Spotify Technology's (NYSE:SPOT) Has Quality Earnings but Sluggish Subscription Growth Worries the Market

Spotify Technology S.A.'s(NYSE:SPOT) just released Q2 earnings. While EPS surprised the second quarter in the row, the stock continued tanking. It seems that the sluggish premium subscription growth is spooking the market more than it should. Our analysis suggests that investors might be missing some promising details.

Earnings Update

• Q2 GAAP earnings per share -€0.19 (beat by €0.22)
• Revenue at €2.33b (+23.3 year-over-year)
• Premium subscribers 165m (missed consensus by 400,000)
• Gross margin : 28.4% vs 25.2 consensus

Updated guidance:

• 177-181m premium subscribers by Q4
• Total revenue €2.48-2.68b

After a big run in 2020 that saw the stock break out from the range and make an all-time high at $366, the stock collapsed back to the low 200s. After a short pullback, it is now evident we will most likely see lower lows and test the support around $180.

Even the upgrade by Guggenheim didn't manage to keep it up. Guggenheim moved it to Buy from Neutral, quoting an established sustainable position as the global industry leader.

The market looks to be concerned about the growth of the premium subscribers base. After all, it is subscribers that bring the recurring revenues to the company. This reaction is questionable, given the historical low churn rate of the premium subscribers base.

View our latest analysis for Spotify Technology

Zooming In On Spotify Technology's Earnings

One critical financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio, we first subtract FCF from profit for a period and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing because it means paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2021, Spotify Technology recorded an accrual ratio of -0.71. Therefore, its statutory earnings were very significantly less than its free cash flow. To wit, it produced a free cash flow of ¬252m during the period, dwarfing its reported profit of -¬223.0m. Spotify Technology's free cash flow improved over the last year, which is generally good to see.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability based on their estimates.

The Impact Of Unusual Items On Profit

Spotify Technology's profit was reduced by unusual items worth ¬13m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but things might improve sooner rather than later on the upside. We looked at thousands of listed companies and found that unusual items are very often one-off. And that's hardly a surprise, given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Spotify Technology to produce a higher profit next year, all else being equal.

Our Take On Spotify Technology's Profit Performance

Considering both Spotify Technology's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate its underlying earnings power. After considering all this, we reckon Spotify Technology's statutory profit probably understates its earnings potential! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing.

For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Spotify Technology.

After our examination into the nature of Spotify Technology's profit, we've come away optimistic for the company. But there is always more to discover.

For example, many people consider a high return on equity to indicate favorable business economics, while others like to "follow the money" and search out stocks that insiders are buying. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity or this list of stocks that insiders are buying to be helpful.

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Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.