Spotify: An Inflection Point
Q3 2023 ER Update
Edited by Brian Birnbaum and an update of my original Spotify deep dive and my Q2 update. (I cover this company quarterly and it is one of my largest positions).
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Onto the update now.
In Section 1.0 I go through my Spotify thesis.
In Section 2.0 I analyze Spotify´s operating leverage.
In Section 3.0 I analyze the evolution of the podcast and audiobook verticals.
In Section 4.0 I analyze the financials of the company
In Section 5.0, I conclude the write up.
1.0 Thesis Recap
Spotify is not what it seems and presents one of the more asymmetric opportunities in the tech space at present.
While the market sees Spotify as a music streaming app with no competitive advantages, I see it as an audio network without any real, threatening competitors that’s in turn evolving into an audio search engine. At a P/S ratio of 2.4, the upside is vast.
The above is perhaps best evidenced by record MAU (monthly active user) growth, decreased marketing spend, and increased prices in Q3. If Spotify, as just another audio platform, is a commodity, why does it keep on growing so fast?
Q3 was our second largest third quarter ever for MAU net additions. - Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
As you might imagine, I spend the remainder of this update proving why Spotify is not, in fact, a commodity.
The essence of our business model is to deliver unparalleled value to our user base through an ever improving consumer and creator experience.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
Spotify is actually an incremental value delivery machine. Constant and rapid improvements are deeply embedded in the company´s DNA, luring customers at times subconsciously to engage at increasing rates.
Spotify´s moat is invisible to most. The market does not yet fully understand that, in the digital space, a marginally improved user experience leads to exponential adoption, both comparatively and absolutely. Spotify´s superior user experience is a result of its exclusive focus on audio, which competitors like Amazon and Apple cannot match despite far deeper pockets.
Spotify’s nascent operating leverage is the result of rapid iteration and incremental value combining with cost efficiency–the signature combination of a world-class business.
But the new part of the Spotify modus operandi is our focus on efficiencies. And we're starting to see some leverage here coming into play, but this is the state going forward.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
2.0 Dissecting the Operating Leverage
The operating leverage demonstrated during Q3 is limited to music. On the other hand, gross margins are expanding, which management expects to continue for the foreseeable future.
In Q3, the drivers of operating leverage have been:
OPEX reductions and SG&A, with a 13% YoY decline on a constant currency basis.
The early effects of price increases in Q3, which, according to management, have had no impact on churn or gross intake and also illustrate Spotify’s pricing power.
And so what was great was the churn was right in line with expectations. And we talked about in the past when we've raised prices that churn had never been that material, and it was similar to this go around.
And then I guess even just as importantly, we outperformed on the gross intake side, which is one of the reasons why we outperformed on overall subs.
- Paul Vogel, CFO during the Q3 2023 conference call.
The advertising business, which re-accelerated in Q3 to 24% (sequentially and in constant currency terms) from the low mid-teens over the last couple of quarters. According to CFO Paul Vogel, Spotify owes much of this recharged growth to improved advertising sales, more specifically, improvements in attribution and automation.
The improved sales procedures and attribution methods have led to more impressions sold.
Music advertising revenue grew nearly 20% year-over-year, thanks to a surge in impressions sold and steady pricing.
Podcast advertising revenue continued its healthy double-digit growth, fueled by significant year-over-year gains in impressions sold across original and licensed podcasts, as well as the Spotify Audience Network.
Softer pricing partially offset these gains, but the Spotify Audience Network still saw double-digit quarter-over-quarter growth in participating publishers and shows, as well as high single-digit quarter-over-quarter growth in advertisers.
In the graph below, advertising revenues are imperceptible in Q1 and Q2 2023 and now they are back on the radar.
Re-acceleration has occurred within both music and the podcasting. According to CEO Daniel Ek, Apple’s privacy modifications have made it difficult for labels to track the attribution of their ads. As a result, labels are now looking to Spotify for their solutions.
Today, it is very expensive for a label to market an artist in all the various channels that they're doing. It's very hard through the changes that Apple and others made for tracking to happen. So it's very hard to attribute all the way through a stream, what's happening.
Obviously, on the Spotify platform, we can do that directly from being at the point where people discover music to being at the place where people discover -- then consuming that music, which, of course, drives an unparalleled consumer experience and unparalleled marketing experience.
That is a great way where we can help reduce the marketing cost for labels and obviously earn a share of that revenue back. That is why we're so excited about our gross margin projection.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
Gross margin came in at 26.4%, mostly due to “favorability in the music business,” as explained above by Ek. This is an uptick with respect to the last quarter but far from an all-time high. In Q2 2021, for instance, gross margin came in at 28.44%. The decline is due largely to investments in the podcast space.
Zooming in, we can see gross margins just starting to tick back upwards as a result of the above drivers, along with the abortive podcast investments continuing to subside. Management expects margins to continue expanding despite the deployment of audiobooks.
As you look into 2024, we expect to see a continued improvement in our gross margin trends and a continued improvement in our operating income trends as well.
- Paul Vogel, CFO during the Q3 2023 conference call.
3.0 Podcast and Audiobooks Contribution Margins
Over the coming years, podcasts and audiobooks are both poised to contribute increasingly to Spotify´s bottom line and, by virtue of such, the operating leverage drivers analyzed in Section 2.0.
When Spotify cut back on podcasts in Q2 2023, it was seen as a sign of weakness. Meanwhile, I argued that podcasting data increased its ability to iterate on and optimize, just as they did with music. As a result, Spotify now expects podcasts to reach break even soon:
But moving forward, we'll continue to invest, but we also think we're going to continue to get lots of efficiencies and that's through being smarter about where we spend that podcasting budget and also continue to grow the advertising on top of it.
So we feel like we're on track. I think we gave at the Investor Day sort of a one to two-year time line to break even on podcasting. We're right in line with that time line.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
The Investor Day took place one year and four months ago, which means that, per Ek´s comments, at some point in the next three quarters podcasts will exhibit a positive contribution margin, adding yet another weapon to the business’s arsenal.
In turn, it seems that the deployment of audiobooks is progressing very well and management does not think it will require much investment to achieve critical mass going forward. The vertical is therefore also positioned to contribute to the bottom line soon.
And while it’s still too early to see the impact in our numbers, initial signs from subscribers in the UK and Australia are incredibly positive as we bring them more content to discover.
In the first two weeks since launch, Premium subs in these two markets are loving the breadth of titles and have already listened to over 28% of the catalog.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
Obviously, there's some investment when it comes to the audiobooks business, but there's nothing about the launch that will derail our progress on the gross margin side or our progress on the operating income side are probably just as important, our progress on the free cash flow side.
[…] it's not a long window until we see audiobooks really being additive to Spotify from a bottom line perspective.
- Paul Vogel, CFO during the Q3 2023 conference call.
If Spotify succeeds on the audiobook front like it has done in the podcasting space, in addition to music, Spotify users will enjoy three distinct audio verticals, all of which will contribute to the advertising business. In the past management has shared that the number of successful verticals is directly proportional to engagement.
Thus, a user that listens to music, podcasts, and audiobooks should yield much higher advertising revenues than otherwise. ARPU (average revenue per user) is therefore set to rise going forward, if normalized for the various subscription plans that Spotify offers (family, duo etc).
Not only will our expansion into this category supercharge the growth of the audiobooks format, but it also will drive engagement and reduce churn, which further enhances our value proposition. This in turn gives us more flexibility for our business.
- Daniel Ek, Spotify CEO during the Q3 2023 ER conference call.
As you can see below, Premium ARPU has been on a downtrend lately (-6% YoY, on a constant currency basis). Yet this is due to “larger share of family plans” that has been offset partially by the price increases implemented in Q3.
4.0 Financials
Spotify is in great financial health. Nothing stands in its way as it continues iterating towards success.
The most fundamental and necessary financial condition to Spotify’s–or any company’s–success is positive free cash flow. I was fairly concerned last quarter with the decline in free cash flow, Thus, it’s excellent to see Spotify back to business as usual, supporting its strong balance sheet, with €3.8B in cash, €1.28B in long term debt, and €0.55B in capital leases.
Free cash flow was aided by nascent operating leverage, brought about by increased revenue and lower operating costs. The former came in at €3.4 billion for the quarter, up 11% YoY, the latter at 25.41% of revenue, down 28.99% QoQ.
Gross margin of 26.4%, up from 25.75% last quarter, yielded an operating profit of €32m. With Spotify´s renewed focus on efficiency, I believe we will see the company posting a quarterly operating profit going forward. My confidence in the company has been greatly enhanced with the successful introduction of higher prices.
Lastly, it is worth pointing out that SBC (stock based compensation) is trending down, in line with the OPEX decreases. My only concern in this regard, as with many other tech companies that have tightened their belts lately, is whether these OPEX cuts are sustainable. As with SBC, I believe the best way to analyze OPEX is by tracking management.
Good management, such as Spotify´s, will not burn their employee base or their shareholders.I find that in already large companies such as Spotify, good management reveals itself by leaving behind a trail of prudence and strength. When faced with what the market considers as an existential threat, for instance, excellent leaders simply continue focusing on the key variables of the business that, through very deep thought, they have identified as structurally crucial.
Mediocre leaders quickly pivot their attention towards calming the market´s fears.
The world´s best management teams have a distinctive track record in this sense, that can often be detected just by the way they speak.
5.0 Conclusion
Every quarter, Spotify proves its distinguished offering. This quarter we have seen the company deliver record MAU growth and exhibit commensurate pricing power, flying in the face of the market´s shallow understanding of the company.
When I spotted this investment opportunity, my eyes were on Spotify´s culture. I knew that, so long as it persisted, Spotify’s iterations would continue delighting users, leading to outperformance. Similarly, now that it has set its eyes on efficiency, I believe it’s only a matter of time before cash flow growth explodes.
Until next time!
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