Spotify: The Elephant in the Room
The long term has to come.
Spotify reported its first quarter results last week. Here’s the shareholder letter:
I thought their key growth metrics were great, especially relative to Spotify’s beaten down share price.
Numbers beat guidance across the board when normalizing for the Russia exit and a one-time MAU benefit.
Total MAUs grew 19% to 422 million but this included a 3 million benefit from certain users creating duplicate accounts in the quarter after being involuntarily logged out. Excluding that, MAUs grew 18% to 419 million, ahead of the 418 million guidance. There was no impact on MAUs from leaving Russia because it’s a monthly number, not an end of period number.
Premium subs grew 15% to 182 million but would have grown 16% to 183.5 million were it not for involuntary churn of 1.5 million due to exiting Russia. That would have beaten the 183 million guidance.
Total revenue grew 24% to €2.661 billion, beating guidance, which called for 21% growth to €2.6 billion. Constant currency revenue growth grew 19%, which also beat the constant currency guidance, which was ~17.4% growth.
Gross margin of 25.2% slightly beat the 25.0% guidance, and operating loss of €6 million beat guidance, which called for a €67 million loss.
Here is the breakdown between Premium revenue and Ad-Supported revenue.
Two comments. First, Ad-Supported revenue growth decelerated from the 40% growth last quarter, but it was in the 35%-36% range before Russia invaded Ukraine. The fact that it ended up growing 31% for the quarter indicates a decent slowdown in March. That said, CFO Paul Vogel said he expects second-quarter revenue growth similar to first-quarter revenue growth, ie. ~31%, indicating an acceleration from March.
Second, notice how much greater the currency tailwind is in the Ad-Supported segment than it is on the Premium side. It highlights how the Ad-Supported revenue has a much greater mix of U.S. revenue than the Premium business does, which is not surprising.
Overall, first-quarter MAU and subscriber numbers were as good as I could have hoped for. And MAU/sub guidance was fine. 428 million total MAUs is 17.3% year-over-year growth and would have been ~18.6% if it didn’t exit Russia. Premium subs of 187 million is 13.3% growth, but would have been 189 million and 14.6% growth ex-Russia exit. €2.8 billion of revenue is 20.1% growth or 14.1% on a constant currency basis, which is a bit of a slowdown but reflects ARPU gains from price increases starting to roll off.
The Elephant in the Room
The elephant in the room for Spotify is gross margin. Management put out a 30%-35% long-term gross margin target at their 2018 Investor Day and later raised it to 30%-40%, but they are still reporting consolidated gross margins in the mid-20%s. Guidance calls for 25.2% again next quarter and at generally the same level for the rest of this year. That means it will have sat in the mid-20%s for over five years.
Investors are growing impatient. At the Morgan Stanley conference in March, CFO Paul Vogel gave investors some hope by throwing out the term “inflection point.”
But this quarter, favorable gross margin trends from a revenue mix shift towards podcasts and Marketplace activity were offset by increased non-music content spend (podcast), investments in music product enhancements, and modestly higher other cost of revenue. Essentially, underlying gross margin expansion is being reinvesting in growth.
Guidance for second-quarter gross margin is for more of the same. Management expects 25.2% gross margin, which is again driven by core gross margin improvements in music and podcasting, offset by growth initiatives.
Second quarter guidance of 25.2% is a big reduction from the 28.4% reached in the second quarter of 2021 or the 26.4% adjusted for the release of accruals in the prior year quarter.
So when is the gross margin expansion going to come? Basically, the answer is: