The Positives
+ Revenue growth accelerating into FY24e with 28mn new MAUs, 10mn new premium subscribers. SPOT again exceeded its user growth expectations with 23%/15% YoY growth in MAU/Premium Subs. It ended FY23 adding 113mn monthly users, and 31mn new premium subscribers (Figure 1). MAU growth is extremely important for SPOT as it is the main channel used to convert free-to-listen users into premium subscribers. The outperformance in users, together with price increases mid-4Q23, drove an acceleration in revenue growth (4Q23: 16% YoY vs 3Q23: 11% YoY) – with SPOT also expecting growth to accelerate in FY24e.
+ Positive commentary on margins, focusing on monetisation for FY24e. Management was positive on its expanding margins, with 4Q23 gross margin of 26.7% 10bps above guidance. SPOT spent much of FY23 working on being more efficient in terms of investments and costs, from laying off employees to cutting non-performing content. Moving into FY24e, we expect gross margins to expand by ~250bps with sequential increases QoQ, driven by: 1) price increases; 2) improving efficiencies of scale; 3) better monetisation of Podcasts and advertising; and 4) improved deals with record labels/agencies.
+ Remaining focused on prudent spending moving forward. SPOT provided some near-term clarity for spending, saying that it would raise investment hurdle rates, and remain prudent on future spending – as it looks to balance growth and profitability. We forecast FY24e OPEX to decline -5% YoY due to the lumpiness of spend in FY22 and FY23, but to remain in line with its long-term linear trend. Long-term growth remains a key focus for SPOT, but we expect FY24e to be a year of monetising its ever-growing user base given its latest commentary.
The Negative
- Nil.
MAU (Monthly Active User): average number of active users during a month.
The Positives
+ User metrics continue to outperform even after price hikes. SPOT’s outperformance in subscribers was the main driver for its slight revenue beat. The company added 6mn new premium subscribers (16% YoY) even after it raised prices during the quarter, and 23mn MAUs (26% YoY), both ahead of guidance by 2mn – indicating low levels of churn. The 23mn new MAUs was also SPOT’s 2nd largest Q3 addition ever. SPOT guided to 601mn MAUs (23% YoY) and 235mn Premium Subscribers (15% YoY) by the end of FY23e. We view user and subscriber growth as key, given that the company is still in its scaling up phase and has not yet begun to efficiently monetise its users.
+ Margins improving across both premium and ad-supported. Overall gross margins saw a 166bps YoY improvement to 26.4%, with margin expansion across both Premium and Ad-Supported businesses. Premium gross margin was 29.1%, the highest for any Q3, driven by efficiencies from scale, while ad-supported gross margin was 8.3%, a 646bps increase YoY as podcast margins improved. Overall margin expansion reflected improvements in both music profitability and podcast trends. Gross margin beat guidance by 40bps, with expectations for sequential expansion in 4Q23e.
+ Profitabilty seems to have reached an inflection point. With the increase in gross margins, operating profits returned, with SPOT posting EUR32mn in operating income – beating its own guidance by EUR77mn, on lower marketing and personnel costs. Operating leverage seems to have returned, signaling a potential inflection point for profits moving forward as revenue growth (11% YoY) outpaces OPEX (-13% YoY). As a result, we forecast a EUR162mn improvement in PATMI for FY24e.
MAU (Monthly Active User): average number of active users during a month.
ARPU (Average Revenue per User): premium revenue for period divided by average number of premium subscribers for same period.
The Negative
- Nil.
The Positives
+ User growth continues to outperform, highest MAU growth. SPOT continues to attract more users onto its platform, with a record 36mn new MAUs in 2Q23, and 551mn MAUs to end the quarter (27% YoY). Similarly, Premium Subscribers also did well, with YoY growth accelerating over the last 4 quarters (2Q23: 17% YoY) as conversion rates remained healthy. Premium subscriber growth usually lags MAU growth as users gradually convert into paying subscribers.
+ Efficiency still front and centre. SPOT reiterated its focus on improving operational efficiency, evident from its reduction in headcount by 2% QoQ and downsizing of its real estate footprint in 2Q23. SPOT has also raised its hurdle rate for new investments, and also cut underperforming podcast content from its content library. The company also guided that OPEX as % of revenue should continue to fall over the long term as efficiency improves.
The Negative
- Losses widen due to EUR135mn in restructuring-related charges. 2Q23 operating loss stood at -EUR247mn, EUR53mn wider than a year ago. More than half the losses (-EUR135mn) were a result of charges relating to: 1) shutting down underperforming podcasts; 2) reducing real estate footprint; and 3) headcount reductions. Removing these charges, adj. operating loss of -EUR112mn would have been slightly ahead of guidance.
MAU (Monthly Average User): average number of users during a month.
ARPU (Average Revenue per User): premium revenue for period divided by average number of premium subscribers for same period.
The Positives
+ Record user additions for 1Q, both MAU/premium subscriber growth beat guidance. SPOT gained 26mn MAUs in 1Q23, a record number for the quarter; 515 mn MAUs beating guidance by 15mn; and 210mn Premium Subscribers, 3mn above guidance. The company also saw an acceleration in MAU retention and subscriber growth (1Q23: 22% YoY vs 4Q22: 20% YoY), with engagement trends also improving. MAU to Premium subscriber conversion rates also remained at healthy levels, which is important given MAUs are the main funnel that drives Premium subscriber additions.
+ Operating loss beat guidance on lower-than-expected spending. Operating losses fell sequentially by 33% QoQ to -EUR156mn on the back of reduced marketing spend. SPOT is also looking at reducing content production, and optimizing its real estate footprint in further efforts to reduce expenses. Improvements were offset by a EUR41mn severance-related charge and EUR12mn of social charges. 1Q23 operating loss was ~20% better than guidance, with operating margin improving sequentially from -7.3% in 4Q22 to -5.1% in 1Q23.
The Negative
- Revenue missed guidance slightly on weakness in advertising. SPOT’s 1Q23 revenue of EUR3.0bn slightly underperformed its own guidance of EUR3.1bn, citing a ~6% underperformance in Ad revenue as a drag. Additionally, Premium ARPU declined 1% YoY as a result of additional growth in family and duo plans vs single plans. Even with the decline, Premium ARPU was still within the company’s estimates, with the expectation of at least 1 price hike on the horizon this year.
MAU (Monthly Average User): average number of users during a month.
ARPU (Average Revenue per User): premium revenue for period divided by average number of premium subscribers for same period.
The Positives
+ Premium subscriber base growing better than anticipated. SPOT ended 4Q22 with 205mn subscribers (14% YoY), with 10mn additions – 3mn more than it guided. Premium ARPU was up 3% YoY, with premium revenue hitting EUR2.7bn, 18% YoY. MAUs also hit 489mn for the quarter (20% YoY), with a record 33mn new users – 10mn above guidance. The strong set of subscriber/MAU numbers seemingly is validation of the company’s continuous investments in content and platform improvements over the last several years. SPOT guided 500mn MAUs, and 207mn premium subscribers by end 1Q23e.
+ Gross margin beat guidance by 0.8%, operating loss slightly ahead of guidance. Gross margin for 4Q22 was 25.3%, 0.8% above guidance primarily due to lower-than-expected podcast content spend and continued growth in its core music business. Operating loss of -EUR231mn was also slightly better than expected as SPOT benefitted from slowing expense growth. Guidance for 1Q23e is for slightly lower gross margin of 24.9% and operating loss of -EUR194mn due to some drag by severance-related charges and unfavourable FX impact.
The Negatives
- Operating expenses growth to slow, but still growing faster than revenue at 44% YoY. Operating expenses for 4Q22 came in at EUR1.0bn, or roughly 44% YoY, and 6% QoQ. Expenses growth was driven primarily due to higher headcount cost and increasing advertising expenses, with R&D up 64% YoY; Sales & Marketing up 33% YoY; and G&A up 30% YoY. However, expenses growth did slow from 65% YoY in 3Q22, and is expected to continue slowing for the remainder of FY23e with a 6% cut in headcount, reduced investments, and a shift in focus towards improving profitability.
The Positives
+ 3Q22 revenue beat due to outperformance in volume and price growth. 3Q22 revenue of EUR3.0bn beat guidance marginally by EUR36mn, representing a 21% YoY increase, largely due to the outperformance in Premium Subscriber growth, and some FX tailwinds. Premium Subscribers grew 13% YoY to 195mn, beating guidance by 1mn, with Premium ARPU also increasing about 7% YoY (2% QoQ). Premium ARPU continued its uptrend with its 5th consecutive quarter of YoY growth to EUR4.64, showing strong momentum in pricing. Both Subcriber and ARPU growth led to a 22% YoY increase in Premium revenue for 3Q22.
+ MAU growth re-accelerating. SPOT ended 3Q22 with Total MAUs of 456mn, beating guidance by 6mn, representing a 20% YoY increase (5% QoQ). MAU growth saw a re-acceleration, mainly attributed to strength across LATAM and Rest of World regions as a result of successful marketing campaigns.
The Negatives
- Gross margins missed guidance by 0.5%. Gross margin for 3Q22 came in at 24.7%, missing guidance by 0.5% as a result of 3 main factors: 1)accrual adjustment due to renewal of publishing contracts; 2)macroeconomic slowdown; 3)FX headwinds affecting cost of revenue. Premium gross margin was 28.0%, down 1% YoY, with Ad-Supported Gross Margin at 1.8% for 3Q22, down 9% YoY due to slower-than-expected ad revenue growth and increasing non-music content spend.
- Higher-than-expected expenses leading to greater net losses. Operating expenses for 3Q22 grew 65% YoY, led by higher headcount growth due to expansion, higher advertising costs, and 14% negative FX movements. Net loss for 3Q22 was EUR166mn, with YTD net loss at EUR160mn.
MAU (Monthly Average User): average number of users during a given period.
ARPU (Average Revenue per User): premium revenue for period divided by average number of premium subscribers for same period.
Company Background
Spotify Technology S.A. operates the world’s most popular audio streaming subscription service with >430 million monthly active users across 180+ countries and territories. The bulk of its total revenue comes from premium service subscriptions (87.5%), and the remaining 12.5% comes from advertising revenue in its ad-supported segment. Spotify currently has the largest market share (31%) in the global audio streaming industry, with more users than the next 2 closest competitors combined.
Investment Highlights
We Initiate coverage with a BUY rating and a target price of US$117.00 based on DCF valuation, with a WACC of 7.5% and terminal growth of 3%.
REVENUE
SPOT posted EUR9.7bn in revenue for FY21, increasing 23% YoY (Figure 6), with the majority (87.5%) of its total revenue coming from its premium service subscriptions, and the remaining 12.5% coming from advertising revenue in its ad-supported segment.
Premium Subscription: SPOT generated about EUR8.5bn in revenue for this segment last year, growing 19% YoY (Figure 8), with a 5-Yr CAGR of 26%. From the company’s latest 2Q22 filings, revenue from premium subscriptions came in at EUR2.5bn, up 22% YoY (14% YoY in constant currency), primarily due to a follow-through effect on subscriber gains. Revenue in this segment is earned mainly through the sale of its premium services – on-demand and offline listening. This service is sold both directly to end-users, and also through distribution partners such as telecommunications companies. The premium service is typically paid for on a monthly recurring basis, with average revenue per user (ARPU) the main metric used to monitor pricing trends. ARPU had been declining due to expansion into lower-priced regions but has since reached an inflexion point as a result of strong pricing power, increasing QoQ since 1Q21.
Ad-Supported: SPOT generated about EUR1.2bn in ad-supported revenue for FY21, with a growth rate of about 62% YoY (Figure 10), and a 5-Yr CAGR of 33%. Ad-Supported revenue for 2Q22 grew 31% YoY (17% in constant currency), led by growth in ad impressions and cost per 1000 impressions (CPM). Revenue from this segment is generated primarily from the sale of display, audio, and video advertising through ad impressions across the company’s music, podcast, and audiobook content. Advertising arrangements are usually sold on a cost-per-thousand basis and recognized when impressions are delivered on the platform
Revenue Growth: We forecast total revenue for FY22e to hit EUR12bn, which would represent a 24% YoY growth, supported by a combination of FX tailwinds, increasing premium subscribers, and increasing ad revenue. Revenue from premium subscribers in FY22e is expected to hit EUR10.4bn (23% YoY), primarily from subscriber growth and slight increases in the subscription price. Ad-supported revenue is expected to grow 30% YoY to EUR1.6bn, on the back of increasing ad impressions.
RULE OF 40
The “Rule of 40” was first introduced as a benchmark to measure the balance between growth and profitability of SaaS companies, taking into account both revenue growth, as well as profitability (Revenue Growth + EBITDA Margins), with the addition of both metrics needing to exceed the 40% threshold. We have modified this slightly by averaging revenue growth over a 3-year period compared with just a single period growth rate. Adding together SPOT’s 3-year average revenue growth of 23% and its EBITDA margin of 2%, the total of 25% is less than our required threshold of 40% (Figure 12). However, we do expect EBITDA margins to continue rising due to SPOT’s growth in operating leverage.
EXPENSES
SPOT’s cost of sales grew 21% in FY21 to EUR7.1bn (Figure 13), slightly below the total revenue growth of 23%. Cost of sales (73% of total revenue) encompasses mainly royalties and distribution costs related to content streaming paid to third parties – record labels, music publishers, etc. Through FY21, the company had paid more than EUR26bn in royalties, making them one of the largest engines for revenue growth to artists and labels in the music industry.
Premium subscriber cost of sales grew 17% YoY, but decreased slightly as a percentage of premium subscriber revenue from 72% in FY20, to 71% in FY21. The YoY increase was mainly driven by growth in premium subscribers and increases in publishing licensing rates. Ad-supported cost of sales grew 48% YoY, but decreased as a percentage of ad-supported revenue from 99% in FY20 to 90% in FY21. The YoY increase was mainly due to higher royalty and revenue-sharing costs due to growth in advertising revenue and increases in publishing rates.
Operating expenses include research and development (9% of revenue); sales and marketing (12%); and general and administrative (5%). R&D expenses grew 9% YoY, primarily due to personnel-related costs as a result of increased headcount to support growth. Sales and marketing expense grew 10% YoY, primarily due to a EUR128mn increase in advertising costs for marketing campaigns. General and administrative expenses increased only 2% YoY. Total Operating Expense for FY21 was EUR2.5bn (Figure 14) – 26% of revenue.
MARGINS
SPOT’s gross margin was 27% in FY21, and has been gradually improving over the last 5 years (Figure 15). Premium subscriber gross margin was 29.2% in FY21, up 1% YoY, and an increase of 7.3% from FY17 – 21.9% (Figure 16). The increase was primarily due to certain benefits from marketplace programs and beneficial changes in rights holder liabilities estimates. Ad-supported gross margin was 9.7% in FY21, compared with 1% in FY20 (Figure 16). The sharp increase was primarily due to a decrease in streaming delivery, ad servicing, and production costs as a percentage of revenue.
Typically, gross margins have been relatively low due to high royalties paid out to record labels and music rights holders, and continued investments in building up its Podcast and Audiobook content. However, we do expect gross margins to start climbing as the company begins slowing its product investments as a % of revenue over time. Management has also reiterated its goal for gross margins to be in the 35-40% range moving forward.
Operating margin was 1.0% in FY21, and has been steadily increasing over the years – up from -12% in FY16 (Figure 17). We forecast operating margins to dip slightly in FY22e due to unfavourable FX headwinds – SPOT has a larger percentage of US Dollar denominated expenses, but to resume its path upwards in FY23e and beyond, mainly due to increasing operating leverage.
Net margin in FY21 was -0.4%, and has been improving YoY, with positive net margins expected for the first time in FY23e as the company leverages on its growing user base and increasing pricing power (Figure 18).
BALANCE SHEET
Assets: Cash and cash equivalents increased by about EUR1.6bn YoY in FY21 to EUR2.7bn (Figure 19), largely due to a EUR1.2bn issuance of exchangeable notes, and improving cash generated from operations. Short-term investments were at EUR756mn, and generally consist of commercial paper, corporate debt securities, collateralized reverse purchase agreements, and government and agency debt securities, with an average duration of less than 2 years.
Liabilities: SPOT’s largest current liability was its accrued fees payable to rights holders of its streaming content, and was EUR1.4bn in FY21 – falling within accrued expenses and other liabilities category.
US$1.5bn Exchangeable Notes
SPOT issued US$1.5bn worth of 5-year 0% exchangeable notes in FY21, and it was the company’s largest non-current liability. These notes mature in March 2026 with a strike price of ~US$515 per ordinary share (around 5x its current price). Net proceeds for this issuance was EUR1.2bn after transaction costs. The company will be able to repay the notes with its net cash hoard of EUR2.1bn by 2023e.
CASH-FLOW
Free Cash Flow (FCF) grew 51% YoY in FY21 to EUR277mn (Figure 20) and has been increasing at a 5-Yr CAGR of 32%. We expect FCF to triple by FY23e on the back of increasing profitability and operating leverage.
BUSINESS MODEL
Similar to how Netflix has transformed the way people consume on-demand visual entertainment, SPOT has also provided consumers the ability to stream music on demand, transforming the music industry through its >80 million tracks – including >4.4 million podcast titles. The company has also reiterated its decision to actively invest in other forms of alternative and spoken word content like audiobooks and podcasts to complement its existing music library – through direct ownership or licensing arrangements. SPOT also leverages on relationships in the music industry, data analytics, and software, to build and enhance a two-sided marketplace for both users and creators, empowering creators by unlocking new monetization opportunities, and reshaping the way users enjoy, discover, and share audio content. SPOT’s two distinguished services – premium and ad-supported, live independently of each other, with ad-supported services acting as a funnel that drives a significant portion of premium subscriber additions.
Premium Subscription: SPOT provides its premium subscribers unlimited online and offline high-quality streaming access (via PC, mobile, and tablets), to its library of music, podcasts, audiobooks. Subscribers also have the option of choosing from a variety of price plans – Standard, Family, Duo, Student. Prices vary between plans, and are adapted to local markets to align with consumer purchasing power. Subscriptions are usually recurring on a monthly basis, but SPOT has also expanded to include prepaid options and durations other than monthly (longer or shorter durations) to cater to local markets. Most of the new premium subscribers are generally sourced from converting ad-supported users through online platform and marketing engagements.
Ad-Supported: No subscription or platform fees, provide users with limited on-demand online access to music catalogue, but unlimited access to podcasts via PC, mobile, tablets. It also serves as both an acquisition channel for premium subscribers, and a free option for users who are unable or unwilling to pay a monthly subscription fee. Revenue is generated via the sale of video, display, and audio advertisement placements. Advertising arrangements are usually sold on a cost-per-thousand basis. SPOT is also constantly looking to introduce new advertising products across all catalogues. An example of this would be the introduction of an audio advertising marketplace, Spotify Audience Network (SPAN), with SPOT acting as an enabler helping publishers sell targeted advertisements to brand partners. The prospect of monetization has been successful in incentivizing content creators into publishing more content into SPAN, which has in turn made it more attractive for advertisers to be a part of this ecosystem, creating sort of a flywheel effect which will benefit the growth in Ad-supported revenue. Revenue from this segment is reliant on the number of users, total hours of content consumed, and SPOT’s ability to provide relevant innovative advertising products.
INDUSTRY
SPOT is the leader in audio streaming services globally, with almost the same number of subscribers as the next 3 platforms combined (Figure 23). As of FY21, SPOT had an estimated 31% market share in the global audio streaming market, based on subscriber base – almost twice that of its nearest competitor Apple Music. Other competitors include YouTube Music, Amazon Music, SiriusXM, and Pandora. The company’s highest penetrated countries are developed regions like North America and Europe, with other regions such as Asia still in its early stages of adoption (Figure 24).
The global audio streaming industry has continued to grow at a 3-YR CAGR of 19% since FY18, with users also growing at a similar CAGR of 18%. Several factors have contributed to this: 1) increasing smartphone penetration globally has allowed more users to consume on-demand audio wherever they go; 2) traditional radio usage has been declining, with digital consumption taking its share, particularly with car usage being a huge use case in North America. We do expect growth rates to come down slightly, to about 9% CAGR over the next 4 years, mainly due to a huge adoption wave over the last 2 years that was driven by COVID-19 (Figure 25). Similarly, we expect the growth in users to slow to about 7% CAGR over the same period moving forward (Figure 26).
