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Spotify Q3 2022 ER Digest
1.0 Long Thesis Recap and Digest Summary
2.0 The Network
4.0 Podcasts and Audiobooks
1.0 Long Thesis Recap and Digest Summary
Spotify is increasingly becoming an intelligent, global audio network as it continues to grow towards 1B MAUs and add further audio verticals, beyond music. These verticals will have much better unit economics than music and Spotify will be able to deploy them at a marginal cost, leveraging its broad user base and platform. Much cash generation should result.
For over a year now, I have been elaborating on this abstraction by putting together many small qualitative queues that I have picked up by analyzing the company and finally, Daniel Ek has clarified it for us:
Analyst: “What does the Spotify machine look like in 5 years plus?”
“[…] the predominant way to think about it is that it's one user experience shared across many verticals of content. And what that enables us to do is to leverage all the key technology, so all the pillars that we built Spotify throughout the year. So freemium, personalization, ubiquity, all of those facets.
And in addition to that, obviously, it enables us to go and take the scale of the existing audience base and cross-sell to new verticals to gain ground faster.
And so our belief when you look at the audiobooks market is that while books is a pretty big industry, audiobooks is still a niche offering only enjoyed by tens of millions of consumers around the world. And if you think about that from first principles, it's pretty clear that audiobooks should be something that should be enjoyed by hundreds of millions of people, if not billions of people, around the world.
And in a way, I actually think about that -- if you want an analogy, there's probably healthy ones on the B2B business sides, where the hard thing was to get distribution and get the customers in the door, but then a Salesforce or someone else then kept adding more and more products to leverage that existing distribution channel that they've built.”
Naturally, this takes time, but so far the company continues to execute well, with rapid MAU growth and good progress on the podcasting, audiobook and advertising side of the business (amidst the cyclicality). The company continues to invest heavily in these new segments, so progress is not showing up in the financial statement and overall, this is another satisfactory quarter - just not quite immediately gratifying.
2.0 The Network
The overall network continues to grow rather impressively.
Total MAUs hit 456m this quarter, up from 433M last quarter. This type of growth is more than satisfactory and the company seems to be well on its way to its 1B MAUs target by 2030.
Despite the overall macro environment, this is a Q3 record high addition of 23M MAUs, which speaks well of how the product fits in people´s lives. Most of the growth seems to be propelled by emerging nations, with Europe and North America shrinking in relative size. What is also interesting is that users are converting to premium in these emergent regions too, specially in Latin America.
TikTok is a strong rival, but Spotify has the competitive position and qualities to win. I keep a close eye on this, nonetheless.
TikTok looks increasingly like a threat for Spotify. Younger generations are discovering plenty of music on the app and it is making strides into the music market. I have previously shared my thoughts on this, namely that TikTok is actually a CCP Trojan Horse, but we finally get some info from Ek on the matter:
“And obviously, it's been formidable to watch their growth and how well they've been executing throughout the year. So we take it very seriously when we look at that.
Now that said, we have been in markets with Reso for quite some time, and we've seen considerable growth in those markets. So I feel really good about our competitive position as it relates to that. So I feel good about -- yes, we know that they're investing in it. When they've taken share -- they haven't taken share from us. It's been from others.
This seems to coincide with this research piece, that claims that people go to Spotify after discovering a song on TikTok. Nonetheless, this is by no means a static situation and TikTok is a formidable rival. As far as I can see, Spotify´s focus on running experiments should see it through the battle, when factored with all the above:
“Ek: So I mentioned this in the last earnings call, but the number of experiments that we do, the number of product improvements that we do each quarter is a metric that I look at and -- as probably the most important leading indicator for long-term success. So that makes me feel good because we've really kind of improved our product velocity over this year. And I think you're starting to see it already in the product, but you will certainly start seeing a lot more of it coming into 2023.
Across the app, I see an improvement in discovery features, both for music and podcasts. I tweet them when I see them, so stay tuned.
Generally, I think that TikTok presents a problem not only to Spotify, but to Instagram and other similar platforms. It is just substantially better than any of these apps at catching eye balls. This, coupled with the likely malicious intent of its actual owners are going to take the West on a rocky ride - until it is banned.
4.0 Podcasts and Audiobooks
Spotify´s qualitative fundamental properties continue to propel the company´s vertical expansion successfully.
At this stage, Spotify has surpassed its rival Apple Podcasts, but much like is the case with TikTok, this is not a static situation. The reason Spotify has dominated Apple in music and podcasts is because of its intense focus on the space, which translate into a far better culture for the task at hand. I imagine that the best engineers at Apple do not want to work on Apple Music and it shows. This is a qualitative aspect that eludes the market and triggers many, but is the source of alpha.
Not too long ago, Spotify was nowhere to be seen in the podcast scene. This is a recurrent theme in the company: they seem to have the ability to focus on a particular audio vertical and make magic happen. This quarter, we get some further datapoints regarding this situation:
Podcast revenue grew in the strong double-digit range Y/Y across both our Original and Exclusive podcasts and the Spotify Audience Network.
Spotify hit 4.7M podcasts on the platform this quarter.
The number of MAUs that engaged with podcasts grew in the substantial double-digits Y/Y and per user podcast consumption rates continued to rise.
Vogel: “So engagement in podcast has been strong. We've seen podcast MAU as a percent of our total MAU continue to increase. It was up again in Q3. And then podcast consumption per podcast MAU is also up year-on-year. So we've seen really strong trends in general across all of podcasting.”
Moving onto audiobooks, the company launched the vertical this last quarter in the US. Impressions of the iOS offering were not good and we now get some further color on this. It seems like Spotify´s battle with Apple continues:
Ek: “So really, at the core of this is the same argument I've been saying now for about 4 years, which is our view is that this is the next great battle from net-neutrality into what I call the platform-neutrality wars.
But the short gist of it -- it's a pretty lengthy article, but the short gist of it is Apple keeps putting up roadblocks of just stopping us more and more and more. I think the app was rejected 3 or 4 times at present moment, really despite us having lawyers in the room to make sure we were compliant with this.
However, on iOS, the purchasing flow is inherently broken because Apple decidedly wanted it to be broken.”
However, the underlying dynamics that I have explored and exposed in my write ups should see Spotify through the audiobooks vertical, as has happened with music and is currently happening with podcasts. I do not invest in a company for its financial statement today, but for its qualitative, largely imperceptible qualities that make it likely that its earning power will be much better in the future than today.
Ek shares some of his key takeaways regarding the audiobooks launch:
“So I think the really healthy metrics for me is to look at engagement and retention among the audiobooks purchasers that we're having, and that looks just very solid. So it's early but good engagement overall.
Now that said and as I said earlier in the call, the purchasing experience, in particular on iOS, has been below expectation on our side. That's obviously without our control, and it's something that we're working on trying to prove. And I feel good about where we will end up in -- despite of all of that in 2023, and that will allow us to scale. We kind of knew this was one of the possible scenarios, and we've been planning for that. But I'm disappointed, obviously, in all the Apple back and forth.”
The advertising business continues to evolve well. Do not be swayed by macro side-winds.
Advertising revenues came in at 13% of total revenue, which is flat from last quarter. Across the board, ad spending is slowing down and the company is accrediting the plateau to the macro environment:
“Ek: We also saw a margin impact due to slower than forecast advertising growth given the challenging macro environment.”
To not get caught up in the cyclicality of things, you need to understand them at a fundamental level. When do most companies (not For Hims ;)), spend most of their advertising dollars? When they are feeling good. They will feel good again soon enough because downturns do not last forever, but the main question that preoccupies my mind is whether Spotify will have built a solid ad infrastructure by then.
After that, another downturn will come, but the question will remain, will Spotify´s infrastructure continue to be prime for when the good times come back around? You cannot time the advertising market, just like any other market, but you can buy under-priced assets/infrastructures that are likely to yield high returns in the future. Management said the following on the topic:
Vogel: “So one of the things that we look at to monitor the health of the advertising business and kind of discern between what's macro and what is structural is when you look at SPAN and you look at the number of advertisers that are participating in SPAN, that continues to move up. And so even though the macro may impact how much they're spending in any one period of time, which is obviously macro-related, when you look at it from a pure structural standpoint, we feel really good about what we're offering and the number of advertisers that are participating in that ecosystem. And so the fact that we're seeing that up year-on-year and continue to grow shows us that we believe that the overall structural health of our -- the ads business that we are building at Spotify is very healthy.”
Ek: “During the quarter, Sponsored Recommendations continued to exhibit strength with triple digit Y/Y growth in total campaign volume and in Q3 we saw the largest campaign to date for the service. The strength in Sponsored Recommendations was driven by a successful launch of self-serve international targeting and increased artist access to self-serve in Q3.”
In all, it looks to me like this part of this business is getting ready to explode, once it gets fully deployed on the network, which if you remember from last quarter, Ek stated that most of the inventory is not yet available. That situation has not meaningfully changed this quarter, to stay tuned for that.
Tis a healthy company.
I have seen the market miss the point by focusing only on the financials a number times and I believe this is one such occasion. Fundamentally, the company is advancing well on its vertical expansion but it is re-investing whatever gross margin uptick results from it into the new verticals themselves. All other metrics are advancing quite well.
Ek: “Just to remind everyone, this is all consistent with the strategic decisions we communicated in early 2021 and again at Investor Day. So as we've said, we expect this drag on margins to start to reverse in 2023.”
This is translating into an “abnormally” flat margin profile cardiogram which is particularly disconcerting to the market. You really cannot understand what is going on in the business only you focus almost primarily on the matters that I have exposed above. More and more people are joining the network and they are quite quickly consuming audio formats beyond music - this is what matters now.
What is essential at this stage is that the company remains in financial homeostasis, so that it has enough time for the qualitative advancements to translate into superlative financials. For this reason, this time I will start the financial analysis with the B/S and C/F.
Ek: “And this philosophy is not new for those that have followed us for a while, but I realize that this may frustrate some of you who would prefer we manage to the quarter. Some companies do just that, and I get that's what some investors look for, especially now in this show-me market. But simply put, I don't think that's a winning strategy long term nor is it the right one for Spotify.”
“Liquidity remained strong, with €3.7 billion in cash and cash equivalents, restricted cash and short term investments.”
The company ended the quarter with $1.202B in exchangeable notes (up from $1.197B last quarter) and $579M in lease liabilities (up from $608M last quarter), so the balance sheet remains very healthy.
The company produced FCF of $35m in this quarter, for the 10th quarter in a row, despite being in investment mode. This is an essential quality for a play of this sort - financial robustness despite betting heavily on the future.
Meanwhile and despite the higher operating expenses that I will explore in the I/S section, operating cashflow remains very much in the green. In combination with the strength of the balance sheet, it looks like Spotify has plenty of runway to keep iterating and optimizing.
The financials get a bit muddier in the I/S. Management claims the following:
Gross Margin was 24.7% in Q3, down 201 bps Y/Y reflecting:
Δ Continued growth in Marketplace activity and favorable revenue mix shift to podcasting; offset by
∇ Non-music content and product enhancement spend, as well as increased publishing rates and an adjustment to prior period accruals.
Operating Loss of (€228) million reflected the above and Operating Expense growth of 65% Y/Y (or 51% Y/Y constant currency), reflecting:
∇ Higher personnel costs primarily due to headcount growth (global ad sales team expansion, platform investment and acquisitions) and higher advertising costs for growth initiatives (Emerging Markets, Gen Z)
∇ Currency movements had a negative 1,433 bps impact on expense growth, or €85 million, given the unfavorable geographic mix of employee costs relative to revenue.
Factoring the B/S and I/S with the above, this is not a worrying situation. The company has dealt with some macro-headwinds this quarter (and it will likely continue to do so for the next few quarters), but overall the financial health of the company remains exceptional and the fundamentals are advancing very well. The network is growing and users are gradually broadening their audio consumption. What am I missing?
Rise above the quarterly estimates.
How do you evaluate a company that is not managed for the quarter, but for the long run? That is perhaps the main question that investors that are seeking to build wealth in the market should ask themselves. The answer is, by thinking long term and not getting caught up with the dopaminergic mechanisms of the financial industry, designed to trigger you into paying commissions, like “quarterly estimates”.
So long as Spotify´s network continues to grow and broaden the audio formats within it (and be well managed), the business will eventually come out very strong on the other side. In this environment, the cost of capital is much higher now (although I do believe that the Fed will eventually have to pivot, because going from 0% to 3ish% is an ∞ shock), but management acknowledges this and overall, I only see signs of Spotify running over their “competition”.
Ek: “But I also want to reiterate that we're keenly aware that this is an uncertain time and the cost of capital has increased. So inevitably, you should expect our hurdle rate for new investments to be higher. And consequently, you should also take this to mean that we will be more selective with our overall spending moving forward.”
Until next time!
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