Spotify (NYSE:SPOT) stock dropped in late July after the global music streaming giant reported shaky second quarter earnings that missed expectations and included a weak guide for the rest of the year.
Zooming out, Spotify’s earnings broadly confirm that SPOT stock is overvalued at current levels.
From a product, platform, content and engagement perspective, Spotify is firing on all cylinders. Management is doing everything right to ensure that Spotify does turn into the Netflix (NASDAQ:NFLX) of music streaming.
But, despite that reality, the long-term profit growth prospects of the company remain hampered by competition, weak pricing trends and anemic profit margins.
So long as that remains true, Spotify stock does not deserve its current valuation.
Here’s a deeper look.
Spotify is Crushing It Operationally
There’s no denying one simple truth. When it comes to building the best music streaming platform on the planet, Spotify management is killing it.
Management continues to lean into Spotify’s superior UI, advanced data-driven song recommendation algorithm and cool features like lyrics integration to make the platform stand out as the most useful and engaging music streaming platform out there.
Beyond that, management is also doing a great job building out a robust original content portfolio, made up almost entirely of exclusive podcasts. About 21% of Spotify’s user base interacts with these podcasts, so they are increasingly turning into a big engagement driver.
Spotify is also creating other forms of original content (like audio books) to further flesh out the platform’s content moat.
And, perhaps most exciting, Spotify continues to grow its two-sided marketplace, with the number of artists using Spotify for Artists tools on a monthly basis growing 68% year-over-year in the second quarter to more than 690,000.
Spotify Management is Doing Everything Right
All in all, best-in-class product. Most relevant recommendation algorithm in the business. Tons of compelling and engaging original content. A booming “sell-side” business to retain artist loyalty.
From a product perspective, then, Spotify is absolutely crushing it.
The numbers speak for themselves.
In the quarter, monthly active users rose 29% year-over-year. Premium subscribers rose 28% year-over-year. Growth came from all over the globe. Consumption trends rebounded to pre-Covid-19 levels. And churn remained low.
Financial Trends Remain Weak
The financial trends underlying Spotify’s core business, however, remain weak, and project to remain weak for the foreseeable future.
Specifically, there are two problems here. One, sub-par revenue growth. Two, anemic gross margins.
Despite 29% user growth in the second quarter, Spotify grew revenues by just 13%. The sub-par revenue growth can be chalked up to a 9% drop in average revenue per user (ARPU), which continues to fall precipitously because user growth is being driven by value offerings, like Family Plan (up to 6 members for just $15 per month) and Duo Offering (2 people for $13 per month), and promotions like “3 months on us”.
The problem here, of course, is that consumers globally simply aren’t willing to pay that much for music, because the internet has made listening to music very easy and very free. Sure, Spotify offers the advantages of being ad-free, having more songs and some exclusive content. But, as the numbers show, consumers aren’t willing to pay much for those marginal advantages. Maybe $5 to $7 per month. But not any more than $10 per month.
Thus, for the foreseeable future, Spotify will rely on value plans and promotions to drive robust user growth at low price points, especially against the industry’s high competitive backdrop.
Meanwhile, gross margins dropped slightly in the quarter to right around 25%, and project to drop more in the third and fourth quarters. The culprit is huge content investment. This is a necessary investment, as content is the fuel which drives the Spotify growth narrative. But it’s also an investment which won’t phase out anytime soon, and therefore, the outlook for gross margins is to remain sub-30% for the foreseeable future.
That’s just not a big enough gross margin to make huge profit production possible at scale.
Which is a big problem for Spotify stock, since shares are valued for huge profit production at scale.
Spotify Stock is Overvalued
I believe my long-term model on Spotify is reasonably aggressive and quite optimistic.
Still, that model doesn’t support Spotify stock up at $260 today.
I broadly assume that:
- Spotify continues to add 25+ million new premium subs per year, growing to over 500 million subs by 2030 (versus 138 million today).
- Average revenue per user declines moderate and turn into mild growth as user growth slows, and ultimately pans out around $6 by 2030 (versus ~$5 today).
- The ad business scales at a similar pace as the premium subscriber business.
- Gross margins improve with economies of scale to 27.5%.
- Sustained robust revenue growth drives positive operating leverage, and pushes the opex rate down from what will likely be ~30% this year, to sub-20% by 2030.
- Earnings per share roar from huge net losses today, to $13 by 2030.
Those are aggressive assumptions for Spotify’s long-term growth trajectory.
They don’t add up to a $260 price tag for Spotify stock today.
Based on a typical application software stock multiple of 35-times forward earnings and an 8.5% annual discount rate, $13 in 2030 earnings per share implies a 2020 price target for Spotify stock of less than $220.
Bottom Line of SPOT Stock
Spotify is a great company. And Spotify stock was a great buy. Back at $100.
But, with shares now up at $260, Spotify stock is priced too optimistically. Sustained weak financial trends will eat away at the stock up here, and could cause a collapse in the stock back to $200.
As such, my two cents is simple. For now, stay away.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he was long NFLX.