Why Spotify (NYSE: SPOT) is a Buy Ahead of Earnings

Spotify NYSE: SPOT is set to report its Q3 2020 earnings tomorrow, and the question on everyone’s mind is:

Can Spotify reverse its trend of slowing growth?

 In Q2 2020, revenue grew 11.1% yoy. Not bad, but a slowdown from the 23.2% yoy growth in Q2 2019, which itself was lower than the 37.2% yoy growth in Q2 2018. Shares of the Swedish streaming company dipped on the Q2 earnings release, though the numbers also missed analyst estimates.

SPOT has stagnated since the late July release of its Q2 numbers, though it has started climbing ahead of Q3 earnings.

I could see Q3 earnings acting as a catalyst for another leg-up. Here’s why:

Revenue Growth Expected to Pick Up… Slightly

The Q2 revenue trends are a bit concerning, but the Q3 trends look a little better. Spotify’s yoy revenue growth was 29.6% in Q3 2018 and 22.4% in Q3 2019. But the slowdown is expected to stop in Q3 2020, with revenue growth projected at 23.3% yoy.

For a company like Spotify with a 5.7x forward P/S ratio, and no earnings to speak of, revenue growth needs to remain high for shares to continue commanding a premium.

But the more important question is: Can revenue beat expectations?

Advertising Could Fuel a Beat

The (mild) Q2 earnings disappointment was largely attributable to Spotify’s decrease in ad-supported revenue; it fell 21% yoy. Back then, I said that it seemed like a short-term decline. Looking at the Q3 earnings report of Sirius XM NASDAQ: SIRI – one of Spotify’s closest comps – offers a reason to believe in a turnaround in Spotify’s Q3 ad-supported revenue.

Sirius recorded a 46% sequential increase in advertising revenue in Q3; to clarify, after declining 34% yoy in Q2, it declined just 6% yoy in Q3. And in September, Sirius noted, ad revenue actually increased yoy.

So, Spotify’s ad revenue should improve a lot this quarter – and that’s great. But it’s Spotify’s long-term advertising potential that has me really excited.

Spotify is an Advertising Innovator

Traditionally, it’s been difficult for advertisers to run effective ads on podcasts due to targeting and measurement issues. But then Spotify launched its Streaming Ad Insertion (SAI) tool back in January of this year.

The SAI tool inserts ads into podcasts in real-time, targeting users based on their demographics. Spotify might not be able to match the amount of user data that, say, Facebook NASDAQ: FB or Google NASDAQ: GOOG have on their users, but the company has a lot to work with – certainly relative to its competition.

And the bottom line of all of this is that, well, it’s going to boost the bottom line. Advertisers are going to be less apprehensive about spending money with Spotify, and as Spotify’s treasure trove of user data continues to grow, advertisers will be willing to spend even more.

What About Subscriber Growth?

So, I could see advertising leading to a revenue beat, but subscriber growth is an unrelated (but important) matter.

At the end of Q2 2020, Spotify had 138 million paid subscribers and 299 million monthly active users (MAU).

Spotify, at the time of the Q2 earnings release, issued guidance for Q3 and Q4 2020:

• Q3 was 140-144 million paid subs and 312-317 million MAUs.
• Q4 was 146-153 million paid subs and 328-348 million MAUs.

I think all of these numbers are conservative. I think there is a good chance that Spotify beats on both metrics in Q3 – or at least reports numbers at the upper ends of the ranges – and revises its guidance upward for Q4.

That said, my guess is that the market is pricing in a subscribers beat, and the whisper numbers are at least on the high end. So, I’m not sure if Spotify will surge if it beats by a bit on subs. I think it would take a big beat to drive shares higher – but we’re only talking about subscribers.

Advertising Revenue Could Drive Shares Higher

I don’t think that a big advertising revenue rebound is being priced in to Spotify shares, so that’s where I see upside going into the Q3 earnings release.

SPOT is within striking distance of all-time highs. A revenue beat could get it over the hump, and begin another leg-up.