Nobody wanted to own Spotify (SPOT 1.44%) stock in 2022. After a huge run-up in late 2020 and early 2021, investors started to sour on the music streamer due to a lack of profitability. The company put up strong growth across all of its key performance metrics but failed to show gross margin expansion and positive operating profits. In a bear market where Wall Street is focused on what a company will earn over the next few quarters, this was a recipe for disaster, with shares falling 66% for the year.
But there are signs things will turn around in 2023. Already up 15% this year, is Spotify ready to make a comeback?
Sustained growth in music streaming
The majority of Spotify’s growth over the past decade has come from its premium music streaming business. With an estimated 30%+ share of the global market, the company has won supremacy versus big tech giants like Apple, Amazon, and Alphabet, a highly impressive feat. Last quarter, premium music subscribers at Spotify hit 195 million, growing 13% year over year despite the company’s decision to exit the Russian market.
Financially, this equated to approximately $2.8 billion in subscription revenue, or $11.2 billion when strung out to a full year. This is more than double the $1.3 billion in quarterly subscription revenue Spotify generated in the third quarter of 2018. Analysts think this growth is set to continue for many years, with projections for industry spending to grow by 15% a year through 2030 through a combination of new subscribers and price increases. If it can maintain a 30% market share this decade, Spotify’s premium music business should grow along with this broader industry tailwind.
Spotify’s gross margins in music streaming are fairly low, at 28% last quarter. This made it harder for the company to achieve bottom-line profitability (the net loss was $179 million last quarter); however, it has a new business segment that should mend these profitability woes called the two-sided marketplace. These are tools that artists and music labels can use to promote their work to Spotify users. With lower costs compared to the subscription business, the two-sided marketplace has slowly but surely led to gross margin expansion in Spotify’s premium segment, something that should continue over the next few years as well.
Optionality in other audio forms
Spotify is not just a music streaming business anymore. Over the last few years, Spotify rebranded itself as a “global audio platform,” which in plain terms means it wants users to be able to access all forms of audio on its service. Since around 2018, management has started spending billions of dollars to make this vision come to life.
So far, the majority of these investments have been in podcasting. Spotify acquired multiple podcasting studios and distribution platforms, and started to exclusively license content from popular shows. In the near term, this spending has been a drag on margins. But over the long term, Spotify believes it can make money on podcasting by building out a global audio advertising marketplace. It is too early to tell whether podcast advertising will be successful, but there are signs that things are going well so far. For example, Megaphone — one of the distribution platforms Spotify owns — reported a 38% growth in podcast downloads in 2022. More downloads mean more potential slots for advertisers and is a key metric for investors to follow.
Longer term, Spotify wants to branch into things like audiobooks, sports, and live audio. It is even harder to figure out how these mediums will benefit Spotify financially, but it shows the company’s ambitions to become much more than just a music streaming player.
Will the business finally achieve profitability?
I think Spotify has a clear path to finally reaching sustainable profitability levels in 2023. First, it is seeing rapid growth in its promotional discovery tools, which should drive gross margin expansion for the premium music business. Investors should be watching premium gross margins to see if they continue to inch higher this calendar year and for the next few years as well.
Second, management says that 2022 will be the worst year for advertising gross margins, which are getting heavily impacted by spending on podcasts right now. In Q3 of 2022, advertising gross margins were a measly 1.8%, which brought down Spotify’s consolidated gross margins. If advertising gross margins start to recover in 2023, that will boost Spotify’s gross margins (and hopefully bottom-line profits) as well.
Third, management has decided to pull back 25% on employee hiring to save on costs. This will directly impact profitability by lowering its operating expenses from 2023 onward.
Add up all these factors and I think Spotify is in a great position to start generating sustainable profits in 2023, making the stock a great buy at today’s beaten-down price.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Brett Schafer has positions in Spotify Technology. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, and Spotify Technology. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
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