It’s not often that market favorites succumb to a flash sale, but that’s exactly what is happening right now to Spotify (SPOT). The world’s leading music streaming company is currently trading at a ~20% discount from recent peaks after the company reported fiscal third-quarter results, interrupting a massive year-to-date rally that at one point had Spotify up nearly 2x for the year.
While it is true that Spotify’s headlining third-quarter results missed expectations, I don’t see any fundamentals at risk. Important to note is that the entirety of Spotify’s misses were driven by unfavorable FX movements. The same headwind has dragged down all major European tech companies, including and especially SAP (SAP) – with the fall of the dollar against the Euro hurting reported revenues. Spotify’s core metrics, however, including MAUs and premium subscribers, all trended smoothly.
In my view, there’s still a robust bullish thesis for Spotify, backed primarily by:
- Dominant music streaming platform with new territories still to expand into. Spotify already has a leading position in the major developed markets, but new emerging countries provide a major source of untapped revenue growth. Spotify recently launched in Russia, a huge population center, to favorable results.
- Natural profit expansion to come with scale. Spotify’s biggest cost of revenue – content licensing – will diminish as a percentage of revenue as the company continues to engage more users and grow revenue from both Premium and ads. We’ve already seen the benefits of scale in Spotify’s expanding free cash flows
- New content like podcasts also drive differentiation and growth. Spotify has found success in its big bet on podcasting, with the Joe Rogan podcast debuting exclusively on Spotify in September. A growing number of Spotify users are adopting podcasts, and Spotify has cited the addition of podcasts as a major growth vehicle for Premium.
In my view, Spotify is still sitting in the early stages of a very greenfield marketing opportunity – both in terms of content expansions as well as geographical territory expansions – that make it a worthwhile bet to buy on sharp dips. Take advantage of the post-earnings slide to initiate or build up a long position in this fantastic name.
Let’s now cover Spotify’s most recent results in greater detail and pull apart the factors that caused (in my view, unnecessarily) the stock to plummet post-Q3. Take a look at the earnings highlights in the snapshot below:
Spotify’s revenue grew 14% y/y to €1.98 billion. The good news is that this revenue accelerated ever so slightly from Q1’s growth rate of 13% y/y; the bad news is that Wall Street had expected a slightly better result at €2.00 billion, or +15% y/y.
Broadly speaking, there were three high-level themes that drove the business this quarter:
- Spotify continued to grow overall MAUs. As can be seen above, the company added 15 million net-new monthly active users in Q3, with its total user base up 31% y/y – roughly the same pace as the company has been growing for the past several quarters. The increase in users, meanwhile, fed an increase in both Premium and ad-supported revenue.
- Ad rates recovered. As we have seen across the internet sector, advertising pricing saw its deepest valley in Q2 as companies responded to the coronavirus by yanking their marketing budgets. As a result, ad revenue had declined by more than 20% in Q2, but as can be seen in the chart above, ads returned to 9% y/y growth.
- Unfavorable FX movements. The strengthening of the euro against the dollar had a 500bps negative impact to Spotify’s revenue growth this quarter.
Given that the first two tailwinds to the business were true fundamental drivers, and the latter is more of a macro driver over which Spotify has no control, I’m inclined to view Spotify’s third-quarter results in a very positive light.
Some more details that are helpful to flesh out in the results. Spotify noted that both Total MAUs and premium users exceeded the company’s internal forecasts. In particular, Spotify benefited from North American user growth accelerating by 400bps, while developing markets also saw tremendous user growth – Latin America and Rest of World segments grew 30% y/y and 51% y/y, respectively. The latter was supported by very successful promotional activity in India (which, as most know, is the world’s second-most populous country, only slightly behind China), which represents a huge market opportunity for Spotify as the middle class and access to popular technology continues to explode. Another big highlight for Spotify in the quarter: the company recently launched its services in July in Russia (the world’s eight-largest country) to strong customer reception.
Another possible future revenue driver for Spotify: alongside strong user growth, Spotify has recently tested a potential price increase. Streaming and entertainment companies have taken advantage of strong COVID-era demand to pass on some of the rising content costs to consumers; just last month, Netflix (NFLX) also raised the price of its standard plans. While Spotify hasn’t solidified any price increases yet, the company believes its customer base could easily absorb one. Per CEO Daniel Ek’s prepared remarks on the Q3 earnings call:
And while it’s still early, initial results indicate that in the markets where we’ve tested increasing prices, our users believe that Spotify remains an exceptional value and they’ve shown a willingness to pay more for our service.
So as a result, you’ll see us further expand price increases, especially in places where we’re well positioned against the competition, and our value per hour is high. I would however, throw in one big caveat; we will continue to tread carefully in these COVID times to ensure that we don’t get ahead of the market.”
Another big highlight for Spotify this quarter is cash flow. Spotify continues to dramatically expand its cash flow, with FCF rising more than 2x this quarter to €103 million, reversing weakness earlier this year stemming from the decline in advertising rates. This is on top of a rock-solid balance sheet with €3.71 billion in cash and no debt – giving Spotify plenty of firepower to continue investing in content and podcasting to pull in more users.
Spotify remains a strong growth play with several upside catalysts ahead: including launches in new markets, content expansion including podcasts, tertiary revenue opportunities in creating a marketplace business, and possible price increases for Premium. The recent ~20% dip from peaks represents a fantastic, well-timed entry point – investors should take advantage of the fall to buy.
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Disclosure: I am/we are long SPOT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.