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Spotify: Predictable Growth, Slim Income Margins

With a stronghold position in a growing industry, Spotify features great characteristics, such as a predictable revenue expansion path ahead.

However, its net margins remain compressed. As future profitability expectations remain slim, investors need to be wary of the potential risk regarding the company’s future shareholder value creation prospects. (See SPOT stock charts on TipRanks)

That being said, the stock may have upside at its current valuation, if the platform’s massive user base is monetized through additional avenues. I am neutral on the stock.

Predictable Revenue Growth Trajectory

Spotify’s success is the result of the company gathering all the right ingredients. Because Spotify promotes its service on all platforms, it has never limited its user base’s potential reach.

This has been a huge growth catalyst. Even if you are an iPhone user, Spotify’s blander compatibility with multiple devices and operating systems provides a smoother experience than Apple Music (NASDAQ:AAPL).

Further, Spotify’s smart strategy of offering ad-supported streaming has allowed it to grow its prevalence by not demanding a must-have subscription barrier, letting users familiarize themselves with the platform before paying a single dime.

Consequently, Spotify’s MAUs have been swiftly building quarter after quarter. As more MAUs are funneled through the company’s ad-supported business model, subscriber growth eventually takes place.

In Q2, Spotify reported premium subscriber growth of 20%. This is quite an impressive growth rate, considering the company’s 165-million subscriber count should indicate that the company is maturing.

As far as user retention goes, users of Spotify, or any other platform, are highly unlikely to migrate. Due to adapting with their respective platform, including creating playlists, sharing music with friends, etc., migration chances are quite low.

Therefore, considering that the digital music industry is expected to keep growing in the medium-term, Spotify’s user base, and consequently revenues, should keep growing steadily. Revenue growth should experience little to no fluctuations, as has been the case consistently due to sky-high retention rates.

Compressed Net Margins

While Spotify’s high-quality revenue generation traits are great, the problem is that almost none of it makes it to the bottom line. In Q2, for instance, the company’s gross profit margins were only around 28.4%, translating to €663 million in gross profits.

The cost of sales primarily consists of royalties paid to artist/record labels – hence why gross margins are so compressed. Of the €663 million, €651 million were allocated in R&D, marketing, and administrative expenses.

Hence, operating income was barely positive during the quarter. Subtract any financial costs, and Spotify once again reported a money-losing quarter. Not by a lot, but still, unable to show improving margins.

Despite Spotify’s attractive characteristics, the company is competing significantly with a handful of services, such as Apple Music. As these few services try hard to take users from each other continuously, advertising expenditures should remain very high.

Further, music labels have no reason to negotiate lower royalties. Therefore, while Spotify keeps growing, there is no tangible plan for investors to see a juicier bottom line, and hence, growing shareholder value.

Turning to Wall Street, Spotify Technology has a Moderate Buy consensus rating, based on nine Buys, five Holds, and two Sells assigned in the past three months. At $297.07, the average SPOT price target implies 19.3% upside.

Bottom Line

Admittedly, the company may be able to monetize its humongous user base through other, higher-margin offerings.

In that case, Spotify’s shares may carry significant upside, given its P/S multiple of 5.53. Still, uncertainty remains.

Disclosure: At the time of publication, Nikolaos Sismanis did not have a position in any of the securities mentioned in this article.

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