Spotify is Firing on All Cylinders
I’ve written about it before, but I want to talk again about why Spotify is crushing it at the moment. They released earnings last week, and while premium subscriber numbers barely missed analyst estimates, the business as a whole is humming along just fine.
I’m a big fan of this stock for a lot of reasons. Let’s dig into some stats from the earnings report and conference call to show why I think Spotify is poised to become one of the next tech giants.
User Growth at Scale
In the second quarter monthly-active-users (MAUs) grew 29% to 232 million at the end of June. Premium subscribers (those who pay a monthly fee for ad-free content) grew 31% to 108 million. This means that at the end of the quarter, Spotify had 129 million ad-supported users and 108 million paying users.
Here is what the company had to say about the MAU numbers:
“Outperformance [of user growth] was broad-based, with most of our geographic regions growing faster than our expectations. Timing of certain global music releases yielded some incremental benefit, as did our launch on PlayStation consoles across the Middle East and Latin America.”
Spotify has been able to grow at scale because, unlike Apple Music, they are prevalent in 79 countries worldwide. Here is a geographic distribution of MAUs that I like to look at every quarter:
They don’t provide how fast certain regions are growing, but it is likely they are getting tremendous rates from India, Latin America, and the Middle East at the moment.
On the premium subscriber front, here is what Spotify had to say about the quarter:
“Intake from our bi-annual campaign was in line with our expectations, monthly churn declined both sequentially and Y/Y to a record low 4.6%, and our winback percentage on gross ads reaccelerated Q/Q. However, intake into our Student product was below plan. As we have discussed previously, our goal is to perform at roughly the 70th percentile of our guidance range and we missed on subs. That’s on us.”
I like two things from this paragraph. One is that Spotify’s churn-rate (how many people leave) continues to decrease, showing the stickiness of the service. If anyone reading uses Spotify, you know exactly what I am talking about. The other thing I like is them owning up to a mistake/missed goal. A lot of companies will give excuses for earnings, sales, or other misses. An indicator of quality management is a group who can admit their mistakes like Spotify did this quarter.
High Sales Growth and ARPU Stability
Total revenue grew 31%, premium revenue grew 31%, and advertising revenue grew 34% in the quarter. It is important to note that premium revenue makes up over 90% of sales for Spotify at the moment.
When evaluating a consumer tech platform, investors should always look if a company is growing revenue and not just users. Spotify has consistently done that (at least since they’ve been a public company), showing how much value they are providing to users.
Average-revenue-per-user (ARPU) has been a concern for Wall Street, as it has dropped almost every quarter from a year-over-year basis. This quarter was no different. However, it ended-up only dropping 1%, a good sign that in the short-term we might be getting close to the floor for ARPU (in the long-term investors should look for this number to rise). Spotify said this will continue since their product mix and geographical distribution will be less favorable in the near-term.
Another positive tidbit from the release was the mention that programmatic and studio ads were growing at an impressive rate this quarter:
“Programmatic and Ad Studio revenue growth accelerated to 71% in Q2, and now account for approximately 30% of total Ad-Supported revenue. Programmatic growth in the US exceeded 50%, and our next 5 largest markets in aggregate increased triple digits Y/Y.”
If this part of the advertising business continues to grow at a 70% clip then we will likely see an acceleration in advertising sales growth in the next few years.
Podcasts, podcasts, podcasts. That’s what Spotify has been preaching for the past year. They recently acquired Anchor (where we do our show) and Gimlet Media and claimed they would be spending $500 million this year and $1 billion next year on acquiring original podcast content.
Spotify wants to dethrone Apple as the king of podcasts, and it looks like they are well on their way to achieving that goal. I mean, just read the statistics they gave out this quarter and tell me the momentum is not on their side:
“Tens of millions of users are now streaming podcast content on a monthly basis, and more are discovering new forms of audio content each day. Our podcast audience grew more than 50% Q/Q and has nearly doubled since the start of the year.”
Spotify not only wants to be the largest podcast distributor; they also want to reinvent advertising for the entire medium. Again, here is a quote from the earnings release where Spotify describes how they want to build a YouTube-like advertising service for podcasts:
“Over time, our ambition is to reinvent the podcasting ad experience by building a new tech stack to enable targeting, measurement, and reporting capabilities like we have for our core Ad-Supported offering.”
With all the data Spotify has on its users, they will be able to target ads for their original shows (and in the long-run for any show) that will increase ARPU. Hosts can already see this data through their podcast analytics service. This is a gold-mine of advertising profits just waiting to be exploited.
Operating and Free Cash Flow
When evaluating an unprofitable/break-even business like Spotify, it is important to look at whether they are generating positive free cash flow (FCF). FCF is an important metric (and I’d argue the most important metric) for a stock because it shows whether a company can fund new initiatives without raising debt or diluting shareholders.
Spotify is growing their FCF and operating cash flow at a tremendous rate, with both almost tripling this quarter:
*Green-part is this quarter, and grey-part is YoY growth rate.
Investors should keep a close eye on FCF. It will be a great sign if Spotify can grow this number in the years to come.
Conference Call and Management Team
If you listen to or read Spotify’s conference call (CC) transcripts (which you should do if you own shares of the company), then you know that this executive team just gets it from a communication perspective.
The first positive note is how short their prepared remarks are. It doesn’t affect the financials of a business, but knowing what a waste of time 15-minute prepared remarks are on a CC can make analysts very happy.
The other positive note is how confident/un-fazed CEO Daniel Ek and CFO Barry McCarthy (ex-CFO of Netflix btw) are at any question thrown their way. Sure, it is a given they should be experts on the business they run, but compared to other CC I’ve listened to/read, these guys are top-notch.
Here are a couple of examples from this quarter’s CC (you can read the full transcript here):
Paul Vogel — Head of Investor Relations and FP&A
“Our next question comes from Doug Anmuth at J.P. Morgan. With marketplace services set to launch in early 2020, do you expect this product to be revenue-generating or cost-reducing? Meaning are they incremental revenue or more closely tied into label deals and a way to improve label economics?“
Barry McCarthy — Chief Financial Officer
“This is Barry. For the most part, Doug, we expect them to be margin-enhancing.“
Paul Vogel — Head of Investor Relations and FP&A
“Our next question comes from Brian Russo at Crédit Suisse. Regarding the direct upload and artist distribution offering you recently shut down. Can you discuss the motivation to exit this business, if you have not already? And could you also give us some perspective on how material the investment in this area has been?”
Daniel Ek — Chief Executive Officer
“Well, the first thing, just to — as a bit of an education. We do have a lot of experiments at Spotify when it comes to our product capabilities. And so as you saw in the general consumer sense, you’ve seen us now expand on Spotify Lite going from beta into a formal one, and now Spotify Stations being in beta rolling out to more markets. So the direct upload capability was one of those beta programs.
And as it happens with some of those experiments, they just don’t pan out to the same extent that we originally believed. And therefore, we made the call to refocus our efforts elsewhere. Now as it relates to what we’re focusing on, we are very much focusing on the marketplace side of the business. And in there, we are actively prototyping away new products together with our partners.
And we’re really excited about that, and we hope to come back in early 2020 with more data on that.”
With all the things I mentioned above (user growth, revenue growth, FCF growth, top-notch management, podcasts) as well as some things I didn’t (valuation, leverage vs. the labels, hardware-agnostic), I think Spotify is positioning themselves to dominate the audio market for years to come.
Disclosure: the author is not a financial adviser, and may have an interest in the companies talked about.