Why I’m Not Selling Spotify After a Disappointing Q2 Report

Shares of audio streamer Spotify (NYSE:SPOT) are dropping this week after the company released its Q2 earnings report. Investors were unhappy with the company’s growth in monthly active users (MAUs); Spotify added only 9 million new users in the quarter and reached a total of 365 million. In the Q1 report, management guided for 366 million to 373 million MAUs in Q2, which Spotify failed to reach. While these numbers were disappointing, there was plenty to like about Spotify’s Q2 report, and its long-term opportunity is still intact.

Here’s why I’m not selling Spotify after this Q2 earnings report.

A person listening to headphones on a bus.

Image source: Getty Images.

The numbers

While MAUs came in below expectations, most of Spotify’s other important metrics were strong in Q2. Premium subscribers (users who pay a monthly fee for ad-free music listening) grew 20% year over year to 165 million, with premium revenue growing 17% to $2.43 billion in the quarter. Premium gross margin expanded to 30.8% in Q2, albeit with some benefits from a one-time payback on royalty estimates.

One of the big knocks against Spotify is that it will fail to expand gross margin because of the heavy payouts it is required to make to music labels and artists. This quarter showed that those claims might not be warranted. Gross margin also expanded because of the increased usage of its music discovery marketplace, which is where artists pay to get promoted within users’ Spotify feeds. The marketplace is just getting started, bringing in high-margin dollars that can help Spotify’s premium gross margin tick upward over the next few years.

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Premium subscribers were solid, but the highlight of the quarter was advertising revenue, which grew 110% year over year to $325 million. It is only a small part of Spotify’s business right now but did help overall revenue rise 23% year over year and total gross profit increase 27% year over year, outpacing premium revenue growth.

Look at the big picture

Another reason investors were disappointed in Spotify’s Q2 results was the guidance it gave for the end of 2021. Its range for end-of-year MAUs was reduced from 402 million-422 million to 400 million-407 million. Reduced guidance isn’t good news, but this shouldn’t scare long-term investors in Spotify. Yes, this new guidance would mean a large slowdown in year-over-year MAU growth, from 27% down to 17%, but Spotify would still be growing MAUs by 59 million in 2021, which is not far off from the 74 million it added in 2020.

Year Total MAUs (millions) Year-Over-Year Growth
2017 160 N/A
2018 207 29%
2019 271 30.9%
2020 345 27.3%
2021 404 (midpoint of guidance) 17.1%

Investors should pay attention to Spotify’s progress with podcasts, into which the company has invested hundreds of millions over the last few years. This quarter, podcast revenue grew 627% year over year, albeit off of a small base (it is a subset of advertising revenue). However, with this rapid growth and new deals with top shows like Call Her Daddy and Armchair Expert, podcast revenue can become a big driver of Spotify’s financials within the next few years. It has just taken a lot of up-front investments to get going.

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Don’t forget about Spotify’s other bets either. In Q2, the company launched Spotify Greenroom, a Clubhouse competitor with live audio rooms. The app is currently free and hasn’t done a full commercial rollout yet, but on the conference call, CEO Daniel Ek said that the company is moving rapidly with Greenroom and plans to integrate it within the main Spotify app sometime soon. Greenroom and live audio will likely not contribute much, if any, sales for many years, but they are additional long-term bets like podcasting that could eventually pay off.

Valuation remains reasonable

Right now, Spotify’s market cap sits at $41.3 billion. If the company hits the midpoint of its 2021 guidance, it will generate $11.2 billion in revenue this year, giving the stock a forward price-to-sales ratio (P/S) of 3.7. This isn’t cheap when compared to Spotify’s low gross margin (which put a ceiling on its long-term net profit margin), but it is entirely reasonable if you think this business can continue growing at a double-digit rate.

Daniel Ek believes Spotify can eventually get 50 million creators and 1 billion users on its platform. If you agree with his claims, then Spotify still has a long road of growth ahead of it, and there’s no reason to sell the stock just because one earnings report didn’t live up to expectations.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

View more information: https://www.fool.com/investing/2021/07/31/why-im-not-selling-spotify-after-a-disappointing-q/

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