Spotify: The New Modus Operandi
The stock is up 148% year-to-date. How much is left?
[Note: This post was delayed because my Dad recently passed away. Thanks for understanding.]
I thought Spotify’s third-quarter report was pretty great. Here’s the third-quarter slide deck if you haven’t seen it.
User and subscriber growth continued to show impressive strength. MAUs grew 26% y/y to 574 million, adding 23 million sequentially and 2 million ahead of guidance. That was the company’s second-largest quarter ever for MAU net adds. Premium subs grew 16% y/y to 226 million, adding 6 million sequentially and 2 million ahead of guidance. Fourth-quarter guidance calls for more robust growth with MAUs reaching 601 million and Premium subs reaching 235 million. The long-term 1 billion MAU figure that has been thrown around for a long time no longer feels like a big stretch anymore.
As an aside, I’ve been building out my long-term scenario analysis for Spotify on a regular basis since early 2019. It’s interesting to look back and see how my assumptions fared versus what actually played out. In March of 2019, my Base case assumed:
Spotify would reach 433 million MAUs and 207 million Premium subs by the end of 2023. In contrast, the company should reach 601 million and 235 million, respectively, according to guidance.
Spotify would generate €11.3 billion of revenue in 2023. With just the current quarter to go, management’s guidance calls for €13.3 billion.
Spotify would generate €3.5 billion of gross profit in 2023, which is a 30.6% gross margin. Given fourth-quarter guidance, Spotify will reach €3.4 billion of gross profit, which is a 25.6% gross margin.
Spotify would spend €2.7 billion on opex in 2023, which led to about €700 million of operating income. It looks like opex this year will be closer to €3.7 billion, leading to a €300 million of operating loss.
In sum, Spotify handily beat my 4-year forward user, subscriber, and revenue estimates but underperformed on gross margin, opex, and therefore operating income and free cash flow. The gross margin underperformance is largely due to the Ad-Supported segment and specifically the podcasting business, which has been in investment/cash burning mode for a few years but is now finally on the verge of breakeven. I hadn’t contemplated that margin/profit hole when I made those 2019 estimates because a big podcast investment wasn’t on my radar. Notably, Premium gross margin is now over 29%, rising, and much closer to the 30.6% figure I’d estimated.
If Spotify was going to outperform in one area or another, I’m glad it did so with users and revenue. I think robust top line growth is the most critical indicator of future business value. The larger the company can be, the larger the ultimate free cash flows can be on a steady state basis once operations are fine tuned and optimized for profits. If Spotify had instead underperformed on users and revenue over the last four years—due to stronger competition?—but outperformed on margins and free cash flow, I would be much less enthusiastic about the future value of the business. Certainly, some cash flow would accrue to shareholders sooner, increasing the present value of the shares, but the ultimate size of the cash flows would be limited by a smaller than otherwise user/subscriber base. So I’m really pleased with Spotify’s performance since 2019 relative to my initial Base case assumptions. And if guidance is met, the business would almost reach my initial Bull case Premium sub number and would even beat my initial Super Bull case for total MAUs.
Revenue
Revenue growth was 10.6% y/y, which is the 8th straight quarter of decelerating revenue growth. But looking under the hood at the impact of foreign exchange rate changes tells a different story. Constant currency revenue grew 16.8% y/y, the third straight quarter of accelerating revenue growth. As you can see, guidance suggests that continues to 20.0% constant currency revenue growth in the fourth quarter.
Gross margin expanded 166 bps y/y to 26.4%, ahead of guidance by 40 bps. Premium gross margin expanded 110 bps y/y to 29.1% while Ad-Supported gross margin went from 1.8% in the year-ago quarter to -5.7% in 2Q23 to 8.3% this quarter. Podcasting was only a small negative drag to overall gross margin and management expects it to hit breakeven in the short term and turn positive thereafter. That’s consistent with their comments at the 2021 Investor Day.
The opex efficiency might be the even bigger standout. In this screenshot from my model, you can see…
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