Spotify: Entering a New Chapter
Q4 2023 ER Update.
Edited by Brian Birnbaum.
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1.0 Lapping the Podcast Investments
Spotify’s free cash flow print this quarter is indicative of the company entering a new chapter.
Spotify is not a music app. It’s an audio network.
As I’ve reiterated throughout my coverage of Spotify, the company is set to transform its income and cash flow statements as it gains operating leverage via the addition of new audio verticals beyond music.
Over the past year we have arguably lived through an attention economy recession, with consumers looking to spend more time doing analogue things–and yet Spotify has grown its user base at record pace.
Certainly, the narrative about TikTok killing Spotify seems less plausible now.
Q4 is a very strong quarter. MAU grew by 28 million to 602 million and we added 10 million net subscribers, finishing at 236 million.
Both MAU and subscriber growth continued to be above our historical trend and outperformed forecast.
-Daniel Ek, Spotify CEO, during the Q4 2023 earnings call.
Spotify owes its unrelenting growth to an unmatched focus on audio consumers and creators. This ecosystem has become the music industry’s top of the funnel, and Spotify is now leveraging that position to add to the platform podcasts, audiobooks, and other audio verticals.
Labels keep 75% of the money Spotify makes via music. But new verticals like podcasts and audiobooks have no gatekeepers and, thus, far better unit economics. As they scale these new verticals, two things are bound to happen:
The average user will spend more time on the platform.
Spotify will make more money per hour of audio streamed.
The theory is simple and execution has been brilliant thus far. But deploying podcasts has required significant financial commitment. It’s taken a toll on Spotify’s financials, exacerbating what for now remains to be poor unit economics, which the market has frowned upon–until now.
Today, however, Spotify is the number one podcasting app in many markets worldwide. In Q4 2023, the segment nearly broke even, in line with management’s projections on last quarter’s call. Furthermore, unlike podcasts, audiobooks require marginal capital for deployment and it is also doing well.
In Q4, we became the number two provider of audiobooks behind Audible, which is notable given how entrenched the legacy players are.
-Daniel Ek, Spotify CEO, during the Q4 2023 earnings call.
As I outlined in Q3 2023, Spotify has hit an inflection point. Podcasts have begun to mature, but audiobooks remain in early stages. The major evolution is that, by all appearances, these verticals no longer require significant financial commitment. As such, we are now likely to see Spotify’s financials exhibit a step change.
As with many other growth companies, Spotify has a fair amount of non-cash expenses. Thus, the metric that I watch to evaluate its operating leverage is free cash flow.
Free cash flow–and/or the ability to generate free cash flow–is one of the most important financial metrics. The trick is understanding that it's the ability, not just the actual manifestation of, generating cash that matters most, since many companies invest most or all of their earnings back into their businesses as CapEx.
This phenomenon creates incredible opportunities because lesser investors think higher multiples automatically = expensive. In reality, the Amazons, Teslas, and of course Spotifys of the world are simply compounding their earnings by constantly reinvesting (and avoiding enormous tax bills)–which leads to another of most important metrics: Return on Capital Employed (ROCE).
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Spotify’s management admits that there is a component of timing in this quarter’s free cash flow print. Still, the trend is appealing. I believe the uptick from Q3 to Q4 2023 is mere prelude to further growth.
2.0 Spotify’s Organizational Evolution
Spotify keeps winning because it’s an extraordinary organization that has consistently evolved to meet the challenge that lies ahead.
Spotify’s torquing financials, which I cover in the next section, are largely the result of rapid evolution as an organization. Previously, it focused on delighting the customer and growing.
Now, it’s also focused on efficiency.
Perhaps boringly simple, the reason Spotify has been able to outpace Apple and Amazon–and by a wide margin–is that it focuses more on audio consumers and creators.
But at a deeper level, what enables Spotify to translate that focus into value is its organizational structure and culture. Spotify is highly decentralized, has a meritocratic and experimental culture, and implements many other properties conducive to iteration and growth.
Daniel Ek’s unflinching focus and tinkering with the Spotify machine is the primary reason I believe they will succeed.
So looking into 2024, you should expect a continuation of what you saw in 2023, strong product development, which leads to strong growth, but with an increased focus on monetization and efficiency, which in turn drives profitability.
-Daniel Ek, Spotify CEO, during the Q4 2023 earnings call.
By simplifying the organizational structure of the company, as Spotify’s co-president Gustav Soderstrom explains in this podcast, Daniel Ek has set the company up to manage multiple verticals at once.
By integrating efficiency, he has set the company up to be not just an app that consumers love but, more importantly, an excellent business.
Over the coming year or two, I believe these modifications will proliferate growth across the board, leading to considerably higher levels of free cash flow.
How do you, on the one end, save, and how do you tell people that you want to grow? And I think this is why in my last response, I focus so much about the mindset of being relentlessly resourceful and what it actually means.
So I don't think it is either or, I think it's both.
And so I think we need to become more efficient by deprioritizing some of the existing things, but we also need to invest in some of the new.
-Daniel Ek, Spotify CEO, during the Q4 2023 earnings call.
3.0 Financials
With the podcast vertical nearing break-even, Spotify’s operating leverage has seen a considerable increment from last quarter. Other factors come into play too, but they do not detract from the thesis.
Income Statement
The company’s focus on efficiency has led to OpEx as a % of revenue declining from 32.60% to 28.74% since Q3 2022. Though up from 25.41% last quarter, this is due to €143M in charges related to efficiency actions.
Despite the relatively larger OpEx, cash from operations and free cash flow are ticking up.
Finally, free cash flow was positive EUR396 million in Q4. While some of the strength was timing related, we remain confident that we've entered a new chapter in terms of expanding the business, a business' cash generation potential.
-Paul Vogel, Spotify CFO during the Q4 2023 earnings call.
Considerable QoQ increases in gross margins are visible in the graph below. Gross margins are back to a level not seen since Q3 2021, due primarily to “favorability” in the podcast business.
It would thus seem that the uptick in cash flow generation stems from podcasts quickly becoming accretive and music margins continuing to improve. With the magnitude of the QoQ delta in free cash flow, 2024 is looking favorable for Spotify.
Further, premium ARPU (average revenue per user) continues rising following the price increases in 2023. With rising ARPU undoubtedly contributing to rising operating leverage, it’s strange that management makes no mention of such, whether on the call or shareholder deck, as a source of leverage.
Management made further remarks about audiobooks this quarter, stating that they see the vertical being highly accretive. The uptick above together with the below remarks lead me to believe that this is indeed an inflection point for Spotify:
What I will say is while we're investing in audiobooks, we still see a nice improvement in gross margin through 2024, which Ben has talked about at length already on the call.
And so we feel like we have a model for audiobooks and the progression of audio books over the next couple of years. It's going to be very additive.
-Paul Vogel, Spotify CFO during the Q4 2023 earnings call.
On a less positive note, advertising revenue continues to grow hand in hand with the platform, with no signs of non-linear growth. Ad revenues as a percentage of all revenues came in at 14%, essentially flat YoY.
Management claims that, adjusted for FX (foreign exchange), advertising as a percentage of revenues came in in the “high teens” in Q4 2023. They also stated that rising premium ARPU has made advertising revenues smaller as a percentage of all revenues.
Much like podcasts becoming accretive, audiobooks coming online, and premium ARPU rising, the advertising business is likely to drive operating leverage going forward.
In my studies of Roku and Netflix, I see advertisers coming back to the market. I believe this will benefit Spotify’s advertising business as well, as the arbitrage with respect to radio is yet to close.
Cash Flow Statement and Balance Sheet
As mentioned previously, the above dynamics yield a healthier cash flow profile, which further bolsters an already fortified balance sheet.
4.0 Conclusion
The thesis is evolving favorably as more folks use Spotify to listen to anything. The company has engaged a number of drivers to increase operating leverage, which have driven the bottom line in Q4 2023.
Assuming relatively normal economic circumstances, we should see financials meaningfully improve from here with the new verticals becoming accretive.
Going forward, if the advertising business kicks into gear–compounding the increases driven by the new verticals and price increases–I believe operating leverage will rise non-linearly. Longer term, if it becomes a super app, Spotify’s operating leverage will explode.
At the moment, Spotify can’t do this because of Apple. But should the regulation eventually give way to this development, shareholders could be rewarded asymmetrically. The below excerpt from the Q4 earnings call explains why Spotify at present is not able to become a super app and what needs to happen for it to do so:
We outlined our response to how we would be compliant with the DMA (Digital Markets Act). But obviously, that then very much depends on Apple’s stance in allowing us to do so.
And Apple then obviously subsequently responded with their stance, which is very much incongruent with our stance on the matter and frankly, I think it's a bit of a farce because it looks on the surface that they're complying with it, but behind the surface, they're doing pretty much everything to make this such an unattractive experience that's no [sane] developer want to pick any of the new terms.
Now the good news, I guess, from the investor standpoint, and I know that there initially with some questions about whether or not this would be a downside for Spotify. I don't think that's the case.
So we still have the ability to be on the old terms and keep going as we're currently going.
But there are future upsides that could be quite significant. We talked a little bit about it with fan clubs, all these other things that we could do for creators that we would probably be barred from doing because it simply would mean that all of Spotify would be unprofitable if we took these new terms.
And just as a last reminder, this law will come into play [on] March 7th. So obviously, my hope is still very much that the European Commission will take action and allow this to happen because it will be far greater for the ecosystem, both for consumers and creators alike.
-Daniel Ek, Spotify CEO, during the Q4 2023 earnings call.
Until next time!
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