🎧 Spotify: Layoffs Pay Off
🎧 Spotify: Layoffs Pay Off
But advertising and the user-mix are a problem
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Spotify (SPOT) has more than doubled in the past year.
Founder-CEO Daniel Ek explained in the latest earnings call:
“While many believe that Spotify has a great product, we needed to prove that we also could be a great business. I think we are really starting to show this now.”
After a challenging 2023 marked by three rounds of layoffs, the stock has gained investors’ favor again and is close to its 2021 all-time high. The business appears to have finally turned a corner, expanding margins and cash flow.
⚠️ But there is a catch. Despite more marketing spend, the growth of the active user base has become soft in mature markets like Europe and North America, signaling potential saturation. Developing markets still bring in more users, but they convert to Premium at a much lower rate and offer poor monetization potential via ads.
Let’s get deeper!
Today at a glance:
Spotify Q2 FY24 earnings.
Recent business highlights.
Key quotes from the earnings call.
Future developments to keep an eye on.
1. Spotify Q2 FY24
As a reminder, Spotify’s Monthly Active Users (MAUs) include:
Premium subscribers who pay ($11.99/month in the US) for unlimited online & offline access, ad-free.
Ad-supported users who have limited access and regular ad breaks.
Due to the overlap between Premium and Ad-supported during a quarter, the sum of the two is usually slightly higher than the total MAUs.
Paid conversion in % of MAUs is above 50% in Europe and North America and roughly 40% in LATAM. While the ‘Rest of World’ segment grows users fast, paid conversion is weak and worsening, hitting a low of 16% of MAUs.
Key user metrics:
MAUs grew +14% Y/Y to 626 million (5 million miss).
Premium subscribers grew +12% Y/Y 246 million (1 million beat).
Ad-supported MAUs grew +15% Y/Y to 393 million.
Income statement:
Less than 40% of Spotify’s active users convert to paid subscribers. But Premium drives 88% of the company’s revenue and 93% of gross profit.
Main highlights:
Revenue grew +20% Y/Y to €3.8 billion (+21% Y/Y fx neutral), in-line.
💶 Premium grew +21% Y/Y to €3.4 billion.
📢 Ad-supported grew +13% Y/Y to €0.5 billion.
Gross margin was 29% (+5pp Y/Y).
Operating margin was 7% (+15pp Y/Y).
Non-GAAP Earnings per share €1.33 (€0.28 beat).
Cash flow:
Operating cash flow was €492 million (13% margin, +13pp Y/Y).
Free cash flow was €490 million (13% margin, +13pp Y/Y).
Balance sheet:
Cash, cash equivalent, and marketable securities: €5.4 billion.
Long-term debt: €1.3 billion.
Q3 FY24 Guidance:
MAUs +11% Y/Y to 639 million (+13 million sequentially).
Premium subscribers +11% Y/Y to 251 million (+5 million sequentially).
Revenue +19% Y/Y to €4.0 billion (or +20% Y/Y fx neutral).
Gross margin 30% (+4pp Y/Y).
Operating margin 10% (+10pp Y/Y).
So what to make of all this?
User metrics were a mixed bag. Overall MAUs increased by 11 million sequentially. It was the softest net addition in three years.
Paid conversion remained exceptionally high at 39% of MAUs (-1pp Y/Y).
Premium revenue growth was boosted by recent price hikes, with a 10% growth in ARPU (Average Revenue per User). Spotify recently hiked its US price twice (in July 2023 and early June 2024). These were the first price hikes since its US launch in 2011. The company’s growth profile would be in the low teens without the price hikes.
Ad-supported revenue growth was relatively soft at 13% despite a small base. Spotify is still struggling to monetize efficiently compared to Big Tech.
Spotify's gross margin reached a new high of 29%. If you recall, Spotify pays roughly 70% of its Premium revenue in royalties to record labels and music publishers. Since Spotify doesn’t own most of its content, publishers collect the lion's share of revenue. The gross margin beat in Q2 came from “music content cost favorability,” which is more related to the content mix and not necessarily a durable improvement. Despite a fourfold increase in monthly active users over the past six years, the gross margin has stubbornly remained low. Why? Because you can’t offset poor unit economics with volume.
Can the gross margin improve? Don’t expect Spotify’s gross margin profile to improve dramatically. Roughly 30% gross margin is a glass ceiling for the core Premium business due to the royalty costs attached to the vast majority of the content consumed on the platform. Management anticipated a gross margin boost from the advertising business, but it has yet to materialize. Due to investments in original content and technology, the ad-supported revenue currently yields a lower gross margin than Premium.
Operating expenses peaked in Q2 FY23 and have decreased in the past year after the layoffs. The company cut roughly 6% of the workforce in January, 2% in June, and 17% in December 2023.
Q3 outlook implies a slowdown. The sequential user additions could be slower than last year (Spotify added 6 million Premium Subscribers in Q3 FY23). As a result, a showdown in revenue growth is on the horizon.
But profitability is on the right track. After barely breaking even since 2018, Spotify was profitable for the third consecutive quarter. The operating margin could hit a new high of 10% in Q3.
Cash flow has turned the corner. Spotify generated nearly half a billion in free cash flow in Q2 and over €1.3 billion in the trailing 12 months. It shows that the business is sustainable and allows management to re-invest in the platform.
2. Recent business highlights
New ways to subscribe: Management introduces new plans like Audiobooks Access in the US, giving access to 15 hours of audiobook listening for $9.99/month and a Basic subscription that removes audiobooks from the Premium plan. Spotify also offers discounted plans like Student, Duo, and Family, incentivizing multi-account adoption within a household.
Discovery: Spotify is trying to catch up to other social media feeds to encourage discovery on its platform. That includes Live Listening Parties when new albums launch or prompt-based AI playlists in beta. It remains very early and somewhat unsophisticated compared to the live content and algo-based recommendations on YouTube or Meta apps.
Advertising: Ad revenue on Spotify remains small, given its 393 million ad-supported users. The ARPU was roughly €1.15 per user in Q2. For perspective, in the same quarter, Meta’s Family of Apps delivered an ARPU of $11.89, Snap achieved $2.86, and Pinterest $1.64. Spotify launched a new in-house creative agency to build brand experience. The problem? This agency approach is hard to scale. In short, Spotify’s advertising execution looks more like Live Nation Entertainment and less like Meta.
Podcasting: Spotify realigned its content strategy last year when it let go of most of its podcasting department and adopted a case-by-case approach. Now, management is touting the growth of video podcasts on its platform. So much has changed since Ek claimed Spotify wanted to become the “TikTok of audio.” The focus on audio was, in retrospect, the wrong call. All along, Spotify should have focused on the artists and helping them monetize their fanbase. The most significant value capture is to become the OnlyFans for music creators—exclusive, timely content through an artist-specific subscription (or in-app purchase).
3. Key quotes from the earnings call
Founder-CEO Daniel Ek on price increases:
“We also implemented a price increase in several key markets, including the US, which we are rolling out now with great success. In fact, we are seeing less churn in this round of increases than we did in our prior one – which was already very low by any measure.”
Spotify has pricing power, as evidenced by its relatively low churn, even during price hikes. These curated playlists are valuable! But remember, the platform remains dependent mainly on labels for pricing decisions.
On the soft MAU gains in 2024:
“We have significant potential to attract a large number of new users in developing markets. However these users can be a little more inconsistent – engagement looks different in these markets, as do the channels to acquire them and conversion to paid can be slower. This makes it difficult to get the same level of ROI effectiveness from our marketing spend.”
In short, user growth has tapered off in mature markets, and pursuing paid user acquisition in developing markets is tricky because the return on advertising spend can be subpar. So, management is focusing on three buckets in developing markets:
Partnerships and optimization of the marketing-channel mix.
Increasing the marketing spend strategically.
Improving the free products to boost engagement and retention.
On the user-mix:
“The relationship from free to paid is no longer a one-size-fits-all scenario and we are less dependent on new free users to fuel our revenue growth in the short to mid term.”
I’m going to disagree with Ek here. If the user growth stops in Europe and North America, Premium conversion will eventually hit a ceiling. Price hikes and ad monetization will become the main leverages to maintain revenue growth.
On future growth:
“The way we believe we create higher LTV is by creating win-wins. We want to both do things for the existing creators we have in more new ways, like concerts, and potentially when we see things we’ve already invested in and other groups of creators finding value in that, we’ll expand into other verticals as well.”
There is a tremendous untapped opportunity to monetize the relationship between an artist and highly engaged fans a la Patreon. But I wouldn’t hold my breath. YouTube has been moving faster than Spotify to create a vibrant creator economy.
4. Future developments to keep an eye on
‘Must have’ subscription
According to Hub Entertainment Research, the average US household uses nearly 13 sources of entertainment across video, music, gaming, and social platforms.
Hub asked over 3,000 US consumers which media subscriptions they consider ‘must-have.‘ Here are the main takeaways:
Less than half of media sources were ‘must-haves.’
Spotify was deemed uncancellable' by 75% of respondents.
Only YouTube Premium had a comparable vote of confidence.
Three music services were in the top 10 (Spotify, YouTube, Apple).
Now that Spotify seems to have turned the corner and reached comfortable free cash flow margins, the high durability of its subscription makes it a more compelling business proposition.
The market has started recognizing this with a valuation near an all-time high at roughly 40 times free cash flow.
Traditional competitors trail by a wide margin:
YouTube Music and Premium surpassed 100 million subscribers in 2024.
Apple Music could reach 110 million paid subscribers by 2025 (according to JPMorgan), but it’s still a far cry from Spotify’s 246 million Premium users.
Some other competitors are relevant based on geographies or age groups, like Amazon Music, Deezer, Joox, Pandora, and SoundCloud. However, as Spotify increasingly leans on advertising, it must vie for our attention and increase engagement. That brings us to TikTok.
TikTok Music is coming
In this newsletter, we’ve often discussed the critical role of TikTok as a music discovery tool for younger generations. Platforms that offer short-form videos are the perfect use case for this. So much so that TikTok’s parent ByteDance commissioned a report from Luminate that estimated that 62% of TikTok users pay for a music streaming service, compared to 43% of consumers overall.
While Spotify has a rock-solid subscription service, it’s still dependent on content owned by other publishers, making the competitive moat somewhat precarious. More importantly, the ability to monetize ad-supported users remains in question when music content is abundant elsewhere and highly commoditized.
ByteDance launched the TikTok Music app in beta in Australia, Brazil, Mexico, Singapore, and Indonesia, offering a music catalog that competes with Spotify and Apple Music, with partnerships with major record labels.
Critically, TikTok could aggressively funnel its estimated 1+ billion monthly users to its Music app after its worldwide launch, posing the most critical threat to Spotify’s dominance.
Of course, TikTok might get banned in the US, adding a layer of intrigue and uncertainty. But that’s a discussion for another day.
Edit: ByteDance announced it would shutter TikTok Music on September 24.
Ole Obermann, TikTok Global Head of Music Business Development, explained:
“We will be closing TikTok Music at the end of November in order to focus on our goal of furthering TikTok’s role in driving even greater music listening and value on music streaming services, for the benefit of artists, songwriters, and the industry.”
This is good news for Spotify, as it removes a potential future competitive threat in mature markets. But it’s a reminder that music streaming is a difficult business, and most of the value capture is elsewhere.
That’s it for today!
Stay healthy and invest on!
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Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
Fantastic deep dive!
Another, admittedly very biased, perspective: I have subscribed to music. What makes them think I’m interested in dozens and hundreds of podcasts?
If podcasts are such a fantastic product, why not offering it as a separate subscription? Why shoving it down the throat of those who are there for the music only?
Same model at Netflix: You start with videos, now games are part of it, too. Why do I have to pay for that as well?
Understandable from the company’s perspective. It’s about maximizing revenue.
But it also means that providing value to the paying customer is at most at the second position on their priority list.
We’ve offset the costs of Netflix with holding a appropriately sized position in Netflix shares.
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