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Morningstar | Spotify Pleases the Street With Better-Than-Expected 2Q Results; Shares Remain Overvalued

Spotify reported slightly better-than-expected second-quarter results, driven by user growth and partially offset by continuing decline in revenue generated per user. Management provided top- and bottom-line guidance in line with our estimates. However, due to stronger second-quarter user growth along with an anticipated increase in spending on subscriber acquisition, we increased our revenue growth and operating loss estimates, which did not change our $124 per share fair value estimate on Spotify. We continue to believe that while no-moat Spotify is ahead of the pack in the growing music streaming market, it faces stiff competition from behemoths such as Apple, Google, and Amazon. Unlike Spotify, these moaty firms don't just rely on streaming music or listener ARPU to drive profitability. They can continue to run music as a loss leader while monetizing users via other products and services. While we expect Spotify to expand margin and become profitable in 2021 and beyond, we do not think the firm’s current valuation is warranted and continue to view this no-moat and very high uncertainty name as overvalued.

Total second-quarter revenue grew 26% year over year to EUR 1.3 billion as the firm added net 24 million users to its premium subscriber count, pushing that figure up 41% over last year to 83 million. Sequentially, Spotify added net 8 million premium subscribers during the quarter. More aggressive promotions and discounts likely helped push Spotify’s subscriber count higher. In our view, as the firm lacks a network effect moat source, we think Spotify will be forced to continue with such a strategy, which will weigh on its ability to monetize its users. This was evident during the quarter as average revenue per user declined 12% year over year and inched up only 4% from last quarter to EUR 4.89.

Overall gross margin expanded a bit more than we had modeled mainly due to growth in ad-supported gross margin. We continue to believe that ad revenue can drive most gross margin expansion for this firm. Within its ad-supported segment, Spotify may prosper from either a rise in freemium users and, in turn, the number of advertisements shown, or from average revenue per user by selling more ad inventory per user and/or extracting higher ad prices. We expect Spotify gross margin to widen to 32% by 2027, from 21% in 2017 and 26% during second quarter 2018.

More investments in R&D resulted in operating loss of EUR 60 million (excluding one-time costs associated with the firm’s direct-listing). R&D expense as a percentage of sales went up 2 percentage points from last year to 11%, while sales and marketing spending remained at around 14% of total revenue.

While Spotify’s subscriber growth was slightly higher than expected, competition continues to heat up. According to Digital Music News, Apple Music U.S. subscriber count likely surpassed those of Spotify in 2018 and stand at above 20 million. Plus, while total Apple Music subscriber count is only half of Spotify’s 83 million, Apple subscribers have doubled since December 2016 compared with Spotify’s 69% increase during the same period. In addition, we are not convinced that the Spotify offerings which include subscription to over-the-top provider Hulu, will be a difference maker. Nor do we think they may create customer loyalty. In fact, some of Spotify’s biggest competitors, including Amazon, Google, and Apple can more easily provide similar offerings as they already have vast libraries of attractive video content.

On the content side, as we have mentioned in our previous reports, we think Spotify will remain very dependent on labels. Unlike Netflix on the video side, Spotify does not own any of the content that keeps attracting listeners. Some may view the firm’s offerings of creator tools, such as Spotify for Artists, indicative of Spotify attempting to become a label. However, such a strategy can also affect its current relationships with the major labels.