Spotify: Phenomenal User Growth, but Margins Remain a Concern
Another quarter of the same for Spotify: phenomenal user growth, but gross and operating margins remain a concern.
Summary
MAUs increased 27% YoY to 551m (vs. 530m guidance) and represented the largest number of quarterly net MAU additions in Spotify’s history.
Recently announced price hikes on premium subscriptions should help to increase premium ARPU from Q4 onwards.
Spotify’s gross margins remained stubbornly low in Q2, likely explaining the 14% drop in shares post-earnings release.
Spotify’s Q3 guidance was very strong, calling for 25% YoY growth in MAUs to 572m and for gross margins to expand to 26.0%.
Spotify’s valuation is undemanding at 2x LTM revenue and 8x LTM gross profit, but I believe investors need to see several quarters of sustained gross margin expansion for the stock to re-rate higher.
Introduction
In this article, I provide an update on Spotify’s latest Q2 2023 results. Spotify is one of my largest personal holdings and a very controversial business, despite being one of the most recognised and loved consumer brands on the planet.
Unfortunately, this quarter did little to quell investor concerns and the question still remains: can this great consumer product become a great business?
The “Good” of Spotify’s Q2 Results
1) Phenomenal user growth
As has become the norm with Spotify, Q2’s user growth numbers smashed their guidance out of the park.
Monthly active users (MAUs) increased 7% QoQ and 27% YoY to 551m (vs. 530m guidance) and represented the largest number of quarterly net MAU additions in Spotify’s history.
Premium (i.e., paid) subscribers increased 5% QoQ and 17% YoY to 220m (vs. 217m guidance) and was the largest Q2 net subscriber additions in the company’s history.
As a ratio, 40% of Spotify’s 551m MAUs are premium subscribers.
Overall, growth remains very strong for Spotify. Any concerns about decelerating user growth due to macroeconomic concerns appear misguided as the company continues to grow very quickly across all geographies, but particularly in their “Rest of World” segment which jumped to 30% of MAUs in the quarter.
2) Healthy revenue growth
Spotify’s Q2 total revenue of €3.2b increased a healthy 11% YoY (14% in constant currency), which was in-line with their guidance from the prior quarter.
The difference in growth rate between total revenue (14% YoY in constant currency) and MAUs (27% YoY) largely comes down to the fact that Spotify’s recent user growth has been primarily driven by: 1) ad-supported users and 2) new premium subscribers in geographies (e.g., India, Spain) with lower ARPUs. Indeed, in Q2, premium ARPU decreased 3% YoY in constant currency, which should be slightly offset from Q4 onwards due to Spotify’s long overdue recent price hikes on their premium subscription plans.
Looking out, the price increase will moderately help in Q3. We're looking for FX neutral ARPU kind of flat to down 1% in Q3, and then we should expect a meaningful in improvement in FX neutral ARPU in Q4 as we get the full benefit of the price increase into Q4. So minus 3% this quarter, call it zero to minus 1% in Q3 and then nicely positive.
Ad-supported revenue also returned to growth, with 12% YoY growth (15% in constant currency), reversing the trend of several quarters of weaker growth.
3) Strong Q3 guidance
Spotify’s Q3 guidance was much stronger than I expected, particularly given their natural conservatism when making forecasts. In Q3, Spotify expects the following (keep in mind that Spotify tends to beat their forecasts):
572m MAUs (+25% YoY).
224m premium subscribers (+15% YoY).
€3.3b total revenue (+9% YoY growth including around 600bp of currency headwinds). This includes minimal impact from the price increases announced on premium subscriptions this week, which should flow through from Q4 2023 onwards.
Gross margin = 26.0% (vs. 24.7% in Q3 2022).
Operating loss of €45m (vs. a €228m loss in Q3 2022).
4) Exciting product initiatives
Spotify’s highly regarded “AI DJ” - which provides personalised music playlists - has now been rolled out to all premium subscribers in the UK and Ireland. I’m excited for this to launch in the Australian market (hopefully in Q3!).
The company also launched “Spotify Ad Analytics”, a platform for brands and agencies to measure the efficiency of their ad spend on Spotify. More transparency means that (if) Spotify is delivering value for their advertisers (which I imagine they are given how underpenetrated advertising is in the music industry outside of radio), it should translate into increased pricing power and higher ad penetration.
Based on the conference call, it also sounds like Spotify is experimenting with offering podcast summaries, similar to what Blinkist does for books.
So, an easy way to think about it as an investor is if you think about podcasting today, it's really high-quality content, but it requires quite a lot for you to get into new podcasting. So one very easy thing we can do with this -- these new AI developments is, of course, summarize what these podcasts are about. And by doing so, you can imagine it becoming a lot more easier to merchandise new podcast for consumers which drives in turn higher engagement and more growth for creators, which is a really positive thing.
The “Bad” of Spotify’s Q2 Results
1) Gross margins remain stubbornly low
I feel like a broken clock with these articles, but here we are again …
While revenue and user growth came in at or above expectations, Spotify’s gross margins refused to budge, coming in at 25.5% on an adjusted basis, which excludes one-off measures related to redundancies. On an actual (i.e., non-adjusted basis), gross margin was a dismal 24.1%, one of their lowest quarterly gross margin figures since their direct listing in 2018.
As can be seen in the below diagram, gross margins have barely budged since 2020 and even trended down in recent quarters due to heavy investments to build out their podcast infrastructure (which gets categorised in COGS rather than OpEx).
2) Widening operating losses
Operating loss on a non-adjusted basis came in at €247m, well short of guidance for a loss of €129m. On an adjusted basis (which excludes one-off costs related to staff redundancies and scaling back their real estate footprint), operating loss beat expectations, coming in at €112m. It’s funny how management can always beat guidance with a few little “adjustments” here and there.
While continued operating losses are disappointing (especially in the era of “efficiency” and “cost-cutting”), Spotify’s strong balance sheet with €3.5b cash and equivalents should help investors sleep at night. Spotify has no need for a capital raise to pursue their growth plans or fuel further R&D.
Moreover, almost all of the jump in operating expenses in Q2 was the result of increased R&D spend, consistent with their product-led growth strategy. As can be seen below, YoY increases in R&D spend were much larger than those for S&M and G&A expenses:
R&D expenses = +35% YoY.
S&M expenses = +2% YoY.
G&A expenses = -6% YoY (due to redundancies and cuts on other non-core spending).
The Bottom Line
Well, in short, there isn’t one (sorry, not sorry).
On a more serious note, this was another predictable quarter from Spotify. Growth in MAUs was well above expectations, revenue growth was solid, but gross and operating margins again failed to show meaningful signs of improvement.
With shares up almost 100% YTD prior to this earnings release, I’m not surprised to see shares sell off 14% post-earnings release. It’ll take time for Spotify management to reclaim the trust of investors that they can achieve their lofty 2030 goals of “40% gross margins and 20% operating margins”. At the current rate, one could argue that Spotify is more likely to reach 1b MAUs before they achieve 30% gross margins.
At the current valuation of around 2x LTM revenue and 8x LTM gross profit, Spotify remains a cheap business for their growth potential and dominant market position in the audio market. Sure, there are threats - Amazon Music and TikTok Music, but the real threats right now to shareholder value lie within Spotify’s HQ.
A couple of quarters of sustained gross margin expansion (which Spotify has guided to in Q3) and the stock should re-rate materially higher to the $200-300 range, rewarding patient long-term investors. I haven’t sold a single share since my initial purchase in mid-2021 (and averaged down several times in late-2022 below $100), so I’m putting my money where my mouth is and holding on for the ride.