Spotify Q2 2023 ER Digest

Update

Edited by Brian Birnbaum and an update of my original Spotify deep dive.

1.0 Key Lessons from Amazon and Meta

Successful network businesses focus on scale first and then profits.

If you go back in time and analyze how value is created and then captured in the tech space, you may appreciate as I do that scale tends to precede profits. As it refers to networks, this dynamic is particularly exacerbated, as illustrated by two of the more notable examples of our time: Amazon and Meta (deep dives).

Before these two companies reached a certain level of dominance, they could have pivoted from focusing on scale to focusing on profits. However, their competitive positions would have likely been eroded and in aggregate, the resulting shareholder returns much lower than otherwise.

Essentially and with a good degree of reason, the market commands all companies to drive profits as soon as possible, but this is the antithesis of value generation in networks. However, one can also fall in the pit of being too lenient on network businesses, blindly subscribing to the dream of eventual profits that never arrive.

Thus, analyzing networks and their hypothetical profitability requires taking a middle way, which I summarize in watching for the continued satisfactory evolution of:

1. An ethical and highly capable management team, which translates into the following desirable organizational properties:

   1. Limited politics.

   2. A culture that attracts and retains talent.

   3. A flat organizational structure that allows information (good and bad news) to move quickly around the company.

2. A strict adherence to empirically iterating the network, with the ultimate goal of increasing user value.

3. Fast-paced iteration that surpasses evolving competitive pressures.

4. A philosophy of sharing economies of scale with users.

The above have made Amazon and Meta (and many other companies that I have studied) great, leading to increasingly dominant competitive positions over time.

I’m long Spotify because they have precisely these traits. Spotify has faced gargantuan competitors since inception yet has nonetheless managed to thrive thanks to organizational loyalty to the above approach. As of Q2 2023, Spotify continues to move down the correct path.

The company still exhibits no signs of operating leverage. That being said, MAUs (monthly active users) continue to grow at record pace. Whether Spotify can drive profits once it gets to a certain scale is, naturally, uncertain, but I would argue that their iterative capacity is likely to get them there.

“Total MAUs grew 27% Y/Y to 551 million, up from 515 million last quarter and above our guidance by 21 million. Driven by record high net additions with outperformance across all regions led by Rest of World and Latin America.”

2.0 Ads are Re-accelerating

Ads are Spotify´s handiest tool to yield operating leverage and they seem to be picking back up.

As Spotify gets deeper into new verticals (podcasts, audiobooks, and more to come), the average minute listened on the platform becomes more valuable. This is because users now listen to specific topics that advertisers can better target. In aggregate, this is likely to equate into a high operating leverage across the platform.

Over the past year or so, ad weakness has permeated the world with businesses preparing for a hypothetical recession. There is no telling when ad strength will come back, but in the meantime Spotify continues to implement the ad-tech stack in order to be ready for when it does.

Per my studies of the ad-tech space, facilitating ad attribution across a large network is a highly complex and costly challenge, so this part of the thesis is naturally not exempt from risks. However, harkening back to Section 1.0, so long as Spotify continues to scale up without damaging its balance sheet, it is in a position to iterate its way to success on this front.

Ad revenue as a % of total revenue was growing fast from Q3 2020 to Q4 2021 yet has since stalled. During this period of ad weakness, the ad business has been growing linearly in the monetary sense with the rest of the network, with no resulting gains in operating leverage. But in terms of activity, it is starting to pick up again:

1. Music advertising revenue grew mid single-digits Y/Y, reflecting double-digit Y/Y growth in impressions sold, offset significantly by softer pricing due to the macroeconomic environment.

2. Podcast advertising revenue growth re-accelerated to more than 30% Y/Y with sold impressions across Original and Licensed podcasts and the Spotify Audience Network hitting an all-time-high, partially offset by softer pricing.

3. The Spotify Audience Network saw double digit Q/Q growth in participating advertisers and publishers and high single digit Q/Q growth in participating shows (shows that choose to plug ads into their content).

I do not have insight on how Spotify´s ability to enable advertisers to measure ROI is evolving, but I suspect that the rising activity is indicative of progress on that front. If they apply the organizational principles outlined in Section 1.0, continued success is likely.

“We expect advertising to be even better in 3Q, which is baked into our guidance.”

“SPAN performed really well in the quarter, which helped on the podcasting side. So a lot of it just came from that. It came from improvements in all areas of kind of our ability to deliver and on the podcasting side, better sellout rates in general.”

- Paul Vogel, CFO during Q2 2023 ER.

3.0 Financials

A deep look into the financials reveals the business is doing fine and that, in fact, margins are beginning to tick up. The free cash flow decline is a source of concern.

Income Statement

Operating loss came in at an initially concerning $(247)M, but most of the delta QoQ stems from $135M in net charges:

1. $44M related to shut down of various podcasts and impairment of real estate.

   1. As a result of this, gross margin came in at 24.1%. Excluding the above impact, adjusted gross margin came in at 25.5%.

   2. Looking at the various gross margin definitions of the company, I believe the figures are still quite noisy, with little to be inferred.

      

      Car Thing was a next-generation stereo designed to stream Spotify's music and podcasts from the user's phone through the car audio system. Spotify terminated it because it failed to gain traction.

2. A further $91M related to real estate optimization and severance.

The larger than expected loss therefore does not stem from some form of structural degradation of the business. Excluding the above impact, operating loss was $(112)M, which is down 42.4% YoY. Thus, despite the alarming headline the company is actually getting leaner.

From the above, two further concerns emerge:

1. The fact that they are now cutting off podcasts after a rather aggressive investment spree may come across as impulsive. Another way to view it is that Spotify now has a lot more data on podcasts and can thus operate within the vertical as it has done traditionally with music: by making lots of tweaks all the time. It has effectively reached critical mass in the podcast vertical.

2. Adjusted gross margin is up from 25.3% to 25.5% YoY. Two forces influenced the delta:

   1. Positive: improved podcast profitability and growth in marketplace activity.

   2. Negative: higher music royalty costs.

While rising royalty costs are concerning, I believe that they are to be expected in an inflationary environment (although at this stage, gauging inflation has become difficult). On the other end, Spotify rose prices in more than 50 markets over the quarter, but this is fundamentally no different to any tweak they make across the network: lifetime value is the focus.LTV is the holy grail for Spotify and the market does not quite understand this yet. 

Further, notice that ARPU is trending down recently. I suspect this has to do with the rapid growth in emerging nations.

Cash Flow Statement

On a different note, free cash flow has been languishing for some time. In this quarter, it is allegedly due to “reduced favorability in net working capital specifically related to the timing of certain payments in Q2.” It sounds fairly vague to me and although I trust management and Spotify has an ample free cash flow production record, I remain vigilant on this aspect.

Balance Sheet

Spotify ended the quarter with a strong balance sheet: $3.5B in cash and equivalents; $1.16B in exchangeable notes; and $522M in lease liabilities.

4.0 Guidance

I rarely look at guidance, but this time around I am intrigued by how management is thinking about margins in what remains of FY2023. The outlook for Q3 2023 is:

1. Total MAUs: +21M

2. Premium subs: +4M

3. Total revenue: 3.3B EUR

4. Gross margin: 26% - Primarily driven by Y/Y improvement in podcasting and Other Cost of Revenue.

If over the coming quarters Spotify´s margins exhibit a clear rising trend, the market may be happy to reconsider the current valuation of the company, at just 2.14 times sales.

5.0 Conclusion

In all, the thesis remains unchanged. Spotify continues to adhere to the traits that make it a great company and it continues to work well towards an inflection point. Meanwhile, the balance sheet is phenomenal and remains very strong.

However, the languishing free cash flow, as a result of cutting back on podcast investments (and others) is a source of concern. I would have liked to see management break down the quantitatives behind the podcasts they decided to cut off, instead of just brushing over it.

As some of you know, I doubled down on my Spotify investment at $97 per share, and I feel confident that the move will pay off in the years to come. Although the past few years have resembled a diminutive version of the dotcom era, Spotify is looking fundamentally strong.

At a P/S ratio of 2.14, the stock has tremendous upside. First from the market realizing the company’s potential, then further upside as the company continues to materialize into an audio network and, eventually, an audio search engine.

As Spotify gradually understands the content of podcasts (and analogous formats), it is going to enable people to search for info like any search does, except the output is going to be audio files.

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 podcasts for consumers which drives in turn higher engagement and more growth for creators. - Daniel Ek, CEO during the Q2 2023.

Until next time!

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