Spotify Technology: Be Careful

Investment Thesis

Spotify Technology (NYSE:SPOT) is the world's leading music streaming service provider. In Q2 2023, they reported adding a record 36 million net monthly active users (MAUs), bringing their total to 551 million. While they provide a great service that millions obviously love and use daily, I am still skeptical of the stock for one main reason:

CONTENT IS KING

Spotify currently makes no money on its operations. Its earnings per share have been negative for the past five years, and the situation has not improved. In 2022, EPS was -$2.42, and analysts expect it to be even worse in 2023, at -$2.95. Spotify has missed analyst consensus multiple times now, and I find it difficult to see the company turning earnings around any time before 2025 or 2026.

The cost of producing or retaining content is not going to get cheaper. AI may help the company become more efficient, but this is banking your investment thesis on the hope that Spotify will be able to utilize the tool to create and utilize content more efficiently for its users. This may happen, but it could be a while.

The truth is, Spotify is at the mercy of its record labels. They are the ones who maintain the pricing power and leverage, as they gather royalties each time a song is played on SPOT. Over 80% of music licensing is controlled by three major record labels: Universal Music Group, Sony, and Warner Music. Not to mention, Spotify faces stiff competition from the largest tech companies with the deepest pockets: Apple (AAPL), Google (GOOG) (GOOGL), Amazon (AMZN), and Samsung (OTCPK:SSNLF).

There is no doubt that Spotify is seeing solid growth and adoption, with a five-year sales compounded annual growth rate of 22%. However, this has not translated to the bottom line yet. MAUs grew 27% year over year in Q2 2023, which is a great sign. Now sitting at 551 million users, I find it hard to see the company continuing at such a high growth rate. They are now one of the most subscribed service providers in the world, yet have not found a way to consistently stay profitable.

You can argue that podcasts will help lower churn and retain customers, that AI will boost margins, and that MAUs could hit 2 billion by 2030, but at the end of the day, it is all speculative. Seeking Alpha's analyst estimates see 2024 EPS at $0.43, which seems extremely lenient, and would put the stock around a 365x P/E multiple. For me to accept that and be confident in my investment, I would need to see interest rates near 0 and triple-digit growth.

My point is, SPOT is extremely overvalued and trading based on speculation. The company may not have much debt, in fact, cash exceeds debt on the balance sheet, but it still struggles to generate cash flow from operations. The cost to create content for creators is not getting cheaper, and I believe that if SPOT does not tweak its business model, it will continue to struggle. At a $30 billion+ market cap, I find it hard to justify holding the stock, especially when compared to relative competitors with smaller market caps and positive net income.

I reiterate: content is king. As time goes on, operational costs will only get more expensive for SPOT to retain original, top-tier content. Spotify's stock is up over 100% year-to-date, wiping away any favorable risk-to-reward ratio.

I will closely watch the stock over the next six months, expecting a pullback back down to the $120s or lower if earnings or guidance are that poor.

Until SPOT can convince me that it will be able to consistently generate profits and steadily grow users, I can't justify owning the stock. We will have to see if they grow into their steep valuation or if estimates and stock prices come back down. I highly suggest steering clear of the stock for now.

Fundamentals

The main thing I want to focus on is Spotify's margins. They have struggled to find their footing throughout the past few years, which I believe is because the business model is ultimately flawed. They have a great product, service, and interface that customers love, but at the end of the day, they are just a middleman.

Gross profit margins, EBITDA, EBIT, and net income margins are all below the company's five-year average and well below the sector's median. This tells me something is wrong with the business. Spotify has no pricing leverage. Whether it's premium subscribers or free subscribers that help them generate ad revenue, Spotify needs to figure out how to reduce operating costs and debt expenses to improve margins. Margins have been all over the place, and AI hopes have given the company a spark, but I still struggle to see how AI will help if Spotify does not own the content.

Management expects third-quarter gross margins to come in at 26%. Anything else could cause a wide pullback in the stock, especially given its 1.71x two-year beta. Analysts predict that gross margins can reach 30-35% over the next five to ten years, but I want to see progress in the short term before I can believe that and look to the future.

Free cash flow has also taken a big hit in the past two years, sitting at just above $20 million, which is a tenth of what it was in 2021. Spotify will need to continue to spend to create and bring in high-quality content to help retain customers. FCF will be key to helping finance content creation and to retaining top talents like Joe Rogan. Spotify will have to find a way to make cash flow more consistent.

Now, SPOT does not have a lot of debt, which is great. As I mentioned before, they have more cash than debt, which is a good sign. However, the true content creators and owners cannot say the same. Look at Warner Bros. (WBD), for example; they have an insane amount of debt. If other companies and content creators have high debt to finance projects and content creation, that just means they will raise prices for a third party like Spotify. Spotify's costs are not going to get any cheaper, so they need to find a way to cheaply create new content.

Take Netflix (NFLX) for instance. In my opinion, they are the king of content. They constantly put out award-winning movies and TV shows, such as Stranger Things, Bridgerton, Squid Games, Peaky Blinders, and The Queen's Gambit, just to name a few. In the subscription services industry, you need to offer customers something that others can't. I can't say that Spotify does that.

Apple Music, Amazon Music, and YouTube Music all offer almost exactly the same product. What separates these companies is that they don't need their music services to generate cash flow. In fact, they all probably operate at a loss, but that's okay. They just want to bring you to their other products or services, which puts Spotify at a disadvantage.

It's not all bad, though. I want to give Spotify credit for the user base they've built and the incredibly user-friendly interface that people love. However, just because it's a great product doesn't make it a great investment. They've taken multiple steps to innovate and diversify their platform.

Valuation

I briefly addressed the stock's P/E ratio earlier. It currently has no P/E ratio since EPS is negative. Using (generous) analyst estimates, we can estimate that the stock's forward 2024 P/E ratio is over 360x, which is ludicrous. This is one reason why I believe the stock is due for a correction in the near term after an over 100% YTD rally.

Even looking at the stock on an enterprise value to sales (EV/S) basis, it seems overvalued, trading at 2.1x EV/S, 17% higher than its 5-year average of 1.79x. This tells me that the company's value has increased at a faster pace than sales. Sales have grown at a steady rate, but I expect them to decelerate in the coming years given how large the company has become. Either way, I still find it hard to justify the stock's $29 billion enterprise valuation.

Using EV/S and analyst estimates, I have created a next twelve-month price target scenario. I have the stock slightly above fair value, with a terrible 0.7x risk-to-reward ratio. This means that I see more downside risk than upside risk in the stock at current levels.

In addition to this price target scenario, I do not like the look of the stock chart either. Using the Fibonacci retracement tool, SPOT has been struggling to pass a huge resistance point at $159.56. This leads me to believe that the stock does not have the momentum or catalyst to continue moving higher.

My bear case scenario above is around $129 a share, and the next true support level on the chart is around $128. I truly believe that the stock could see a pullback to this range in the coming months, which would be a better entry point for investors who love the product and company. For now, I suggest that investors stay cautious and avoid buying SPOT at current prices.

Risk

If I haven't made it clear by now, there are multiple risks to note when considering Spotify's stock, including negative profitability, unjustified valuations, lack of pricing power, not owning the rights to its content, and intense competition. The company's business model has multiple flaws, and it has large competitors with much more cash who are gunning to take its customers.

Don't get me wrong: Spotify is taking cautious measures to try to fix its problems by diversifying its product offerings, utilizing AI, and monetizing its platform. However, all of this is easier said than done.

Spotify has also become a juggernaut in the music industry, but its high monthly active user (MAU) growth will eventually come to an end. I believe that as it sits at 551 million MAUs, the growth rate will start to decelerate, as it no longer has as many potential customers to attain. Plus, its competitors will continue to invest heavily in their products to build their platforms and attract more people to buy Apple iPhones, use YouTube, and visit Amazon's website and apps.

Conclusion

Spotify offers a great product. It is user-friendly, knows each listener's preferences, and has a great global presence. However, all of this combined does not outweigh the cons for me. To put it simply, Spotify cannot figure out how to consistently be profitable.

In today's age, content is king, and Spotify owns none of its audio. Customers have too many options to choose from, so Spotify needs something special to separate itself from its competitors. It has not found that yet.

Yes, AI may help Spotify become more efficient and profitable, but as a middleman in the industry, I don't see it helping anytime soon. That is why I am giving Spotify a sell rating. I find it hard to see the company has a strong positive direction in the next 6 months. 2023 Q2 growth was okay, but margins continued to be hit. Until I see steady improvement on top and bottom line margins, I will be staying away from this one. Competition is too intense, and I would not say Spotify has any long-term moat or edge over the industry.

I would look in a different direction when picking a growth stock with a better risk-to-reward ratio than buying a stock with high volatility.