Recap of Spotify's Q2 Earnings

It's been said that volatility is a requirement to make outsized returns in the market. The person who said that might have been thinking about Spotify.

Spotify has been on a torrid run this year as its stock price had risen over 100% YTD by Monday this week. Spotify seemed to be taking strides to finally improve their profitability, and their user growth has been very impressive over the past year and a half.

However the market did not like Spotify's Q2 earnings which were released yesterday, and the stock finished down over 14% on the day. I think it's worth dissecting what is going on with Spotify's business, and why I think there are reasons to be optimistic.

First the good news, Spotify's user growth continues to be very impressive. They added 36 million monthly active users in Q2, 21 million more than their guidance and the best quarter they've ever had in terms of new users. Premium users was also very strong as they added 10 million new premium users, 3 million above their guidance and tied for the best quarter they've ever had in terms of adding premium users. These are fantastic numbers and should not be discounted. More customers is a good thing and proves that people see value in Spotify's service.

What was not so great about Spotify's earnings was that despite more and more users being added to the platform, those users have not translated to better profit margins yet. It's true that the margins dropped in Q2 largely as a result of one time charges incurred for efficiency measures (layoffs and real estate terminations), but still the market is clearly frustrated that there hasn't been much progress here. One of the criticisms of Spotify that I hear most frequently is that the business model provides that music labels take a huge chunk of the economics of streaming music off the top, and this makes streaming music just structurally unprofitable. The result will be that Spotify will never be a good, profitable business.

However I think beneath the surface we are seeing movements in the fundamentals of Spotify's business which will show up in the numbers, and possibly as early as later this year.

Spotify announced broad price increases on Monday which will raise prices by between 5% and 20% for many premium users depending on what type of account you have. This will give a substantial one time shot to revenue growth. It was rumored that Spotify was holding out on price increases until they could negotiate a better split between them and the music labels. For obvious reasons Spotify is not willing to divulge what, if any concessions they received from the labels in order to proceed with these price increases. However if they did get concessions, then it should be visible in higher gross margins on premium subscribers, starting in Q4. Regardless of whether or not there was concessions currently, I think the long term trends favor Spotify in terms of their bargaining leverage with labels. Spotify's userbase continues to climb rapidly and the share of major labels as a percentage of overall streams continues to fall. This should bode well for Spotify long term.

There was also a nice rebound in the growth of ad revenue and this to me is the big key to making Spotify more profitable. We know that an ad driven model can be very profitable because we've seen platforms like YouTube be very successful. YouTube has the benefit of being part of Alphabet's ad ecosystem so comparing Spotify to YouTube is a tough comparison, but I think Spotify can still make big strides in advertising to improve their monetization of ads and grow this part of their business. If ads, and particularly podcast ads can become a much bigger piece of the overall revenue pie, then that will be very good for Spotify's profitability. This quarter was a step in the right direction on that front.

The fact that they've added so many users in the last year and a half should provide a tailwind for revenue growth over the next year. New ad supported users don't necessarily monetize well early on, so there is usually a lag between the user signing up, and the revenue on that user being earned. There is also a certain cycle where new users come in as ad supported but gradually as they engage with the app, they upgrade to become a premium user. So new ad supported users are a powerful funnel for future new premium users. That should bode well for premium user growth over the next year.

Lastly, their expense growth seems to be slowing down and coming under more control as management had indicated. If they can maintain their revenue growth for the reasons above, while at the same time slowing the pace of expenses, then that by definition should lead to better margins.

So while this quarter left room for improvement in terms of profitability, I think the seeds have been sown for improvements over the latter half of 2023, and particularly in the 4th quarter as those price increases come into effect. I have been a big fan of Daniel Ek and Spotify's strategy of trying to create as much value as possible for customers before trying to extract value from them. I think that strategy has been key to outcompeting much larger competitors for users. Now we will find out if it can also translate into financial success. I think it will.