Spotify: Cutting costs ‘will be difficult,’ strategist says

New Constructs CEO David Trainer joins Yahoo Finance Live to discuss Spotify earnings, job cuts, subscriber growth, rising subscription prices, competition among streaming platforms, and the outlook for Peloton.

Video transcript

[AUDIO LOGO]

- Spotify painted a mixed picture in its fourth-quarter earnings, posting a wider-than-expected loss and a beat on gross margins. The company blamed its widening losses on higher personnel and higher advertising costs and said it plans to further scale its podcasting business. But our next guest is not so optimistic on the music giant's podcasting future, saying investors should consider the, quote, "hard limit on the profit potential of the segment."

Let's get to it with New Constructs CEO David Trainer, alongside Yahoo Finance's Allie Canal. Good to have you, David. So first, I want to get your take on this because you really don't see a path forward in terms of where Spotify's profitability is going to come from in this streaming picture.

DAVID TRAINER: It's a really tough business. I mean, delivering content over the internet is not a competitive advantage. And when you look at the future cash flow expectations required to justify the stock price, there's a huge disconnect between what we think the business profitability can be and what the market currently expects it to be.

ALLIE CANAL: Well, David, let's pick up on that because on the earnings call, Spotify did stress that cost pressures will ease in 2023 as the company pulls back spending across the board. Where would you like to see those cost cuts most concentrated?

DAVID TRAINER: I mean, I think across the board is right. I mean, we're showing negative margins, right? So as long as margins are negative, they've got to have pretty extreme cost cutting. And I think that's going to be difficult in order to maintain market share and maintain growth.

I mean, that marketing and advertising expense is important to compete against all the other streaming services. And that's partly because there's not a lot of differentiation between one streaming service and another. And there maybe never will be except for original content, which, of course, is extremely difficult to consistently produce at a high-quality level.

So yeah, an unprofitable business that's been burning through a lot of cash needs to do whatever it can to get to profitability. But there are going to be trade-offs to that path to profitability that make it difficult for the business to grow into its valuation as well.

ALLIE CANAL: You mentioned gross margins. Are you confident that Spotify can hit those targets? They said in the long term, they expect margins between 30% to 35%.

DAVID TRAINER: Not really. And I mentioned margins. I'm really talking about the net operating profit after tax margin, like the margin that, at the end of the day, the investors should care about. Gross margins can be good. But if you're still not generating an after-tax profit positive margin, it sort of doesn't matter that much how good the gross margin is because you're still not making any money.

There's a lot of things they can do in terms of how they calculated gross margin. We like one version of the truth, the net operating profit after tax margin, return on invested capital. We do spend a lot of time trying to calculate those consistently and accurately across lots of companies. So we can look at a company like Spotify and understand just how competitively disadvantaged it is relative to its peers and other companies.

- And I want to talk management. Obviously, we saw a C-suite change. We also saw the layoffs that Spotify had as well. But still, at least they had at least that quarter, that record quarter in terms of subscriber growth.

When does all this translate? When does this actually make it a path forward for where Spotify goes from here? Can they do anything in terms of perhaps raising the price of subscriptions or streamlining elsewhere?

DAVID TRAINER: Rachelle, that's kind of the catch-22. I mean, it's a great question. At the end of the day, are they ever going to generate any cash flow?

And I think the answer is, well, maybe. But even if they do get to some positive level of cash flow, it's so far below what's already baked into the stock price in terms of huge amounts of future cash flow creation. So there's a disconnect here between valuation and the underlying economics and fundamentals of the business for all the reasons you just laid out. It's going to be tough.

ALLIE CANAL: And, David, Spotify not raising prices on those US-based subscriptions despite the price hikes that we've seen from YouTube Premium and Apple Music. Missed opportunity here or a strategic play?

DAVID TRAINER: I think a strategic play. I think it speaks to the relative competitive weakness of their business compared to these bigger firms that have bigger, larger platforms that bring a lot more to the table, a whole ecosystem around music, video, pictures, other devices, TV. And Spotify is just a niche little player. So it's going to be really difficult for them to make a lot of money and compete with firms that can offer a very similar service along with a whole lot of other services.

Firms like Google and Apple are making tons of money. They can afford to lose a lot of money in streaming music and podcasts without even blinking an eye. Spotify can't.

- That's certainly a very stark comparison in terms of the cushion that Apple has. A big thank you to Allie there. David, stick around, though, because there's another stock that investors have largely shunned, which is Peloton. The stock down more than 80% over the last year as it continues to run into a series of issues with its products and sales. And as the stock continues to struggle, many are speculating that a big tech firm could sweep in and buy it.

Mega shareholder of Peloton Blackwells Capital is pushing the company to sell. And when you think of tech giants like Apple, Disney, Sony, Nike as potential buyers, David, I want to get your thoughts. I know you say the stock could go to zero. Who could this be the strongest play for for big tech

DAVID TRAINER: I think that getting a buyout is a Hail Mary, right, I mean because the business itself is never going to, we think, make much money. And then you say that out loud and you wonder, well, who wants to buy a business that's never going to make much money? What can Peloton do that we can't do? What is special about them that would justify us paying more than a penny, $0.15, I don't know, or just building it on our own?

And so, look, we have a concept here we call stupid money risk, which means you never know how much somebody might pay. And we've seen plenty of companies that were probably going to go to zero get bought out for way more than what they deserved. And, unfortunately, the acquiring companies have had to incur some major write-downs for those decisions.

But stupid money does exist. And, Rachelle, I don't really see anybody really making a buy on Peloton unless it gets way, way lower. Why not buy it out of bankruptcy? Why pay a premium now for a product that is really not that differentiated?

- I think that was the problem because even when they started selling on Amazon, there's a million bikes on there. There's a million treadmills on there as well. Very hard. And then to have to pay for more ad spend to compete with some of these products already on there, is bankruptcy, do you think, really where Peloton is going to end up heading?

DAVID TRAINER: We think so. We put it, I think it was the third stock we put on our zombie stock list. And for all those stocks, right, there's a real issue because they're burning so much cash, they've got a limited amount of cash flow or cash on the books to sustain that burn.

So the clock is ticking, right? I mean, Peloton's only got a few more months, I think, of cash. I think the CEO several months ago said, hey, if we don't figure it out in the next six months, it's curtains.

So this talk about getting bought out is normal in the bankruptcy process. You kind of throw up the white flag and say, hey, we're for sale. Someone buy us. Otherwise, it's going to be to bankruptcy.

And has lot of times shareholders and investors will, bigger shareholders and investors will rally around trying to get that purchase done because it's way better to sell before you have to go into bankruptcy because if they go into bankruptcy, there's nothing for equity holders, right? There's no cash flow. There's debts. There's payables that are going to soak up whatever cash and assets are on the books before equity holders get anything.

- So, David, when people look back and dissect what happened with Peloton as a pandemic darling, having its special moment but not really having that sort of forethought as to what could happen afterwards, what do you think will be the biggest takeaways from the Peloton story?

DAVID TRAINER: I think do your diligence, right? Understand that the stock market is not just like an ATM machine. You put money in and you get it out, right, or it grows. I mean, the stock market is a capital allocation mechanism. And if you're not intelligent about how you allocate your capital, you can lose it all.

And that investing in narratives is dangerous because investing in narratives when there are no fundamentals there usually means that it's a big grift scheme, which is another way of saying it's a method for taking money from the pockets of many and putting it into the pockets of a few bankers and executives. So if you're investing without understanding the fundamentals, understanding the competitive position, you're really taking a big risk that you're going to lose a lot of money. And people just need to understand and get back to the basics of intelligent capital allocation when they think about investing. And Peloton is a great example of if you don't, you can lose it all.

- Stark lesson, indeed. Don't invest in a narrative. New Constructs CEO David Trainer, thank you for joining us this morning.