'They've gone too far': How Spotify dug a giant hole — and how it can dig itself out

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On February 19, 2021 Spotify (SPOT) shares closed at a record high of $364.59. The company's market cap was north of $69 billion.

Today, the stock is trading below $80 a share, down roughly 70% in 2022 and off nearly 80% from that record close. Its current market cap? $15 billion.

In the last several years, Spotify has sought to broaden its business from one that charges users to stream music into the leading business in the entire audio market.

"We believe our market that we're going after is audio," Spotify CEO Daniel Ek said in a 2019 interview. "And that's going to be at least a billion, probably 2 or 3 billion people around the world, that would want to consume some form of content like that on a daily or weekly basis."

Ek said if the company is going to "win that market," meaning audio, they'd need "at least a third" of this multi-billion user opportunity. "We're still very early days in our journey," Ek said.

In the intervening years, Spotify has spent $1 billion pushing into the podcast market, signing on celebrities like the Obamas, Prince Harry, and a Kardashian. The company paid $230 million to acquire podcast studio Gimlet in 2019. Spotify then paid a reported $200 million to bring Joe Rogan exclusively to the platform, and another $200 million for The Ringer in 2020.

But after a disastrous 2022 for investors, Spotify's dive into podcasting raises key questions about the company at large:

  • Does the business model work?

  • How long until sustained profitability?

  • Is the streaming service losing core appeal for the younger audiences, who are the most avid music consumers?

  • Has its CEO lost credibility with investors?

The answers to these questions hold the key to whether Spotify can mount a turnaround in the eyes of investors in the years ahead.

Peak investment year

Spotify's most recent results once again disappointed on the bottom line, after the platform reported a wider-than-expected loss of ($0.99) per share in the third quarter and another quarter of declining gross margins, which came in at 24.7%, missing expectations for 25.2%.

The company blamed its sinking bottom line on the renewal of a large publishing contract outside of the U.S., as well as softness in the ad market.

The slowdown in ad spending has been felt across the tech sector, with YouTube (GOOGL) advertising revenue coming up $400 million short of estimates as buyers tightened budgets amid rising inflation and interest rates.

But there may be even more fundamental problems facing Spotify, analysts say.

“Many investors question whether Spotify will ever be able to generate significant lasting profitability (especially given the concentrated power of the music labels & competition not necessarily focused on generating profitability),” Pivotal Research Analyst Jeffrey Wlodarczak wrote in a note to clients following the company’s third quarter earnings. “The results/outlook do not provide evidence to the contrary.”

A Spotify executive told Yahoo Finance the company is looking to improve its rates of profitability beginning in 2023 on a gross margin and operating income basis, categorizing 2022 as a peak investment year as the platform dives into medium-to-long term investments.

One of those heavily invested areas has been podcasts, which Spotify has spent more than $1 billion on over the past four years.

"We believe 2022 will be the peak in terms of the negative impact of our investments on gross margins, and we expect podcasting gross margin to turn profitable over the next one to two years and on a meaningful ramp from that point onward," Spotify CFO Paul Vogel echoed during the company's investor day.

"They've gone too far in terms of sacrificing the economics in order to get monthly active user growth," CFRA Analyst John Freeman told Yahoo Finance: “Ad-based gross margin was higher in 2019 than it is now — how is that possible?"

To answer that question (and understand where the platform could be heading), investors need to go back to the beginning.

Spotify's disruptor origins

Founded by Swedish entrepreneurs Daniel Ek and Martin Lorentzon in 2006, Spotify was founded as a solution to music piracy and officially launched two years later.

Ek "came into the music business at a time when it was still in a really bad way — it didn’t have a path yet,” Mark Mulligan, managing director and lead music analyst at MIDiA Research, told Yahoo Finance.

Spotify CEO Daniel Ek speaks  during a press event in New York May 20, 2015. Spotify, which provides free on-demand music or ad-free tunes for paying customers, said it will now also provide video content and podcasts. REUTERS/Shannon Stapleton
Spotify CEO Daniel Ek speaks during a press event in New York May 20, 2015. Spotify, which provides free on-demand music or ad-free tunes for paying customers, said it will now also provide video content and podcasts. REUTERS/Shannon Stapleton (Shannon Stapleton / reuters)

In 2006, piracy was still rampant as consumers — fueled by the rise of peer-to-peer music sharing platforms like Limewire and Napster — ditched hard copy CD and vinyl purchases in favor of free, albeit illegal, song downloads. Recorded-music revenues plummeted as a result, dropping from an all-time high of $14.6 billion in 1993 to just $6.7 billion in 2014 and 2015, according to the RIAA.

"Ek went in and said, 'I can see you’ve got a problem with piracy. Let me help you.' That psychology of positioning Spotify as a way to help the music industry rebuild from piracy allowed Ek to gain the support from record labels," Mulligan explained.

Spotify's services were initially available in select European countries such as the UK, Spain, Sweden, France, Norway, and Finland, before entering the U.S. market in July 2011. And as the platform scaled, Ek eventually sought help from the financial markets to return capital to early investors.

Spotify made its public market debut via a direct listing in April 2018, and shares opened for trading at $165.90, giving the company a valuation of $29.5 billion. The stock closed at $149.60 at the end of its first day of trading. At the time of its debut, Spotify was the biggest company to ever go public via direct listing.

The Spotify logo hangs on the facade of the New York Stock Exchange with U.S. and a Swiss flag as the company lists it's stock with a direct listing in New York, U.S., April 3, 2018.  REUTERS/Lucas Jackson
The Spotify logo hangs on the facade of the New York Stock Exchange with U.S. and a Swiss flag as the company lists it's stock with a direct listing in New York, U.S., April 3, 2018. REUTERS/Lucas Jackson (Lucas Jackson / Reuters)

How Spotify makes money

Spotify's business model relies on both paid and ad-supported users.

The platform has two tiers: a limited ads service for free, and an unlimited premium service for a subscription fee of $9.99 per month for individuals. As of the end of the third quarter, the platform boasted 273 million ad-supported users and 195 million premium subscribers.

The company's primary source of revenue is premium subscribers, with subscription fees accounting for 87% of revenue in the third quarter.

At the heart of the company's push into the podcast space is a desire to bring down its reliance on premium subscribers and broaden its ad business.

The company has spent aggressively to bolster its original content offerings amid increased competition, with tech behemoths like Apple (AAPL), Amazon (AMZN), and Alphabet (GOOGL) entering the music streaming space. But these costs have weighed on the bottom line.

Spotify reported operating expense growth of 65% year-over-year in Q3, citing higher personnel costs, primarily due to headcount additions, along with higher advertising costs for growth initiatives targeting emerging markets and Gen Z.

"If you weren't making money two years ago, when things were so much better economically," Freeman said, "why are you still accelerating spending today?"

"I've never seen a software-based business that has over €10 billion euro in revenue that can't turn the turn a profit and that struggles with operating margins," said Freeman. "It's a conundrum to me. ... This is a software based business, right? And they focus too much on the content and not on the software."

Freeman was specifically baffled by Ek's opening comments during the company’s latest earnings call, which included: "Top-line growth in the platform is the leading indicator for future success on all other financial metrics."

In Freeman's view, given current trends, the margin pressures from spending big on content will not be short-term pain — in fact, they raise "structural" concerns.

Mulligan highlighted one aspect of the content game that has always loomed large for Spotify: big music labels like Universal Music Group, Sony Music Entertainment, and Warner Music Group.

“Most record labels don't really see Spotify being there to help them anymore,” he said. “Record labels like to have as much control as they can have, and they don't like any individual partner to be particularly strong.”

Spotify learned that lesson when the company tried to license a handful of songs directly from artists and managers in 2018.

“The record labels got absolutely furious, and they made Spotify backtrack within months,” Mulligan said. “Spotify had to find something else to grow the business beyond its core streaming music proposition, and that was podcasts.”

Spotify's podcast bet

Spotify's push into podcasts brought in roughly $215 million in revenue in 2021 after the company spent roughly $1 billion on podcasting-related acquisitions and production.

In the third quarter of 2021, Spotify revealed it was the number one most-listened to podcast platform in the U.S., citing Edison Research and internal company data. Since then, the company has continued to emphasize the unit's future growth prospects.

Dawn Ostroff, Spotify's chief content and advertising business officer, told investors the audio giant was still in "investment mode" but expects the podcast segment to be a "$20 billion opportunity" with continued improvements in both ad products and monetization.

Ek also underscored the potential of the platform's podcast unit, estimating he expects it to generate margins between 40%-50%, driven by A-list deals.

“Though the choppy macro backdrop continues to pressure advertising growth, we believe the underlying fundamentals of [Spotify’s] advertising business remain solid," JPMorgan analyst Doug Anmuth wrote in an October note to clients following the company's third quarter earnings. "Going forward, we believe Spotify’s investments position the company well for future growth, w/Podcast profitability likely ~1-2 years out, which should support [Gross Margin] expansion."

That initiative began when Spotify, after acquiring Gimlet Media for a reported $230 million in February 2019, locked in a three-year pact with the Obamas later that year — however, the couple ultimately decided against renewing their contract, opting for a deal with rival Audible.

The company ramped up its podcast push in 2020, striking a multi-year licensing contract reportedly worth over $200 million to bring Joe Rogan exclusively to the platform.

Rogan is the most popular podcaster on Spotify's platform, with 11 million listeners per episode.

But Rogan's brand of talking to anyone about anything brought Spotify under intense scrutiny for spreading misinformation about COVID-19 vaccines and treatments — prompting an open letter from hundreds of scientists, professors, and public health experts who urged Spotify to crack down on Rogan and pandemic misinformation at large.

The controversy caused price target cuts from analysts and a decline in the company's share price. Nevertheless, Ek refused calls for the company to "take on the position of a content censor."

"To be frank, had we not made some of the choices we did, I am confident that our business wouldn’t be where it is today," Ek reportedly told employees at a town hall earlier this year.

Aug 20, 2022; Salt Lake City, Utah, USA; Joe Rogan after the fight between Amir Albazi (red gloves) and Francisco Figueiredo (blue gloves) during UFC 278 at Vivint Arena. Mandatory Credit: Jeffrey Swinger-USA TODAY Sports
Aug 20, 2022; Salt Lake City, Utah, USA; Joe Rogan after the fight between Amir Albazi (red gloves) and Francisco Figueiredo (blue gloves) during UFC 278 at Vivint Arena. Mandatory Credit: Jeffrey Swinger-USA TODAY Sports (USA TODAY USPW / reuters)

Shortly after the Rogan deal, Spotify purchased Bill Simmons' sports media empire, The Ringer, for nearly $200 million in November 2020. One month later, the platform signed Meghan Markle and her husband, Prince Harry, to a 3-year podcast deal for an estimated $15-$18 million.

Markle's "Archetypes," which launched in August, is the first podcast series to debut under the exclusive partnership. Spotify highlighted the podcast's success in its earnings report, after the show hit number 1 on its trending charts in six different countries.

Additionally, the platform began leaning on live podcasting in October 2020, but recently scaled back that type of programming amid a drop in demand, ending live audio productions like "Deux Me After Dark," "Doughboys: Snack Pack," "The Movie Buff," and "A Gay in the Life."

"Spotify probably wouldn't have gone after podcasts, at least not in the way that it has, had it been able to do more in music," MIDiA’s Mulligan said.

"Spotify's biggest challenge with podcasts is not so much: 'Can it actually drive the consumption?' It's more 'Can it drive the revenue?'" Mulligan said. "Driving revenue is predominantly going to be about advertising revenue. Historically, Spotify has never been anywhere near as good as driving ad revenue as it has for subscription revenue."

Freeman agreed, remarking: "I have no problem with Spotify's advertising model, but I do have a problem with its execution."

'I don't think Spotify has the pricing power'

As Spotify pursues growth from ad-supported revenue, its near-term quest for improving profitability will likely see the dial turned in a familiar place: subscription fees.

Spotify indicated on its latest earnings call the company is actively exploring raising prices on its U.S.-based tiers. Both Apple Music and YouTube Premium recently raised prices on their respective plans.

"It is one of the things that we would like to do, and this is a conversation we will have in light of these recent developments with our label partners," Ek told investors. "I feel good about this upcoming year, and what it means about pricing for our service."

JPMorgan's Anmuth estimated a $1 price increase to Spotify’s premium plan would lead to incremental revenue of €200 million.

Others are not as convinced.

"I don't think Spotify has the pricing power," CFRA’s Freeman said, arguing the service is not differentiated enough compared to competitors. Mulligan added competitors such as YouTube Music and TikTok perform much better with younger listeners.

"When you've got an older user base and your app is associated with an older user base, it's harder to attract younger subscribers," Mulligan said. "I suspect that a really important part of future growth will be working out how to build a value proposition that will require something different than what appeals to aging millennials."

'There are aspects of this business that Ek doesn't get'

As Spotify enters the next phase of its corporate journey, some analysts have begun asking whether Ek is the right CEO to lead the company.

"I think that there are aspects of this business that Ek doesn't get," CFRA's Freeman said. "And I give all props to very successful entrepreneurs who built companies, but sometimes you kind of have to wonder whether they are the person to take the company onto the next leg of growth and the next leg of maturity. I think we're getting close to that point."

Freeman downgraded shares at the end of October to Hold from Buy and slashed his price target to $87 from $139 per share share.

"I think at the level where we're at now of 5,000 people, the reality is you can't be in the weeds on a lot of things," Ek said back in 2019. In 2021, the company employed closer to 6,600 people.

"I would say Spotify runs perfectly well without me for the most part," Ek said. "But what I am is I am the pacesetter. I am the person who, whenever we kind of start resting on our laurels, I start saying, we need to pick up the pace."

Spotify CEO Daniel Ek speaks  during a press event in New York May 20, 2015. Spotify, which provides free on-demand music or ad-free tunes for paying customers, said it will now also provide video content and podcasts. REUTERS/Shannon Stapleton
Spotify CEO Daniel Ek speaks during a press event in New York May 20, 2015. Spotify, which provides free on-demand music or ad-free tunes for paying customers, said it will now also provide video content and podcasts. REUTERS/Shannon Stapleton (Shannon Stapleton / reuters)

Whether Ek remains atop the company, however, is a question that remains with he and his co-founder for the foreseeable future. As of the end of 2021, Ek owned 16% of Spotify's outstanding ordinary shares and maintained 31.9% voting control while Lorentzon owned 10.9% of shares with 42.5% voting power.

Some analysts, however, think that it’s possible for a company that reported an operating loss of €228 million and free cash flow of just €35 million in its most recent quarter to reach durable profitability — even if that goal remains years away.

"Spotify's 30-35% gross margin target seems reasonable [in the long-term (2027 and beyond)], but we remain in a market that is, at least for now, focused on short-term profitability and heightened possibility for a global recession (in Europe in particular)," Pivotal Research’s Wlodarczak said.

Wlodarczak maintained a Hold rating on the stock but lowered his price target from $105 a share to $100, noting investors will have to play the long game amid near-term risks.

Those near-term risks, however, could cause more trouble for Spotify’s future.

"We're potentially going to go into the longest recession in living memory," MIDiA's Mulligan said. "It is likely that investors are going to be much more focused on the promise of value in the future. Growth story companies are going to be less interesting to the more risk averse investor than they were five years ago.

"That's the biggest thing: Regardless of how good a job Spotify may or may not do, more and more investors are going to want bankable revenue as a valuation methodology for share prices."

Alexandra is a Senior Entertainment and Media Reporter at Yahoo Finance. Follow her on Twitter @alliecanal8193 and email her at alexandra.canal@yahoofinance.com

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