Spotify: A Compounding Effect

Accelerating user growth despite lower ad spending, on the cusp of a multiyear margin expansion, with 3x the scale and a lower stock price compared to the 2018 direct listing?

From a long-term investor’s perspective, Spotify’s first-quarter report was really strong. I’m not talking about the backward-looking financial metrics—gross margin is still ~25%, operating expenses are still too high, and operating income is still negative. But a snapshot in time is far less important than where the puck is going. And on the margin, it feels like we’re on the cusp of something really great—accelerating user growth, improving gross margins, improving operating expense leverage, and with any luck, a long overdue price increase in major markets that comes with a more favorable revenue split with the labels. With a multiyear perspective in mind, here’s what I found most important.

First, the best leading indicator of how big and profitable Spotify can be in the future is user growth. MAUs grew 26 million in the quarter to 515 million, ahead of management’s 500 million guidance. Premium subscribers grew 5 million to 210 million, also ahead of the 207 million guidance. And guidance for the second quarter calls for adding another 15 million and 7 million, respectively, to reach 530 million and 217 million, respectively. This growth is an acceleration from last year’s pace.

People tend to discount the importance of scale with Spotify because its primary cost—music royalties—is a variable cost. The thinking is that user growth doesn’t create much value because most of the revenue from additional users goes out the door to the rights holders. This is not Netflix with its fixed cost content where the next subscriber comes with no additional content costs. But I still think scale is critical for Spotify in perhaps more nuanced ways. For example, the larger it gets the more it can spend on R&D, which topped €1.4 billion last year and is on pace to grow again this year. R&D is what drives the hundreds, even thousands, of improvements in the product that then contribute to the impressive and even accelerating MAU and Premium sub growth we’ve seen. AI DJ? No one else is innovating like this. Spotify has been able to run circles around the competition for a long time despite using the same raw material—music rights—as its competitors. That’s not intuitive. The difference is Spotify’s continuous investment in product transforms the underlying commodity into a value-added product that consumers undeniably prefer. And that’s only possible with an aggressive R&D budget, which itself is only possible with a meaningful scale advantage.

Exhibit 1 shows Spotify paid subscriber growth versus Apple Music until the latter stopped disclosing it in 2019. The more hopeless it seems for competitors, the less you’d expect them to spend on R&D, the greater Spotify’s product advantage becomes, which drives more consumers to Spotify, which drives lower CAC, which we may be seeing right now. More on that later.

Furthermore, the more scale Spotify achieves the more important it becomes in the music ecosystem and the more leverage it will have as a platform. Subscriptions and streaming is 69% of Universal Music Group’s recorded music revenue. Spotify is the largest contributor to that. Spotify has gone from the startup that had to beg and even give equity to the labels to obtain music licenses to the 515 million MAU behemoth that is now using its scale and technology chops to get discounted royalties and now appears to be negotiating lower royalties in conjunction with a major price increase. None of this would be possible without scale.

Second, you might have to squint to see it but Spotify’s long stagnant consolidated gross margin finally appears to be heading higher. Gross margin of 25.2% beat guidance by 30 bps and would have been another 10 bps higher without severance charges included in cost of sales. That’s only marginally higher versus a year ago, but second-quarter guidance of 25.5% gross margin would be a 90 bps year-over-year increase and the highest consolidated gross margin since 2021. This is the result of what management has been saying since last year—podcast investment spending driving big underlying losses will go from deeply negative in 2022 to approaching breakeven and eventually turn substantially positive. That’s going to allow more of the higher and improving music gross margins to shine through, resulting in a higher consolidated gross margin. Here’s CFO Paul Vogel on the first-quarter call reiterating what management has been saying for a while:

Here’s an exhibit I last posted in Spotify: Wait for It showing my deconsolidation of the company’s gross profits between music and podcast: