Spotify Technology S.A. (NYSE:SPOT) Q1 2023 Earnings Call Transcript

Spotify Technology S.A. (NYSE:SPOT) Q1 2023 Earnings Call Transcript April 25, 2023

Spotify Technology S.A. misses on earnings expectations. Reported EPS is $-1.16 EPS, expectations were $-0.85.

Operator: Good morning. My name is Julian and I will be a conference operator today. At this time, I would like to welcome everyone to Spotify’s First Quarter 2023 Earnings Call. . I would now like to turn the call over to Bryan Goldberg, Head of Investor Relations. You may begin your conference.

Bryan Goldberg: Thank you, and welcome to Spotify’s first quarter 2023 earnings conference call. Joining us today will be Daniel Ek, our CEO; and Paul Vogel, our CFO. We’ll start with opening comments from Daniel and Paul and afterwards, we’ll be happy to answer your questions. Questions can be submitted by going to slido.com, S-L-I-D-O.com and using the code #SpotifyEarningsQ123. Analysts can ask questions directly into Slido, and all participants can then vote on the questions they find the most relevant. . If for some reason you don’t have access to Slido, you can e-mail Investor Relations at ir@spotify.com, and we’ll add in your question. Before we begin, let me quickly cover the safe harbor. During this call, we’ll be making certain forward-looking statements, including projections or estimates about the future performance of the company.

These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed on today’s call, in our letter to shareholders and in filings with the Securities and Exchange Commission. During this call, we’ll also refer to certain non-IFRS financial measures. Reconciliations between our IFRS and non-IFRS financial measures can be found in our letter to shareholders, in the financial section of our Investor Relations website and also furnished today on Form 6-K. And with that, I’ll turn it over to Daniel.

Daniel Ek : All right. Hey, everyone, and thank you so much for joining us. As we open this call, I really can’t help but feel a tremendous amount of excitement about the progress our team made this quarter. In fact, this quarter represents our strongest Q1, since going public. And over the last few months, we’ve celebrated a few significant milestones, including surpassing over 0.5 billion users and reaching more than 200 million subscribers. Further, our user growth exceeded our expectations by 15 million and our subscriber numbers by 3 million. And at our scale, it is pretty remarkable to see this level of reacceleration in our user growth, but it is a trend that’s been consistent now for over the last five quarters. In fact, the last two quarters saw the largest MAU growth in our history.

The outperformance was broad based, meaning growth was pretty evenly spread across every region without a single market dominating. And on top of this, we were able to accomplish this level of growth with lower marketing spend. We look at this as a promising sign. But it’s too early to draw any conclusions yet. And as you heard me say repeatedly over the years, a healthy top line user growth is the leading indicator of our ability to achieve future success on all other financial metrics. And when we successfully attract new users, it’s only a matter of time before the conversion rate that subscriber increases, which then of course, drives our revenue upwards over the long term. And this is a formula that’s been worked for us exceptionally well, and one I fully expect to play out again.

And speaking of long term, I want to spend a moment talking about our approach to investment timelines and the outcomes they can deliver when we stay on the course. So let me give you a recent example. For those who turn in through our March Stream On event, we unveiled numerous creator tools and the debuted in an entirely new and updated Spotify experience, including a first of its kind AI DJ. And these changes marked the biggest updates to our user experience since we introduced mobile more than 10 years ago. But of course, this didn’t happen overnight. These are things that we’ve been building on over the last 12 to even 18 months, and in some cases even longer. And as we shift to rolling out these features, as well as several others across our 184 markets, we’re seeing an acceleration in MAU retention and subs.

And sometimes our investments manifest themselves immediately. But more often than not, their impact is gradual and takes shape over several quarters, or sometimes even years. And while we really can’t anticipate when the benefits will materialize, we do know that our growth is a consequence of our relentless pursuit of learning, iterating and improving. We make strategic investments, and we wait for the results to compound for proving out the benefits for users, creators, and of course, our other stakeholders. And by delivering an exceptional experience that is centered on creating value for the stakeholders, overtime, we’re seeing a correlation with a stronger financial performance. I’ve often talked about the fact that our success is not attributable to just one thing, but literally 100s, if not sometimes even 1000s of improvements that we’re investing in and working on in parallel.

And that’s not to say that every one of them ends up producing the outcomes we strive for. But over time, the things that do work, they do add up. And together they have a compounding effect. So think of it really as waves of innovation, investment and improvement. There’s an ebb and there’s a flow overtime, but overtime, it really becomes more predictable and produces steadier results. And the key then, it seems is to maintain a long term focus to help us navigate current short term uncertainties. But don’t let all my talk about the importance of long-term investing allow you to believe that we are rethinking our commitment to driving efficiency. So as many know last quarter and building on what we shared at last year’s Investor Day, I talked about shifting towards becoming a more efficient company.

There’s really no question that we’ve become leaner in the last six months, but this progress is still early in its reflection on our financials. The actions we’ve taken coupled with other opportunities to reduce spending in areas like marketing and content production and real estate should lead to a steady progression of key metrics throughout the year, all of which makes me even more bullish about the remainder of 2023 and beyond. And with that, I’ll turn it over to Paul for more detail behind the numbers, and then Bryan will open it up for the Q&A.

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Paul Vogel: Great. Thanks, Daniel, and thanks, everyone, for joining us. Let’s start with Q1. User growth was exceptionally strong in the quarter. Total monthly active users grew to 550 million in Q1. This was 15 million ahead of guidance, up 26 million quarter-over-quarter the largest Q1 net additions in our history and the second largest all-time only surpassed by Q4 of last year. The strength was broad-based, and we had record Q1 net additions across nearly all age demographics in both developed and developing regions. Moving to premium. We finished the quarter with 210 million subscribers, 3 million ahead of guidance, thanks once again to broad-based strength across all regions. Engagement trends were strong in Q1 with healthy uplift to year-over-year growth in content hours per MAU across all platforms.

We also saw positive trends in our DAU to MAU ratio as well as in churn. Our revenue grew 14% year-on-year, topping $3 billion in the quarter. Results in the quarter were just slightly behind forecasts as premium revenue slightly outperformed, offset by a very modest underperformance in advertising. This marks the first Q1 in Spotify’s history where we surpassed €300 million in ad revenue. And turning to gross margin. Gross margin of 25.2% was above guidance by 30 basis points. Moving to operating expenses. Growth was lower than forecast helped by less marketing spend than plan. When combined with our better gross profit, operating loss was ahead of guidance by €38 million. The better than planned results also include €44 million of severance-related charges.

Free cash flow was a positive €57 million in Q1. Now looking ahead, it’s clear we have a lot of momentum coming out of Q1. With respect to second quarter guidance, we continue to see strong momentum in MAU and subscribers, we’re forecasting 530 million MAU, an increase of 50 million from Q1 and 270 million subscribers, an increase of 7 million over Q1. We are forecasting €3.2 billion in total revenue, a gross margin of roughly 25.5% and an operating loss of approximately €129 million. On revenue, the currency translation benefits we’ve been experiencing for the last six quarters are expected to reverse in Q2, led by the weakening U.S. dollar relative to the euro. As a result, we are forecasting a 300 basis point headwind to growth. Excluding this effect, our constant currency revenue will be closer to €3.3 billion, reflecting our expectation for accelerating currency-neutral growth to 14% versus 13% growth we delivered in Q1.

From a profitability standpoint, we continue to expect a steady ramp in gross margins throughout 2023 as well as sequential improvements in our operating loss. And then one final note. As Daniel mentioned in his remarks, we will continue to be diligent regarding operating efficiency improvements and we’ll be looking at areas such as real estate optimization. During Q2, we hope to finalize some of these decisions, and this could lead to material non-cash charge during the quarter. We have not included any potential charges in our Q2 guidance, but should they occur we will break them out during our Q2 earnings report. And with that, I’ll turn it back over to Bryan.

Paul Vogel: Yes. As I said in my opening comments, we’re slightly behind on the ad side, about 15 — about 20 million or so. The quarter was choppy, again, incrementally throughout the quarter, it got a little bit better. We feel like we have momentum heading into Q2, but I think we’ve had similar sort of trends heading into Q1 as well. So it’s a little bit too early to say. Overall, I think we feel really good about our relative position in the ad market and how we performed relative to how the overall market performed in Q1. Again, it was a bit up and down. We missed by a small amount, but nothing really that concerns us in any way.

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Q&A Session

Bryan Goldberg: All right. Our next question is going to come from Mike Morris on AI. Use of AI technology to create new music has resulted in concern from artists and rights holders as seen with the recent fake Drake track. What does Spotify’s responsibility in allowing or preventing the distribution of creative music that draws from another artist’s work?

Daniel Ek: Yes. I mean, first off, let’s acknowledge that this is an incredibly fast moving and developing space. I don’t think in my history with technology I’ve ever seen anything moving as fastest, the development of AI currently is at the moment. And obviously, you pointed out in your question that there’s two parts of this. One is, our role as a platform for allowing innovation of creative works and then how we do to protect the creators and the artist ecosystem that we care so deeply about. And so the big part of this is we have that dual focus, and we take that role of guardian, the artist creativity and the support that we are doing for artists and creators very, very seriously. So we’re in constant dialogue with the industry about these things.

And it’s important to state that there’s everything from what you’ve mentioned sort of fake tracks from artists, which falls in one bucket to everything of just augmenting using AI to allow for expression, which probably falls in the more lenient and easier bucket. So these are very, very complex issues that don’t have a single straight answer on how you take the position depending on what would happen. But we’re in constant discussion with our partners and creators and artists and want to strike a balance between allowing innovation and, of course, protecting artists.

Bryan Goldberg: Okay. Next question from Justin Patterson on operating efficiency. On the fourth quarter earnings call, you framed efficiency is a top priority for Spotify as you’ve transitioned to a new org structure, how are you measuring your initial progress on speed and efficiency? And when can we expect these efforts to roll in more meaningfully to gross margin and operating expense?

Daniel Ek: Yes. I’ll start, and maybe Paul can add to it. So we’re early on in our new work structure and the way we’re working. But I’m feeling really good about it so far. And the leading indicators that I look to is really just speed of decision-making. And we’ve really kind of driven more collaboration and more speed of decisions now than we’ve had probably at any other time in the Spotify history. So I feel good about that. But that obviously will still take some time before that then leads into actual products that then leads to actual business results. So I think as it relates to that, we still have some ways to go before investors will see the actual output. But when I talked about efficiency, it’s important to note that, that’s just one part of the equation.

The other part of the equation, obviously, on efficiency is just being diligent on what we invest in and what we spend on. And I don’t know, Paul, if you want to talk a little bit more about what we’re seeing there.

Paul Vogel: Yes. I would add a couple of things. One is, I think we’ve talked about on the gross margin side seeing sequential improvement throughout 2023, and nothing’s changed there. So you saw the Q1 number come in, you saw the Q2 guidance is sequentially better than Q1, and we expect that to persist throughout 2023. And same thing on the operating loss, we expect to see incremental leverage throughout the year with the sequential improvement in operating loss as well. So we’re starting to see it come through on those lines.

Bryan Goldberg: All right. Next question from Matt Thornton on our subscription business. ARPU was a little lower than expected. Can you talk to what’s driving that, i.e., of how did FX plan mix, market mix, promotional activity vary versus your initial expectations and guidance? And how should we think about ARPU looking forward?

Paul Vogel: Yes. It’s kind of a combination of all the things you mentioned. Clearly, we beat on the subscriber side by 3 million. So when we have that upside, some of it came from additional growth in our family and duo plans as well as people coming on promotional. And so all of those have an impact on ARPU. I would say the product mix, meaning more users coming in on family and duo is probably the biggest driver. Again, it’s pretty minor in terms of where it came in on ARPU and it was pretty much in line with our expectations, maybe a hair below from an ARPU standpoint, but not material.

Bryan Goldberg: Okay. Another question from Justin Patterson. This is on our recent product updates. Daniel, could you share any initial learnings on listener and creator reactions to the new user interface. With the new user interface released, how should we think about the pace of product improvements and monetization opportunities going forward?

Daniel Ek: Yes. Perhaps just to start by setting context. It was a very successful event. We’ve had massive amounts of feedback both from users and creators, where, in particular, this was a greater-focused event. So creators have been overwhelmingly positive about all the new tools that they now have to express themselves and to connect with their audience. But it’s also to temper expectation. It’s probably one of the largest single changes in the history of Spotify. So we take that very seriously. So for instance, the new home feed that we announced is still being rolled out. So most consumers in the world don’t yet have access to that. We’re rolling it out slowly just to make sure we have performance dialled up and that we can react to the feedback.

And we’ve already made lots of iterations with the user feedback we’ve gotten. So it will be very successful when it’s fully rolled out, and I feel really good about that. But I’m using this as a moment to educate all investors and analysts as well that there are some product improvements that we do that you just can’t turn on the button on. And there’s some that you can. And this happened to be one of those things that takes multi quarters for us to roll out because it’s not just a feature or something else. It’s a whole new infrastructure behind it with a whole new instrumentation for our AI tools as well. So it’s an important piece of infrastructure that we’re basically still rolling out, but I feel really good about it and the response.

And I think once that’s fully rolled out, we can iterate massively on top of that as well. But the big focus for the next few months from the teams is just really kind of rolling this out, making sure it’s very performant and that we can start then allowing our machine learning and AI teams to start iterating on top of that. And then we’ll see compounding improvements for many years, just like I outlined in my initial remarks.

Bryan Goldberg: Okay. Next question from Mario Lu. With regards to the 6% workforce reduction announced earlier this year, is that the final or first round of reductions this year? And should we expect any additional severance charges other than the €41 million in your operating expense in Q1?

Paul Vogel: Let me take the second part first, just to get it out of the way. So the €41 million is the charge on the operating expense line. There was actually €44 million overall. There was a small component of a severance that hit gross margin. So there’s been two numbers that have been floating out there, but it’s €44 million in total, €41 million to hit the OpEx and then that €3 million that hit the gross margin side. And in terms of workforce, nothing else at in terms of workforce reductions. I think we’ve talked about, I’ll let kind of Daniel take the efficiency side from here.

Daniel Ek: Yes. I mean the only thing I’d really add is that we have really become a lot leaner over the last six months, but I think that progress is still early in its reflection on our financials. And then what investors should probably expect going forward is for us to keep looking for waste that can help us. And that includes, obviously, everything from our real estate footprint. We will keep reviewing the content deals we’ve made, are they performing, not performing and obviously have a much higher hurdle rates, as I mentioned last quarter as well on any new investments going forward.

Bryan Goldberg: Okay. A question from Rich Greenfield for Daniel. I would love to hear your perspective on the recent Apple versus EPIC ruling being able to message about paying for Spotify off platform is clearly positive, but it appears that the court largely cited with Apple. And then I would also love to hear more about your recent trip to Washington, D.C.

Daniel Ek: Yes, Rich. I would characterize it probably as disappointed but not surprised with the ruling. As you rightly called out, it does still include the anti-steering provision, which I think is very important and a good step in the right direction. And I think it’s also worthwhile pointing out, I just briefly read through the judge’s remarks, I may be getting this, but I’m wrong, but I’ll try to paraphrase it, where the judge, I think, was referring and reacting to the fact that there’s a larger conversation going on in Washington about future regulation and the judge just noted that they were simply making a decision, a ruling based on the existing law and not future regulation. And this is kind of the point why I went to Washington I do believe new laws are needed for this and that the App Store bill or Ooma bill that is also called is a very much needed improvement.

And I had great meetings. I really did from bipartisan, both Republicans and Democrats. I found them to be very supportive of the issue, very understanding of some of these things. And I think a lot of the people I spoke to didn’t realize it was this bad. And for us, just to kind of level set for those that may not be involved in the intricate details. The primary issue for me is that when I started as a 14-year-old entrepreneur, the Internet was this democratic place that anyone anywhere in the world could have an impact. And right now, we’re in a place where billions of consumers are using the Internet primarily through smartphones and primarily through apps. And there’s literally two companies now that control all of that on the internet, and they can unilaterally change the rules.

They, in Apple’s case, can prevent us from talking to our customers and prevent customers from even understanding that there are better deals in the marketplace. So this is super important to me on a principal level, I want better climate for innovation to bring progress. I want consumers and if they’ve opted into communication from a company, I want that company to be able to communicate to that consumer without the interference of these platforms. And those message points really resonated across both the House and the Senate and across the aisle of both Republican and Democrats. So I feel encouraged but it’s still early days here in the U.S. And obviously, we’ve had a lot more progress on this issue lately in Europe.

Bryan Goldberg: Great. Next question from Mario Lu on gross margin. Gross margins beat guidance by 30 basis points, but saw a drag from other cost of revenue. Can you explain what within other cost of revenue was the main drag and if that’s expected to continue going forward?

Paul Vogel: Yes. So there’s a little bit of nuance in this. So let me kind of go through it. So when you look throughout 2022 and into 2023, we’ve seen a sort of steady increase on the other cost of revenue line. A lot of that has come from streaming delivery and other compute costs that had slowly risen throughout the year and it’s been impacting us. And so when you look at it Q1 versus Q1, that trend had still continued to put a little bit of pressure on the gross margin as a negative. That being said, some of the outperformance we saw in Q1 actually related to that being less of a drag than we thought and starting to see some of the efficiency improvements and initiatives that we put in place starting to pay off. And so while the increase that we’ve seen for the last kind of three, four quarters persisted, the incremental increase was less given some of the efficiencies.

And so we feel really good about that. We’ve got more plans in place to continue to improve that line item, which is sort of the non-royalty-bearing side of gross margin. So I think we’re in a good place going forward with how that should trend.