EUR 850.00 For Business Accounts Only

Morningstar | Spotify Reports Mixed 4Q Results; Increasing FVE to $130; Shares Remain Fairly Valued

With slightly better-than-expected subscriber growth offsetting the continuing decline in average revenue generated per user, Spotify’s fourth-quarter revenue came in ahead of our expectation but in line with consensus. Helped by gross margin expansion and lower costs associated with stock options and restricted stock units, Spotify’s operating income and margin were above our internal projections and consensus. As we have noted for some time, no-moat Spotify must begin acquiring content or diversifying its revenue. The firm took a step in that direction as it announced the acquisition of two podcast firms, Gimlet Media and Anchor. The impact of those acquisitions on Spotify’s top and bottom lines will be minimal. After slightly increasing our margin assumptions due to higher guidance provided by management and rolling our model forward, we are raising our fair value estimate by around 5%, to $130 per share. Although the stock is down in reaction to the mixed results, it remains in 3-star territory. We continue to recommend a wider margin of safety before investing in this no-moat and very-high-uncertainty name.

Spotify reported total fourth-quarter revenue of EUR 1.5 billion, up 30% year over year, driven by a 34% increase in monthly active users from whom the firm generates subscription and ad revenue. The firm’s premium subscriber count increased 37% from last year and 10% from last quarter, mainly due to the holiday season and further promotions and discounts, which hampered the monetization of the users. Average revenue per premium user declined another 7% year over year to EUR 4.89. The lack of a moat source, more specifically the network effect, is forcing Spotify to consistently lower its prices in order to compete with competitors such as Apple and YouTube. We note various promotions, such as the latest one with Google Home, which drove some of the growth in premium subs, may not help Spotify retain those users. We think apps such as YouTube Music, Google Play Music, Apple Music, and Amazon Music will still have the upper hand as they are also available in and well integrated within those companies’ entire ecosystem of products.

Improvements in both premium and ad-supported gross margin drove the firm’s overall 220-basis-point gross margin expansion to 26.7%. Premium gross margin was helped a bit by one-time adjustments to some agreements. While the firm said it expects expansion in premium gross margin, we remain convinced that ad revenue can drive most gross margin expansion for Spotify. 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’s overall gross margin to widen to 32% by 2028 from 26% in 2018.

Lower spending on research and development and general and administrative expense, year over year and sequentially, helped Spotify generate operating income for the first time. Fourth-quarter operating margin was 6%. Lower G&A expense was mainly due to lower social costs. We remain convinced that with further expansion in gross margin, mainly due to ad revenue growth, the firm can generate double-digit operating margin within the next 10 years.

Spotify is more aggressively attempting to reduce its dependence on labels as it continues to invest in building new tools for artists and publishers while trying to add offerings to its listeners. The firm announced the acquisition of Gimlet Media and Anchor, to be completed by the end of first quarter. The prices for which Spotify will be acquiring the two were not released. Based on a study conducted by the Interactive Advertising Bureau and PricewaterhouseCoopers, around $659 million (EUR 580 million) in ad revenue can be generated in the United States alone by next year. While we agree with such an estimate and assume that ad revenue in such a market is likely to grow faster than overall online ad spending, we don’t think revenue generated from the newly acquired podcast offerings will effectively reduce the firm’s reliance on labels. In fact, Spotify guided to the two acquired firms adding only EUR 25 million-30 million during 2019. This represent a run rate of only EUR 33 million-47 million in revenue, which is less than 1% of our estimate of Spotify’s total revenue in 2019. Assuming a healthy 10-year compound annual growth rate of 30%, we think podcast revenue can grow to represent only 1%-3% of Spotify’s total revenue by 2028.

Regarding development of offerings for content creators such as Spotify for Artists, we think the offerings can affect the firm’s relationship with the record labels. The firm says it expects labels to welcome Spotify services, as those services may reduce some costs associated with marketing and promotions for them. However, we think the labels may also fear that these additional offerings by Spotify may attract more licensing directly to the firm and possibly take artists away from the major labels. For this reason, we do not expect more favorable long-term agreements for Spotify. In addition, if the major labels were to increase Spotify’s take rate, the impact on the firm’s bottom line may be limited, as it is more likely to be offset by Spotify’s higher marketing and promotion cost per artist.