The Spotify Play: Q2 Review
Two-Sided Marketplace and Podcasting remain key to future growth (and profits). By Benjamin Tan
Unavoidable: Death, Taxes, and…Advertising
Marriott ($MAR). Walmart ($WMT). Netflix ($NFLX). They are all going after ad dollars. Amazon ($AMZN) has demonstrated just how profitable it can be to further monetize a highly engaged user base, with advertising revenues expected to be well above $30 billion this year. To put things in perspective, this exceeds what YouTube will generate over the same period.
Spotify ($SPOT) plans to milk its customer base the same. With 433 million users and growing, Spotify is targeting much higher ARPU in the years to come. Management believes it can reach €100 in the long run, 4x current levels. On the music side, there are a few ARPU catalysts in play already. The main one is Marketplace, which is a set of promotional tools offered to artists and labels to market their music directly to Spotify users. Think of it as Sponsored Products on Amazon, except that in Spotify’s case, these creators are vying for streams. Marketplace delivered €160 million of gross profits in 2021, and is expected to grow at 30%+ in 2022. At a recent investor conference, CFO Paul Vogel explains:
“A lot of our marketplace tools and services are used by the labels…(which) benefited gross margin, even though they don't show up in revenue. It's been a big driver…we have a lot of services on the marketing side that are working”
Podcasting: Spotify Aggregating Supply
Podcasting continues to be the key focus for Spotify. At the end of Q2, it had 4.4 million podcasts on the platform, up from 4.0 million at the end of Q1. This is an important statistic to track, as Spotify is aggregating not just listeners, but also disparate podcast creators onto its platform. Unlike the music business which is dominated by the Big Three (Sony, Universal, and Warner), content is way more fragmented in podcasting and hence a greater opportunity for Spotify to gain bargaining power on the supply side. By positioning itself as the middleman, Spotify aims to do what YouTube and Amazon have done for video content creators and third-party sellers on their respective platforms. In Q2, the number of Spotify MAUs that engaged with podcasts grew in the “substantial double-digits” and per user podcast consumption rates continued to rise.
Macro: Dampening Advertising but not User Growth
“Going forward, while the macro environment continues to present uncertainty, we are currently not seeing any material impact on our expectations for users or subs growth from the economic downturn. In fact, we are seeing several markets trending ahead of our forecasts. That said, in anticipation of a potential slowdown, we already shared that we proactively reduced our hiring by 25% and instituted a double-down weekly revenue monitoring. We are confident in our ambitions to get to 1 billion users by 2030, while at the same time, we are also focused on improving our gross margins and continuing to generate positive free cash flow.”
Even though ad-supported revenue as a percentage of total topline reached a new Q2 high of 13%, there are headwinds facing Spotify on this front. Advertisers have been quick to reduce marketing budgets amid softening consumer sentiment, as seen from recent results of bellwethers like Alphabet ($GOOG) and Facebook ($META). Without FX impact, Spotify’s ad-supported revenue grew 17% in Q2 to €360 million: solid but not spared from macro-led pullbacks. That said, secular tailwinds like continual shift of advertising budgets from linear to digital and programmatic favor Spotify.
Other Q2 highlights include:
Largest Q2 net additions of users (19 million) in history after adjusting for Russian exit and the March outage
Churn was in line with expectations and down on a year-over-year basis; macro and price increases had no impact. It should be noted that unlike streaming television, almost all consumers subscribe to only one music service each. When consumers start to tighten spending, stickiness for Spotify will be on a different dynamic, compared to that of the many SVOD players
Operating income was hit by write-offs on Car Thing, higher headcount, and unfavorable exchange rates that added 10 full points to Opex growth. FX will continue to have a significant Opex impact in Q3 and likely way higher than the €78mn headwind estimated, given recent weakness in Euros and a disproportionate amount of Opex denominated in USD relative to revenue
Judging by the cadence of podcasting investments - the combination of Megaphone, Anchor, Kim Kardashian, and Batman does not come cheap - FY 2023 is shaping up to be an inflection point in terms of operating profits. Management expects podcasting's negative impact on gross margin to peak in 2022, and that podcasting margins will turn profitable over the next 1-2 years before ramping faster thereafter. In other words, between now and then, Spotify is asking investors to hang in there.
(Author is long $SPOT)
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