We recently made a list of Morgan Stanley’s Best Overweight & Quality Stocks: Top 25 Stocks. In this piece, we will look at where Spotify Technology S.A. (NYSE:SPOT) ranks on the list of the top overweight and quality stocks.
The close of September has cemented the paradigm shift on Wall Street. With the Federal Reserve’s first interest rate cut being all that investors could hope for as it reduced rates by 50 basis points, since the cut, the flagship S&P stock index and the broader NASDAQ stock index are up by 2% and 3%, respectively. The rate cut has also now moved Wall Street’s focus to the next big catalyst for the stock market, i.e, the third quarter earnings season.
For a market that has touched new highs this year due to artificial intelligence, the second quarter earnings season was nothing short of fireworks. It saw the AI narrative wobble temporarily after mixed results from the world’s leading AI GPU designer and the semiconductor industry reckoned with the fate of the semiconductor manufacturing stock that ranked 5th on the list of Jim Cramer’s Top 12 Must-Watch Stocks.
Starting with the chip maker, its second quarter earnings were nothing short of a bloodbath. They saw the firm’s non GAAP net income drop by a whopping 85% annually and turn a year ago GAAP net income into a non GAAP loss of $1.6 billion. At the same time, its gross margins dropped by 0.4 percentage points, and in the worst example of the cherry on top, the firm also announced that it will be suspending dividends starting from the fourth quarter. As a result, its shares tanked by 30% after the earnings, and since then, we’ve seen multiple reports claim that other companies are interested in acquiring it.
As for the GPU designer, its second quarter revenue jumped by 122% – a no small feat considering that the year ago quarter’s revenue was $13.5 billion. However, even as the Q2 revenue of $30 billion beat analyst estimates of $28.7 billion which was fueled by its AI data center division’s revenue jumping by 154% annually, the shares fell by 6% in extended trading. At the heart of the fall was a tepid third quarter guidance of $32.5 billion (analyst estimates were $31.77 billion), a gross margin miss by 0.1 percentage point, a Q3 margin guidance miss by 0.5 percentage points, and the delay of its Blackwell GPU to the fourth quarter. For investors already worried about the ability of AI to generate a profit, the margin miss in particular wasn’t comforting. Consequently, since the earnings report, the firm’s shares are down by 1%.
However, investment bank Morgan Stanley sent the GPU designer’s shares soaring by 6.8% in September in a bullish note that shared that the firm could earn $10 billion in its fourth quarter alone from the latest Blackwell chips. This upgrade came on the back of MS remaining consistent in its analysis of the stock market this year. The key themes that it has identified are the labor market, commercial real estate, and the split in the stock market between large and small cap stocks.
In July, the bank shared that there was “ample room for equities performance to broaden, but this requires a cyclical recovery.” In simpler terms, it means that MS believed that for small cap equities to catch up to large caps in performance, the economy has to perform well. If you’re wondering how wide this gap is, data shows that for small and medium cap and large cap stocks which are in the top 20% in terms of free cash flow margins, the small and mid caps have a forward price to earnings ratio of 0.74x relative to large caps as of April 2024, which is quite low when compared to the April 2009 peak of 1.62x. MS reiterated this belief in its August report, which shared that small cap outperformance “requires economic growth acceleration with lower interest rates. While recent inflation data and the resulting decline in rates was a lift to small cap, softer economic data may constrain its continued outperformance.”
However, MS’ September report took somewhat of a different tune. It focused on the clean energy and infrastructure investments in the US to share that these could help some segments of the American stock market that are typically dependent on growth in economic activity. Government spending through the Inflation Reduction Act (IRA), the Bipartisan Infrastructure Law (BIL), and the CHIPS and Science Act have led to roughly $500 billion in commitments by the private sector to invest in a diverse set of areas ranging from roads, to clean energy manufacturing and heavy industry.
As per the bank, “Government policies such as the CHIPS Act, the Inflation Reduction Act (IRA), and the Infrastructure Act are sponsoring growth in many areas of U.S. manufacturing. These trends could offer through-the-cycle structural support to areas of the economy that are traditionally very cyclical.” On the data front, MS reveals that while in 2022, US manufacturing capacity as a percentage of 2017 output sat at ~126%, this has jumped to nearly 129% as of 2024.
Shifting gears, the third quarter earnings season will soon start to shape how investors view the market. Data from LSEG shows that the flagship S&P index is expected to deliver 5.4% annual earnings growth during Q3. FactSet is more cautious, as it shares that the index should grow earnings by 4.6% annually to mark its sixth straight quarter of growth. MS is of the view that the economy has to continue to deliver on the data front if the stock market is to perform well.
In a recent podcast, the bank’s chief investment officer and chief strategist, Mike Wilson, shared that “the unemployment rate will need to decline and the payrolls above 140,000 with no negative revisions to prior months. Meanwhile, I am also watching several other variables closely to determine the trajectory of growth. Earnings revision breadth, the best proxy for company guidance, continues to trend sideways for the overall S&P 500 and negatively for the Russell 2000 small cap index. Due to seasonal patterns, this variable is likely to face negative headwinds over the next month.”
Our Methodology
To make our list of Morgan Stanley’s best Overweight and quality stocks, we ranked the bank’s recent list of 66 stocks with Overweight ratings, a higher than median quality score, and one month upward EPS revisions by their percentage one month average analyst revisions. The average EPS data was sourced from Yahoo Finance as of September 26th 2024, and the top 25 stocks with non zero percent revisions were selected.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
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Spotify Technology S.A. (NYSE:SPOT)
Number of Hedge Fund Holders In Q2 2024: 88
Average Analyst EPS % Revision: -0.5%
Spotify Technology S.A. (NYSE:SPOT) is a market leader in the global audio streaming industry which has grown in popularity through the internet. It grew its net users by 113 million in 2023, and more importantly, premium users by 31 million in 2023. The growth, coupled with the fact that higher discretionary spending boosts spending, has translated into positive catalysts for Spotify Technology S.A. (NYSE:SPOT)’s share price. Its stock is up 95% year to date and has gained 7% since the Fed announced its 50 basis point interest rate cut. The keys to Spotify Technology S.A. (NYSE:SPOT)’s hypothesis are its user growth, revenue per user, and its artist portfolio. The firm’s commanding position in the streaming industry, as evidenced by its 626 million user base, means that Spotify Technology S.A. (NYSE:SPOT) can easily attract musicians to its platform. It has been executing well on the revenue generation front, with the second quarter marking a 21% annual growth in premium revenue and a 15% growth in ad supported monthly active users driven by features such as longer videos that also run ads.
Baron Funds mentioned Spotify Technology S.A. (NYSE:SPOT) in its Q2 2024 investor letter. Here is what the firm said:
“Spotify Technology S.A. (NYSE:SPOT) is a leading global digital music service, offering on-demand audio streaming through paid premium subscriptions and an ad-supported model. Shares of Spotify were up, largely attributable to impressive beats in gross margin and operating margin as well as the announcement of subscription price hikes. Given the strong value proposition of the product, Spotify is beginning to exercise its pricing power following last year’s initial price increases that saw minimal churn. Users continue to grow at a healthy pace despite the pricing impact. Spotify also continues to innovate on the product side, with early trials of generative AI features and the addition of new verticals like audiobooks, which have seen solid early adoption. On the cost side, Spotify is on a path to structurally increase gross margins, aided by its high-margin artist promotions marketplace, increasing contribution by its podcast division, and growth of the margin-accretive advertising business. We still view Spotify as a long term winner in music streaming with potential to reach more than one billion monthly active users.”
Overall SPOT ranks 19th when we look at Morgan Stanley’s top overweight stocks. While we acknowledge the potential of SPOT as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than SPOT but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article was originally published on Insider Monkey. All investment decisions should be made after consulting a qualified professional.
