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Background
Spotify (NYSE:SPOT) has provided a controversial quarterly report: an impressive addition of new users came along with declining margins. After publishing the 3Q results, the company’s shares were sold off and hit the lows. The main investors’ concern is the company’s attempts to increase margins have not yet been successful. Even despite the launch of podcasts. The podcast segment is assumed to have more margin than the traditional music streaming business. I think it’s time to look at the company’s shares more closely. Spotify’s valuation starts to look attractive at the current level. However, the fact that the company is relatively cheap does not always transform into the growth of its shares. This requires certain drivers. Let’s run through the report to understand whether the fall in the shares price after the report was justified. After that, I will determine some growth opportunities for the company.
Revenue
Quarterly revenue increased by 21% YoY to €3.03 billion, which was 1% better than consensus expected. The growth was mainly due to an increase in the number of active users. The total number of monthly active users (MAU) was 456 million (+19% YoY, 1% better than expected). In absolute terms, 23 million new users were added, which is the highest value for the 3rd quarter results in the company’s history. Excluding the positive F/X impact, the growth was 12% YoY. The total ARPU was at €6.8 (+2% YoY). I expect that annual revenue growth will continue in the coming years and will be at the level of 10-15%. I assume that the revenue growth will be primarily driven by the subscriber growth.
Margins
The decline of margins has become the main weakness of the reporting. The gross margin was 24.7%, 0.5 p.p. worse than the management forecast. The decline was mainly due to the impact of exchange rates, a slowdown in the advertising market, and adjustments related to the renewal of contracts with music publishers. The EBITDA loss amounted to €184 million (margin (-6%), a year earlier it was +4%). The growth of operating expenses amounted to 65% YoY. A 14-p.p. increase was due to the F/X impact. The increase in staff and higher advertising expenses were the main driver of the remaining part of the operating cost growth. Free cash flow was at the level of €35 million (-64% YoY), 3% worse than expected. I expect the pressure on margin to continue in the coming quarters. However, I believe that in the long-term period, the company will be able to reach the 10-12% adjusted margin level. Higher margin levels will depend on the success of the podcast segment.
Subscription revenue
Subscription revenue amounted to €2.65 billion (+22% YoY), within expectations. The number of subscribers increased by 13% YoY to 195 million subscribers. The average revenue per subscriber was €4.61 (+7% YoY). The net subscriber addition amounted to 7 million. In North America, the number of subscribers has not changed significantly. In Europe, the increase was +2.7 million, in Latin America +2.4 million, in the rest of the world +1.8 million.
Advertising revenue
The growth of advertising revenue contrasted with the weakness of the advertising market. Advertising revenue amounted to €385 million (+19% YoY, 5% worse than consensus expected) and reached a level of 13% of revenue. ARPU was at €0.53 (+2% YoY). Growth was double-digit in all regions except Europe. The number of active ad-supported users was 261 million (+23% YoY or +16 million MAU). The largest increase was in the North America segment (+5 million) and in the “Rest of the World” segment (+13 million). In Europe, there were no changes, and in Latin America, an outflow of 2 million was recorded. The growth of the music business was in the high single-digit rate, mainly due to an increase in the number of ad impressions. Meanwhile, the podcast advertising business grew at double-digit rates. Management did not provide exact figures, but said that podcast impressions and CPMs grew double-digit.
Forecast
Management expects active users to grow by 18% to 479 million by the end of Q4, which implies an addition of 23 million new users. The total number of paid subscribers is expected to reach 202 million (+7 million new users, +12% YoY). Revenue is expected to reach €3.2 billion, which implies an increase of 19% YoY. 8-p.p. increase will be due to the positive impact of the strengthening of the US dollar. Gross margin in the 4th quarter is projected at 24.5%. This is less than management expected at the beginning of the year (25%). As a reason, management identified three factors – a weak macro environment, exchange rate impact, and restructuring costs in podcasts. All three factors will have an impact of 0.7 p.p. The operating loss is expected at €300 million (margin -9%, 0% a year earlier). €95 million of the operating loss will be due to the impact of the strengthening of the US dollar. Due to the timing, a negative FCF is expected in Q4, but for the year and in future years, FCF is expected to be at a positive level.
Risks and Final thoughts
In general, SPOT’s quarterly results cannot be called terrible. Yes, there is a decrease in margins, but it is important that the revenue growth rates are at a high level. Considering the fall of the shares price, SPOT’s shares can become an interesting long-term investment. As a long-term investor, Spotify shares seem very attractive to me at the current level. However, in the short term (until the next reporting) I can’t see any significant growth drivers for the stock. The advertising market is unlikely to start recovering in the next month or two, which could give an impetus to the growth of SPOT’s advertising business. As a result, I do not expect a significant growth of the shares until the next reporting period, which may become a growth driver. Nevertheless, at the moment, the company’s shares look undervalued. According to my DCF model, SPOT’s share target price is $97, so in the long term, I have a bullish view on the company’s shares. My DCF model inputs are: revenue CAGR (22-27) is 11%, long-term EBITDA margin is 12%, a long-term WACC is 10%, and the terminal revenue growth is 3%.
A more successful development of the podcast business may give an upside to my valuation. Let me remind you that the music streaming business is not well scalable due to the high proportion of variable costs (royalties to music publishers). According to my estimates, the segment’s peak margin could be around 10%. The share of variable costs in the podcast business is less than in the music business. Due to the higher share of fixed costs, as revenue grows, the margins of the podcast business can become higher than that of the music streaming business. As a result, the overall peak EBITDA margin may be higher than the 12% I used in the model. In my opinion, the main driver of SPOT’s stock growth in the long-term period is the increase in margins.
Separately, I will note several risks that can be headwinds to the growth of SPOT’s shares in the coming months. As the main risks, I note, first of all, changes in currency exchange rates, as well as a decrease in real disposable incomes of the households due to the high inflation, which may lead to a reduction in the population’s spending on non-essential services (in this case, a music streaming subscription). I will also note the growth of competition may lead to an outflow of subscribers to other streaming services. I recommend you familiarize yourself with all company’s risks in the SPOT’s latest financial statements (20-F).
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