Cindy Ord/Getty Images Entertainment
Subscription services stocks, the spec tech to avoid
Speculative technology, aka spec tech, and the technology behind these firms have long-term viability in the race to digitization and Ai. Given the macro environment, these software and subscription-based tech services are priced for growth, but many are not yet profitable because they're in a high-growth mode focused on revenue without concentration on profitability.
While the tech space and COVID-darlings benefited most from lockdowns, low inflation, low-interest rates, and quantitative easing, in rising rate environments, their forward-looking valuations are awful, hence the massive selloffs we're seeing. If you're holding for the long term, you can pick companies that could shape the landscape at a 50-60% discount from a year ago. But be ready for a roller coaster ride and potentially more loss. Monetary tightening is likely to equate to no profits for a very long time for spec tech. When you factor in high inflation and a slowing economy, business to business (B2B) is likely to fare better than business to consumer (B2C). Consumer spending is seeing a slowdown due to the tightening cycle, recessionary fears, and anticipation of more future volatility.
"Given such an uncertain environment, National Retail Federation, the nation's largest retail trade group, forecast that growth in U.S. retail sales this year will slow to between 6% and 8% from the record-breaking 14% annual growth rate in 2021."
As consumer spending cools, the outlook for subscription services stocks indicates limited upside, which is why we're highlighting a top name in subscription service, Spotify (NYSE:SPOT), which has a strong sell quant rating.
1. Spotify
Quant Rating: Strong Sell
Market Capitalization: $19.61B
Quant Sector Ranking (as of 5/2): 204 out of 223
Quant Industry Ranking (as of 5/2): 29 out of 33
Analysts' Downward Earnings Estimate Revisions: 17
Swedish audio streaming and media services provider Spotify offers unlimited online and offline streaming to a catalog of music and podcasts. The company has experienced a sharp decline from its peak 2021 price of $364.59, currently trading for less than $110/share. As evidenced by the below factor grades, not only is the stock's valuation a D-, its bearish momentum and average growth and profitability grades are not music to investors' ears.
SPOT Factor Grades (Seeking Alpha Premium)
SPOT Valuation
Spotify has a poor valuation, with a current 'F' EV/EBITDA grade of 130.33x, which is more than 1000% above the industry average, and a current Price/Book of more than 360% difference from the sector. Its assessed worth is very poor relative to its peers, and quarterly guidance was lowered on the heels of Russia's invasion of Ukraine. Given the business closure in Russia and the strong USD value, operations have been closed in Russia. When you factor in Spotify's slowing revenue growth rates and declining number of subscribers, yet there's an increase in free cash flow, the company is overvalued, so it is essential to look at its growth and profitability prospects.
SPOT Growth & Profitability
Spotify is the world's leading music streaming app. While its vast network can help increase its subscriber base, the company faces immense competition, primarily as variable costs in this inflationary environment limit its future operating leverage and profitability. Stiff competition from Amazon (AMZN), Apple (AAPL), and Google (GOOG) (GOOGL) creates hurdles for Spotify, whose music streaming and podcast platform is well ahead of the tech giants. But Spotify is on a downward trend, as our Seeking Alpha Quant rating system warning banner indicates. Along with the SA Quant rating, SA Contributor Michael Wiggins De Oliveira reveals the declining subscription numbers in his article Spotify: Worrisome Subscriber Numbers Guided for Q2, Here's What You Need To Know.
Michael highlights, "It doesn't appear that Spotify is benefiting from the digital pull forward as much as many investors had previously assumed…As an investor, the last thing you want is to invest in stock where its strongest growth days are in the rearview mirror."
With characteristics historically associated with poor future stock performance, not only is SPOT overpriced, the stock has decelerating momentum when compared to its Communication Services peers.
SPOT Momentum Grade (Seeking Alpha Premium)
Quarterly, you can see above that Spotify's price performance has gradually gotten worse and is much worse than its sector median peers. Although posting solid Q1 2022 results with an EPS of $0.22 beating by $0.46 and revenue of $2.81B beating by $28.08M (7.89% year-over-year), guidance was still lower than expected, and 17 analysts revised their FY1 earnings estimates down in the last 90 days. The mixed results also prompted the stock to drop 11% to an all-time low.
SPOT Revisions Grade (Seeking Alpha Premium)
Another concern facing Spotify is competition. As fellow Seeking Alpha contributor Tech Stock Pros writes, "Competition from Apple, Amazon, and Google will continue to intensify as these large vendors bundle their products and services, making it hard for Spotify to compete."
Spotify's competitors are not the fledgling up-and-coming spec techs. They're the FAANG behemoths with an established market segment that can introduce additional products and services that Spotify needs the capital and heavy investment to grow and compete. Although SPOT is ad-supported, they also remain at the mercy of record labels raising prices and royalties like any company feeling the effects of inflation. The amount of capital Spotify will need to sway subscribers from leaving their platform for the heavy hitters will make it a rough road for the company. And subscribers aren't the only ones leaving the company. This week, Spotify's podcasting tech chief Michael Mignano tendered his resignation, which can fuel investor unease. Is this a sign of things to come? Either way, we have a strong sell quant rating, and it's not the only stock investors should avoid.
Conclusion
Like many equities in this volatile market, record outflows and subscriber loss for subscription stocks pose a number of concerns that indicate why stocks in this industry are at risk of continuing to perform badly. Spotify has a strong sell recommendation because it is experiencing substantial declines and has less than attractive profitability and momentum. With poor guidance, slowing growth rates, and an overvaluation, Spotify is unattractive on many metrics.
Our investment research tools help to ensure you're furnished with the best resources to make informed investment decisions. Consider looking at our Growth Screen and sort by the Quant rank to find stocks that are performing well. Although past performance is no guarantee of future performance, you can discover high-growth stocks with fair valuation frameworks and solid fundamentals that can capitalize on the growth drivers in the tech industry.
