Should Spotify investors be worried about limp ad sales?

Audio Streaming Veteran Spotify Technology (PLACE -3.17%) announced strong third-quarter results by most measures. The company added 7 million premium subscribers and 23 million monthly active users (MAUs) during the quarter. Additionally, revenue grew 21% year-over-year, driven by healthy subscription fees. It’s more than a healthy business – the results have been downright impressive.

Still, investors reacted to Spotify’s report with a brutal haircut. The stock fell more than 9% in Wednesday’s morning session, extending a painful downtrend. Spotify shares lost about 60% of their value in 2022.

This time, the negative market movement came from Spotify’s disappointing ad space sales. Ad-supported revenue grew only 3% year-over-year at constant currencies. This segment barely made a gross profit with a gross margin of 1.8%, compared to 10.8% a year ago.

Indeed, Spotify’s management saw no reason to complain about this quarter, other than annoying advertising activity, that is.

“There is a lot of global uncertainty. But for Spotify, our business continues to do very well around the world,” Spotify CEO Daniel Ek said on the earnings call. “And outside of the ads, we don’t see much impact at all.”

So what happens inside this single point of difficulty? Let’s look.

The view from the CFO’s office

During the earnings call, Spotify’s management team spent a lot of time discussing the digital audio ad market. The company was a pure subscription service until it launched an ad-supported option in 2017. A sophisticated ad-buying platform, the Spotify Audience Network (SPAN), was added at the start of 2021.

The advertising industry is therefore only a few years old. Still, Spotify has already amassed 273 million ad-supported MAUs and the segment accounted for 13% of total third-quarter revenue.

CFO Paul Vogel largely attributed weak advertising growth to macroeconomic issues. Most of the underperformance occurred in the Europe, Middle East and Africa (EMEA) market, where the war in Ukraine is weighing heavily on local economies and many major markets are experiencing even higher inflation than the United States. And Spotify has suspended its services in the UK. on the death of Queen Elizabeth II, leading to another unforeseen downturn in revenue.

Vogel noted advertiser interest was building in October, suggesting the next quarter could see stronger ad sales. However, the difference was not large enough to support an optimistic forecast for the ad-based segment, given the inherently unpredictable nature of today’s global economy.

On the positive side, Vogel sees this downturn as a macroeconomic issue that should fade when the broader market challenges pass, as they will. No bear market lasts forever. He backed up this conclusion with a quick analysis of the growing number of ad buyers on the SPAN platform.

“The fact that we’re seeing a year-over-year increase and continuing to grow shows us that the overall structural health of the advertising business we’re building at Spotify is very healthy,” Vogel said.

The view from the CEO suite

Ek added valuable color commentary to Vogel’s statements. First, he pointed out the temporary nature of Spotify’s limited ad growth.

“The important thing is to decide whether it’s a cyclical or a structural thing. And we strongly believe that it’s more cyclical than structural,” Ek said, “So the long-term growth of the digital advertising will still be healthy, we believe, and there are more offline dollars moving to digital dollars.”

Ek also found an advantage in macroeconomic pressure. The severe sting of the coronavirus pandemic in the first half of 2020 showed that digital ad space was plentiful and affordable when most advertisers were limiting their ad spend. Consequently, Spotify was able to increase its own advertising budget and attract millions of new users at a lower cost.

The benefit of driving growth plays out again in this market, and management isn’t overly concerned about the revenue impact on a 13% slice of the inbound revenue stream.

“This would then present us with a clear opportunity to increase our market share even in a difficult economy, as we can acquire users at a lower cost than [their lifetime value]“, Eck said.

Should Spotify shares be this cheap?

Spotify’s comment suggests that the advertising downturn has stabilized over the past two months, but it’s still too early to wave victory flags. The underlying macroeconomic issues need to be resolved before the ad market symptoms can improve significantly.

This cautious analysis comes into its own after similar reports from online advertising giants Alphabet and Metaplatforms this week. Both tech titans reported disappointing results and suffered significant declines in their share prices.

At the same time, I would argue that Spotify’s primarily subscription-based business model serves as an effective shield against the softness of the advertising industry. Premium and ad subscriber numbers are skyrocketing, and Spotify’s cash earnings have been solidly positive for years.

In other words, Spotify stock should be up, but the stock price still fell 64% in 2022. Trading at all-time lows at price-to-sales and price-to-flow ratios With historically low free cash, Spotify looks like a fantastic buy, despite the tough digital advertising market.

SPOT PS Ratio data by YCharts

Suzanne Frey, an executive at Alphabet, is a board member of The Motley Fool. Randi Zuckerberg, former director of market development and spokesperson for Facebook and sister of Meta Platforms CEO Mark Zuckerberg, is a board member of The Motley Fool. Anders Bylund holds positions in Alphabet (A shares). The Motley Fool owns and recommends Alphabet (A shares), Alphabet (C shares), Meta Platforms, Inc. and Spotify Technology. The Motley Fool has a disclosure policy.

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