1 green flag for Spotify in 2022 and 1 red flag

Spotify (PLACE -4.88%) has a tough 2022 — or at least its stock is. Stock prices are down more than 67% from 52-week highs and likely fell due to a combination of the sharp drop in tech stocks, average earnings reports and operating leverage low or nil in its financial statements.

However, the global audio streaming platform continues to grow its users and revenue, unlike many mainstream internet stocks right now. With the stocks trading at a steep discount, some believe now may be the right time to buy. Here’s a green flag and a red flag for Spotify stocks for the rest of 2022.

Green flag: Growth on all fronts

Spotify has been one of the most consistent producers in the consumer internet and technology sector. In the first quarter of 2022, the company grew its monthly active users (MAUs) by 19% year-over-year to 422 million. Premium subscribers, or those who pay a monthly subscription to listen to ad-free music, grew 15% year-over-year to 182 million. Compared to a company like netflixwhich has hit a wall for subscriber growth, Spotify shows no signs of slowing down as its service becomes more popular around the world.

In financial services, revenue grew 24% year-over-year in the first quarter to $2.7 billion, driven primarily by growth in premium subscribers. Gross profit rose 22% year over year to $683 million. Over the past 12 months, Spotify’s revenue was $11.8 billion and gross profit was $3.15 billion. Both figures have more than doubled since Spotify went public in 2018.

SPOT Revenue (TTM) given by Y-Charts

So why has the stock fallen so much over the past year? It all comes down to a lack of trust in podcast initiatives and operational leverage.

Red flag: Podcast growth slower than expected

Over the past few years, Spotify has invested heavily in the emerging podcast medium. He bought various studios, licensed shows for exclusive deals like the Joe Rogan Experienceand acquired the Anchor and Megaphone distribution platforms.

To leverage these investments, the company launched a new audio advertising marketplace called Spotify Audience Network (SPAN). Similar to how YouTube (part of Alphabet) works, SPAN automatically matches advertisers to shows, which hopefully improves targeting and generates more revenue for the industry. Obviously, as a middleman, Spotify retains a share of all advertising dollars.

But so far, those investments haven’t materialized financially for Spotify’s advertising business. In the first quarter, Spotify’s advertising gross margin was negative 1.5%, which is not a sustainable business model. It is still early days, and given the fixed nature of some of these investments, it is likely that SPAN will begin to generate positive gross margins over the next two years.

But right now, with the bear market hanging around investors’ necks, people are likely growing impatient with a lack of material results. This has led Spotify’s consolidated gross margins to not exceed 25% since 2019, leaving little room for the company to generate positive net income or free cash flow.

SPOT Gross Profit Margin Chart (Quarterly)

SPOT gross profit margin (quarterly) given by Y-Charts

Even as the podcast and advertising businesses struggle to gain operating leverage, Spotify shares may still do well for shareholders over the next five years. With a market cap of $20 billion and 12-month revenue of $11.8 billion, the stock trades at a price-to-sales (P/S) ratio of just 1.7. Even though the company can only make a measly 10% profit margin, the stock is trading at a very cheap valuation, especially given the company’s track record of growth.

Suzanne Frey, an executive at Alphabet, is a board member of The Motley Fool. Brett Schaefer holds positions in Spotify technology. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Netflix and Spotify Technology. The Motley Fool has a disclosure policy.

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