Shares of music streaming platform Spotify (NYSE:SPOT) have outperformed the broader market amid the coronavirus pandemic, mostly because investors have seen Spotify as relatively insulated from coronavirus-related economic disruption.
Spotify stock only trades about 15% below where it was in mid-February. The rest of the stock market, meanwhile, is deep in bear market territory.
The relative insulation thesis makes some sense. In general, the streaming music industry does not have significant exposure to the coronavirus pandemic, and Spotify makes most of its revenue from annually recurring subscriptions.
Spotify is also the unparalleled leader in the secular growth streaming music industry. Management is exceptionally innovative, and the company has time and time again come out ahead of the competition.
Long term, Spotify has tremendous potential.
But, in the near-term, there are risks when it comes to SPOT stock which the market seems to be ignoring. Those risks, strung together, make Spotify stock a tough buy here and now.
- Engagement could drop as consumers stay at home more. Recent data suggests that listening hours on Spotify are actually down since consumers aren’t commuting to work or going to the gym.
- Ad revenues are at risk of collapsing in the second quarter. Spotify makes a portion of its revenues through ad sales, and ad spending trends are going to get whacked in April and May.
- Bigger picture margin concerns remain an overhang. Spotify still operates with gross margins that are equal to its opex rate, and those gross margins are dropping.
- The valuation appears maxed out. According to my modeling, lingering margin concerns offset revenue growth potential, and at current levels, Spotify stock appears fully valued.
Engagement Headwinds
The consensus thesis on Wall Street seems to be that because consumers are stuck at home more, they are streaming music more, and Spotify’s engagement trends should be up in March, April, and May.
Ostensibly, that makes sense. But, when you consider that a lot of users listen to Spotify music or podcasts on their commute to work, or while working out at the gym, then that thesis starts to make less sense.
Indeed, data from Raymond James shows that music streaming and podcast streaming time on Spotify has fallen globally amid the coronavirus pandemic. That’s not great news.
Ad Revenues Will Drop
About 10% of Spotify’s 2019 revenues came from ads on its free streaming platform. That business will get hit hard in the second quarter.
With consumers cooped up in their homes and many of them getting laid off, consumer discretionary spending has dried up. Businesses have responded by cutting their ad budgets. The whole advertising industry will get massacred in the second quarter.
Spotify will not be the exception to the trend. So long as the ad industry tumbles, Spotify’s ad business will be weak.
Margin Concerns Remain
One of my bigger picture concerns with Spotify has always been the company’s weak margins.
At present, Spotify’s gross margins sit around 25%. The opex rate is closer to 27%. Thus, this company’s operating expense base is bigger than its gross profits.
Worse yet, gross margins are actually expected to move lower in 2020, as the company invests more heavily in podcast content acquisition and development. The opex rate could come down with scale. But, not by much, because heavy competition in the music streaming market will require the company to maintain sizable product development, research, and marketing budgets.
These margin concerns didn’t go away because of the coronavirus pandemic. As such, so long as they remain, I believe the long-term profit growth potential of Spotify is relatively muted.
Valuation is Full
Zooming out, Spotify has tremendous top-line growth potential, powered by secular tailwinds in the music streaming industry and an innovative management team. However, a weak margin profile means that Spotify’s bottom-line growth potential is much less robust.
All things considered, it does appear that at $120, Spotify stock is fully valued.
My modeling suggests that $10 in earnings per share is doable for Spotify by 2030. Based on a 30-times exit multiple and a 10% annual discount rate, that implies a 2020 price target of less than $130 — roughly where shares trade hands today.
Bottom Line on Spotify Stock
From a revenue growth potential perspective, Spotify is one of my favorite companies. I see the music streaming platform as sustaining 20%-plus revenue growth for a lot longer, behind robust premium subscriber growth.
But, from a profit growth potential perspective, Spotify is much less attractive. A weak gross margin profile means that robust top-line growth will turn into much less robust bottom-line growth.
Against the backdrop of the coronavirus pandemic, Spotify stock is fully valued considering its long-term profit growth potential. As such, I wouldn’t run into this somewhat resilient stock. Instead, I’d wait for a better entry point.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he did not hold a position in any of the aforementioned securities.
