks and lack of sustainable profit growth ahead. Accordingly, I am neutral on the stock.

Subscriber Base Is Growing

Spotify’s triumph over the rest of its music streaming peers has been built on its multi-platform availability and access. In my view, the fact that Spotify can be accessed from practically any device and operating system is the platform’s most significant growth catalyst.

Further, I am keen on Spotify’s ad-supported streaming, which has assisted the platform in attracting potential future subscribers by familiarizing them with the product before they have to spend a penny.

Consequently, the platform’s MAUs have been expanding quarter-over-quarter very consistently. So long as new MAU are being funneled via Spotify’s ad-supported business model, the subscriber base is set to be gradually expanding further going forward. This was once again demonstrated in the company’s most recent results. However, is the growth rate good enough?

In Q4, Spotify reported premium subscriber growth of 16% to 180 million. This implies a deceleration from last quarter’s 19% and likely confirms my ongoing concerns regarding the company converging towards a maturity phase.

The company noted that Spotify tested a shortened holiday promotional campaign for its Standard plan, which diverted typical gross intake seasonality. Considering that, premium subscriber growth could have decelerated further, excluding this promotion, which is further worrying.

On the one hand, I appreciate the fact that it is very improbable for Spotify subscribers to migrate to other platforms since once one becomes familiar with the platform, including creating playlists and sharing music with friends, changing platforms would be quite annoying.

On the other, if Spotify’s potential for sustaining profit growth moving forward lies in rapidly growing its subscriber base, things may not be looking that good based on Q4.

Margins Remain Inadequate

In spite of Spotify’s high-quality cash flow predictability traits, the company’s bottom line remains very uninspiring. In Q4, Spotify’s gross profit margins came in at 26.5%, declining sequentially from 26.7%.

COGS mainly include royalties paid to artist/record labels. Hence, gross profits are bound to remain compressed. Of the €712 million in gross profits, €253 million were allotted to R&D, €340 million to marketing, and €126 million to administrative expenses. These amount to €719 million, outweighing gross profits.

Hence, not only is it uncertain when and if the company will be achieving GAAP net income, but it’s hard to tell if the company will ever be able to post a robust operating income.

In any case, investors should not expect a dividend anytime soon.

Wall Street’s Take

Turning to Wall Street, Spotify Technology has a Moderate Buy consensus rating based on 15 Buys, six Holds, and one Sell assigned in the past three months. At $247.81, the average Spotify price target implies 62.7% upside potential over the next 12 months.

Conclusion

While Spotify does exhibit some attractive characteristics from an investors’ perspective, it doesn’t appear that there is a clear roadmap for the company to achieve sustainable profits – at least in the short term. For this reason, it’s quite uncertain whether the company will be able to sustainably create shareholder value going forward. I remain neutral on Spotify Technologies.

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