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Spotify: still not music to everyone’s ears

Spotify’s valuation has continued to grow since listing earlier this year, with its most recent update demonstrating it is maintaining growth. But the company is still facing several major challenges that is drowning out the music streaming service’s success.

Source: Bloomberg

The jury is still out on Spotify. The Swedish company has silenced critics that questioned whether it could maintain the rate of growth in users and subscribers after its latest set of results showed it remained on course to deliver what it promised when it listed earlier this year. But many are still apprehensive over the music streaming service losing ground in core markets while struggling to enter new ones, as well as tensions between the music streaming service and the major record labels that own its music library.

Spotify users hit 180 million as subscribers grow to over 80 million

With profit not expected for some time, the focus is currently on Spotify’s ability to keep attracting new customers onto its free ad-supported platform and how effective it is at converting them into premium subscribers that pay for an ad-free service and end up engaging with the app more often.

Spotify ended June with 180 million monthly active users (MAUs), 83 million of which were paying for its premium service. The quarter-on-quarter (QoQ) growth in MAUs of 5.9% was the slowest in a year, but premium subscription growth of 10.7% was the highest level recorded over the same period.

Read more about how Spotify’s shares were tested as it learned the tough lessons of going public

Spotify’s premium subscription growth in the second quarter (Q2) vastly outpaced the growth in MAUs, suggesting strong conversion rates after having introduced new options for customers like the Family Plan. This not only secures multiple new users under one account, but also lowers the likelihood of the customer leaving because the whole family is using it. Similarly, it has seen the same result through the partnership with Netflix-rival Hulu which offers both services under a single plan. After trialling out the package by rolling it out to students at the backend of last year, Spotify has now rolled it out to all its standard subscribers in the US.

Spotify revenue keeps rising but losses swell and cash flow tightens

Revenue experienced a rare QoQ dip in the first three months of 2018, but rebounded strongly in Q2 despite foreign exchange headwinds, while its gross margin also improved to come in at the upper end of its guided range. However, bottom-line losses continued to swell (although this was partly driven by the costs of its listing earlier this year) amounting to €30 million in the quarter.

It also booked €32 million of staff-related costs, considerably higher than the €8 million it had guided, because the ‘strong stock performance’ in the period caused stock-based compensation to rise. Spotify shares were 27.5% higher at the end of June than the €132 reference price set at its direct public offering (DPO), and 13% higher than the closing share price on the first day of trading on 3 April.

Spotify keeps growing but takes hit from listing costs in first half

(EUR, millions) Q2 2018 Q1 2018 Q2 2017 H1 2018 H1 2017
Revenue 1273 1139 1007 2412 1909
Gross profit 329 283 232 612 337
Operating loss (90) (41) (79) (131) (218)
Pre-tax loss (392) (180) (187) (572) (359)
Net loss (394) (169) (188) (563) (361)
Net operating cash flow 30 84 72 114 165
Net invest cash flow (17) 139 (42) 122 (167)
Net finance cash flow 55 43 2 98 18
Free cash flow 18 74 59 92 123

Spotify remains financially sound, ending June with €810 million in cash compared to €733 million at the end of March, and €477 million at the end of June 2017.

Spotify currently runs bi-annual campaigns that make its business seasonal, with both revenue and gross margin fluctuating as a result. While QoQ growth in MAUs has remained fairly consistent over the past 30 months, its revenue growth and its conversion of users into subscribers is much more volatile throughout the year. This is demonstrated in the chart below, which also includes projections for Q3 and Q4 of 2018, based on Spotify’s expectations.

Spotify QoQ chart

Spotify tweaks guidance with aim of limiting losses

Growth in MAUs, premium subscribers and revenue all came in at the top end of its guidance for Q2, as did its gross margin, while its operating loss was in the middle of the expected range. 

Having delivered with its latest results, Spotify chose to tighten its guidance for the full year as it reached the midway point. It previously expected to end 2018 with 198 million-208 million MAUs and 92 million-96 million premium subscribers, and the new range for its operating loss could potentially be a big improvement from the previous range of €230 million-€330 million, if it can deliver the top-end of its expectations as it has done with its other metrics.

Its performance for the year so far is outlined below, coupled with Spotify’s new expectations for the remaining quarters and the full year:

(Millions) Q1 Q2 Q3 Q3 FY2018 FY2017 
MAUs 170 180 188-193 199-207 199-207 159
Premium subscribers 75 83 85-88 93-97 93-97 71
Revenue (EUR, billions) 1.14  1.27 1.2-1.4 1.35-1.55 4.96-5.36 4.09
Gross margin 24.9% 25.8% 23.7%-25.7%   24.5%-26.5% 23%-25% 21%
Operating loss (EUR, millions) (41) (90) (10-90) (20-100) (161-321) (378)

(*Q3, Q4 and FY2018 results are estimates based on company guidance)

Over the longer term, the company is aiming to deliver a gross margin of 30% or above, as announced ahead of its listing, which would represent a huge improvement from current levels. However, with no timeframe on that goal (or concrete plans on how it will be achieved) investors will be wary of such an ambitious figure.

Spotify keeps growing in new markets but Apple pulls into pole position in the US

Spotify has become a household name in the US and European markets, and when it was preparing to start life as a publicly listed company it was eagerly boasting that it had at least double the amount of users than its closest competitor, Apple Music. While there is no doubt regarding Spotify’s claim, it did fail to reveal what is now a real concern for shareholders.

Spotify’s growth is coming from new markets, such as in Latin America, and while this was expected to be the case investors are concerned that the company may have already lost its edge in more established markets like the US. Although neither Spotify nor Apple publish geographical data regarding where their revenue comes from, it has been reported (based on the data they do pass on to record companies) that Spotify has 22 million-22.5 million paying subscribers in the US, only a fraction more than Apple’s 21 million-21.5 million.

While there is no suggestion that Spotify has stopped attracting new subscribers in established markets like the US, there are signs that Apple is growing at a faster pace. Based on the same report, Apple has grown subscriptions by as much as 65% over the past year, while Spotify has only managed 32%. While Spotify will feel hard done by for being criticised for generating such high growth, Apple is expected to overtake the Swedish firm in the US from next month. It is also thought that Apple is outpacing Spotify in other key markets like the UK and Canada.

This raises a more fundamental question about Spotify. As a pure-play it lacks resources and firepower compared to Apple, which has better access to new customers that purchase an iPhone, and the financial ability to challenge Spotify on price and costs for as long as is necessary.

Spotify’s valuation has soared from $26 billion upon listing to over $35 billion at its peak, and it has only been listed for three months. These lofty valuations that Spotify has been given have been attached to the potential of emerging markets, but it is also based on Spotify being the number one brand and market leader in developed markets. Quite simply, it is far too soon for Spotify to start losing such large amounts of ground to such a formidable competitor, bearing in mind the company currently third place in the race for music streaming supremacy, Amazon, will only grow as a threat.

Spotify’s delayed entry into India a cause for concern

Coupled with the growing threat in its core markets, Spotify is also having trouble with some of its new geographies. The company revealed in March that it was expanding into the world’s fastest growing economy with a population of over one billion, before conceding after the most recent results that it could not predict when it could make its entry.

Spotify’s previous successful entries into new markets has been down to the combination of the company’s universal library that is popular around the world, and a more local focus that streams what’s particularly popular in each country. There might not be any country that this is more important for than a country that has built the likes of Bollywood entirely on music. But reports suggest that record companies, both in India and abroad, have not yet signed off on Spotify using its music.

Although the current opportunity is quite low, with research suggesting only one in every 76 people that use streaming services are currently paying for it in India, Spotify and competitors are trying to grab market share in order to hold a commanding position in the future when the market matures - like it has done in Europe and the US. Most brokers have based their positive forecasts on Spotify on the basis that there is a sharp uptake for both the company and the wider music streaming industry in Asia from 2019 and beyond, so the fact that Spotify faces trouble breaking in to what is one of the two biggest emerging economies in Asia is not ideal for its future prospects.

Spotify and the big three record labels: are tensions rising?

With just three record companies owning the rights to the vast majority of Spotify’s music, the relationship with Sony Music, Warner Music and Universal Music is all-important for the firm. Its margins are dictated by what it pays these companies, and its sales is defined by having access to their libraries.

While the delays seen during negotiations in India may well just be a part of normal business, there is the suggestion that Spotify’s latest move has rubbed up the music execs the wrong way. The company had to secure the support of the big three record companies before it could come to market, and much of that had been down to its commitment that Spotify was acting as a vital link between the music industry and the consumer, and had no intention of trying to cut them out by striking deals directly with artists. But the company, while keeping its word, bent the rules last year after it started to license music – rather than buying the rights or signing the musicians - directly from smaller artists.

Spotify pioneered the move from downloads to streaming and became an invaluable service for both sides of the market: providing access to an in-depth music library to consumers at a lower cost by offsetting it by the higher uptake, and reviving an ailing music industry by providing new revenue streams and introducing the likes of data into the mix. But there is always reason to cut out a middleman, and this three-strong chain will be tested for years to come. Spotify may be considered the middleman for now, but it may decide that record execs are the disposable ones. But it will have to tread lightly because right now it is nothing without access to the world’s biggest record libraries, while Warner, Sony and Universal have plenty of other partners to focus on. And when those potential partners are the likes of Apple and Amazon, the threat of deteriorating relations with the record companies is even more serious for Spotify.

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However, Spotify’s role is about much more than providing the digital platform. Its data-driven digital tools are constantly evolving and assisting artists to reach out to their audiences, particularly the up-and-coming stars that have not yet found any backing. The company grew the amount of artists available on its platform by 5% in the last quarter, and its new ‘Spotify for Artists’ service (which allows artists to manage their own profiles) now has over 200,000 users per month. Monthly active artists (MAAs) grew by 100,000 over the first nine months after being launched, and doubled in the following six. Spotify’s focus on this side of the business will grow, with the company telling investors to ‘expect regular updates on our progress over time’.

Spotify rolls-out landmark overhaul to ad-supported service

While the ad-supported service has the primary role of providing new customers that Spotify can try to convert into paying subscribers, this side of the business is expected to offer more reward in the longer term as it develops its advertising business.

Spotify began introducing a new user interface for its ad-supported service earlier this year, declaring it the ‘first major revision’ since launching its mobile platform in 2014. The firm says it expects the new interface to ‘drive improvements in engagement, retention, and conversion’ going forward, and investors should take some comfort that the company is successfully delivering strategies for both the ad-supported and premium services.

With Spotify now offering more than music, with podcasts proving popular and audio books still offering plenty of opportunity, its ad-supported service is becoming a modern challenger to more traditional advertising routes, like terrestrial radio.

Read more about what challenges WPP and the wider advertising industry are facing

Most of its revenue sourced from advertisers comes through its direct sales channel, but Spotify is increasingly automating the process. This is being led by Ad-Studio, its ‘self-serve advertising platform’, which aims to lower costs whilst making a quicker and smoother service for businesses. Ad revenue from programmatic channels and Ad Studio now account for 20% of the total. These services are currently available in the US, Canada, UK and Australia, and will continue to be introduced into other markets going forward.

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