EUR 850.00 For Business Accounts Only

Morningstar | Spotify Reports Strong 3Q Numbers but Guidance Disappoints; Shares Are Lower and Approaching Our FVE. See Updated Analyst Note from 01 Nov 2018

Spotify’s third-quarter results exceeded our expectations and consensus as the firm continued to display strong overall user growth. However, we note that user growth was driven by more lower-priced bundled offering subscriptions that decreased Spotify’s average revenue per user. We remain convinced that no-moat Spotify’s first-mover advantage will deteriorate over time as larger companies such as Apple will gain further traction in the streaming music space and may put pricing pressure on Spotify. While management’s fourth-quarter revenue guidance exceeded consensus, its subscriber count expectation was a bit disappointing, in our view. We did not make significant adjustments to our model and are maintaining our $124 per share fair value estimate on the company. The stock is down nearly 6% in reaction to third-quarter numbers and has declined more than 27% since late August. Spotify shares are now in 3-star territory and we advise investors to wait for a larger margin of safety.

While Spotify’s revenue and user growths remain impressive we continue to have a few concerns about the firm’s ability to compete with larger players and to negotiate more effectively with major record labels. First, we expect deceleration in overall monthly active user, or MAU, growth as companies like Apple, Google, and Amazon begin to more aggressively market their comparable music streaming offerings. As a reminder, in our view, Spotify lacks the network effect moat source necessary to fend off those competitors.
Second, while agreements similar to the recently announced one with Google improve Spotify’s presence in smart homes, we think apps such as YouTube Music, Apple Music, and Amazon Music will still have the upper hand as they will be available in those companies’ entire ecosystem of products.

Third, we continue to think that gross margin expansion for this firm will be limited given the lack of any leverage when negotiating take rates with record labels. In addition, the decline in the company’s average revenue per user, indicates no pricing leverage when competing with Apple, Google, and Amazon, in our view.

And fourth, while Spotify’s newer offerings such as Spotify for Artists are attracting content creators, we think the offerings can also affect the firm’s relationship with the record labels. The firm says that 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 taking artists away from the major labels. For this reason, we do not expect more favorable agreement terms for Spotify. In addition, if the major labels were to increase Spotify’s take rate, 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.

Spotify reported third quarter revenue of EUR 1.35 billion, up 31% year over year, driven mainly by a 27% increase in MAUs. The firm’s 191 million MAUs consisted of 87 million premium subscribers, 43% higher than last year. However, average revenue generated from those users dipped 6.5% as without a network effect moat source Spotify has to continue to more aggressively pitch its lower priced family and student offerings. The firm’s third quarter revenue per premium user was EUR 4.73, compared with last year’s EUR 5.06. Total premium revenue increased 31% from last year to EUR 1.2 billion. Ad-supported revenue grew 30% year over year to EUR 142 million, which we view as positive because growth in the segment could help Spotify on the bottom-line more than growth in premium revenue. We think ad-supported gross margin may be helped in the future by the lower-cost programmatic ad sales and the easier to use dashboards for advertisers.

On the margin front, gross margin declined 50 basis points to 25.3% from last quarter mainly due to seasonality as the firm runs more content and artist specific promotions in third quarter. Compared with last year, gross margin improved by three percentage points. While we expect gross margin on premium revenue to remain around 25% within our 10-year model, we have assumed ad revenue gross margin expansion given improvement in demand from advertisers, the higher take rate associated with ad revenue, and lower costs of ad inventory sold programmatically.

Spotify is progressing toward profitability (which we expect will be achieved in 2021) as its third-quarter EUR 6 million operating loss was a significant improvement from last year’s EUR 73 million and second quarter’s EUR 90 million losses. Management stated that such rate of improvement likely will not continue in the fourth quarter nor possibly in 2019 as the firm remains focused on further investments in R&D to come up with more innovative offerings for its listeners and the artists. We expect operating margin to hit around 11% by 2027, a significant improvement from last year’s EUR 1.2 billion operating loss.