Spotify shares tested: learning the lessons of going public

Spotify’s business is based on two revenue sources. The company offers a free music streaming service to users which is driven by advertising, as well as a premium service that allows users to pay a subscription for unlimited access without advertisements. Premium subscribers drive Spotify’s revenue, but the ad-supported service is integral, as customers tend to start using the free service before transitioning to the paid service.

Premium revenue in the first three months of the year was 25% higher than the year before, while ad-supported revenue climbed 38%. However (excluding the FX effect), premium revenue would have risen 36% and ad-supported revenue would have soared 55%.

The growth in premium subscribers, while still significant, was slower in 2017 compared to 2016 and investors were cautious after the rate of quarterly growth delivered in the first three months of this year was the second lowest on record in over two years.

Spotify has done well to grow its premium subscription base at a faster rate than its ad-supported user base over the past few years. Growth in premium subscriptions has outpaced the lifts seen in ad-supported users in nearly every quarter since the start of 2016. Premium subscribers represented 44% of Spotify’s total user base at the end of last year, the highest proportion on record, before experiencing a rare dip to sit at 43% at the end of Q1 2018.

Spotify had already got churn down to a record low as it joined the NYSE, and said churn of premium subscribers was below 5% in Q1, thanks to the retention factors of its family and student plans. Although Spotify does not plan to provide premium churn figures going forward, the company said it expects it to continue falling as its higher retention products penetrate the market and its overall subscriber base matures, helping counter the added churn that will come from entering new markets.

What else was new in Spotify’s latest results?

Spotify remained busy in Q1 despite being occupied with its direct listing. The company continued to expand into new markets and is now in 65 countries after opening up in four new countries in March: Israel, Romania, Vietnam and South Africa, the last of which represents the music streaming service’s first move into the African continent.

Customers tend to start using Spotify’s free, ad-supported service before eventually deciding to upgrade and move to the premium service. This makes the ad-supported service extremely important to Spotify’s strategy and in Q1 the firm launched a new tier that offers new features to its ad-supported users, allowing them to use less mobile data when streaming, personalise their music and listen to playlists without having to shuffle songs or be interrupted by advertising.

If Spotify continues to demonstrate it can convert more and more of its free users into premium subscribers then it is a case of driving volume to the free service by making it more attractive, and securing as many customers before they are swayed by competitors like Apple Music. 

Spotify’s ad-supported service and advertising service

The majority of Spotify’s advertising revenue comes from its direct channel, but a growing proportion is coming from advertisers purchasing advertising on a programmatic basis, which sees the entire process – the purchase, placement and optimisation of advertising on Spotify – automated using software. Revenue from the programmatic channel doubled year-on-year in the first quarter, outpacing Spotify’s expectations.

The majority of ad-spending happens on Spotify’s mobile platform, and video is the fastest growing source of revenue in terms of products. Still, audio advertising is the main contributor to ad-revenue.

A big part of becoming profitable will be effectively monetising the ad-supported service so it is both profitable and able to drive high volumes of customers to the premium subscriber base. In a tentative step towards that, Spotify has launched a beta version of a self-serve advertising platform named Ad Studio which has seen ‘hundreds of advertisers’ launch campaigns since late last year, with ‘thousands more’ signed up. Revenue is still nominal but, as the advertising side of the business becomes more digitally automated, Spotify expects a ‘significant portion’ of ad-supported revenue to come through Ad Studio in the future.

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Spotify’s focus on technology is demonstrated by its spread of spending and hiring, with nearly half of all new staff recruited since the start of the year heading to its research and development (R&D) department. 

Spotify continues expanding partnerships

Partnerships have continued to form, and existing ones expanded. Spotify’s podcast library at the end of March was double the size it was at the end of December after the firm signed several partnerships with major podcast networks and aggregators. Meanwhile, the company has struck a deal to allow Cadillac (owned by General Motors) drivers to automatically connect their Spotify to their car, ridding the need to connect the service to the car’s speakers every time.

Spotify has also strengthened its partnership with Netflix-rival Hulu. A bundle targeted at students was launched in September last year that sold one subscription for access to both Spotify and Hulu, combining their respective strengths in music and video. Spotify had previously only offered this bundle to its premium subscribers but has now rolled out a similar deal to its other users which will be available later this summer.

Spotify shares suffer first bruising since IPO

Spotify shares have failed to gain much traction since listing, and the Q1 results released in early May brought an end to the closest the company’s shares have got to a rally in its short time as a listed entity.

Is Spotify another tech giant struggling to make a profit?

Spotify is confident in its ability to retain its role as the market leader in music streaming. Ahead of its initial public offering (IPO), the firm had boasted that it had at least double the amount of premium subscribers as that of its next biggest competitor. But if there is one firm that cannot ignore its competition it is Spotify, who has Apple and Amazon as direct competition, with added pressure coming from the likes of Alphabet’s Google.

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Spotify may be deemed a music streaming service, but it just as much a technology company as the other big tech. This is because Spotify develops and owns the technology that allows people to stream music, but Spotify does not own the music. In fact, the vast majority of its library is owned by just three companies.

This is what largely dictates margins, as the vast majority of Spotify’s revenue goes to the right holders. This represents a distinct difference between Spotify and its other tech peers. Many tech firms have the benefit of being able to grow revenue whilst keeping costs relatively fixed, but Spotify has to strike the right balance as its single biggest cost, royalties, will rise as more customers join and usage goes up – demonstrating the particular importance of the margin for Spotify. Having said that, Spotify’s latest results demonstrate it has made headway with its margin, and that it will have likely benefited from better deals being negotiated with its biggest music partners last year.

Twitter takes its time to turn to profit

Still, investors have had mixed fortunes when it comes to investing in the new tech firm on the block. Twitter has managed to recently turn a net profit in Q1 of this year, in what many hope will be a new course following $2.3 billion worth of losses between 2013 (when it listed) and 2017. Twitter’s performance has drawn added criticism over the years because Facebook has been far more successful in monetising its social media platform and delivered higher rates of growth.

SNAP suffers the tough lessons of going public

Look at more recent listings and you find yourself turning to SNAP, the owner of loss-making Snapchat that listed in March 2017. The buzz around the IPO was short-lived, and swiftly replaced by a multitude of concerns.

An unpopular redesign, public criticism from the celebrity users that sway its teenage customer base, and the failure to capitalise on the data-scandal rumbling on at Facebook have all marred SNAP’s early days as a publicly-listed company.

Read more about whether Cambridge Analytica is a threat to Facebook’s shares and reputation

Fitbit shares fall from grace

Fitbit, the firm that ‘empowers’ users with data and makes fitness trackers and smart watches, is an example of a tech firm to have disappointed since coming to market in the middle of 2015. Although shares were initially greeted with hype, it quickly fizzled out and shares began to tumble. The company fell to an all-time low in early May, before finding some support after announcing a new partnership with Google, looking for opportunities in the consumer and enterprise health market. However, that too was short-lived as Fitibit shares then suffered following its mixed set of Q1 earnings and concerns over the falling demand for trackers.

While Fitbit is trying to move into a growing smart watch market it is still heavily weighted toward its range of trackers which, as a general product, seems to be falling out of favour. This is placing pressure on the firm to adapt to the market before it is too late, and before the same familiar players like Apple come in and dominate.

What to expect in Spotify’s earnings for the second quarter of 2018

Going forward, Spotify has provided guidance for its upcoming Q2 results, and has reiterated its expectations for the full year.

While some investors may have been disappointed with the growth in user numbers in Q1 of the year, Spotify is expecting the amount of premium subscribers and ad-supported users to soar in Q2. Spotify expects to end June with between 198 million to 208 million users, of which between 92 million and 96 million will be premium subscribers. If achieved, Spotify would have delivered one of the fastest rates of growth managed in a quarter over the past two years.

Q2 revenue will be between 1.1 billion and 1.3 billion euros, as foreign exchange continues to hold back growth, and the gross margin should hold steady or improve further to land somewhere between 24% and 26%. Together, they should help Spotify’s underlying losses to shrink even further. However, the overall operating loss will swell in Q2 to 60 million to 140 million euros, as Spotify plans to book 30 million to 35 million euros in costs related to its direct listing.

Spotify guidance: what to expect for full year 2018 earnings

Spotify’s guidance for the full year should provide confidence to investors that the company will remain on track this year.

The rate of growth slowed significantly in 2017 compared to the year before, and investors will be wary that Spotify is expecting that slowdown to continue this year. Still, Spotify is expecting to report double-digit growth in revenue and customer numbers this year. This is the annual growth that Spotify has delivered over the past two years, and the growth it is forecasting for 2018:

Spotify is learning the lessons of going public

Spotify has a lot going for it. The company has transformed an ailing music industry and introduced a new model to sweep the market from right under the previous market leaders like Apple and Google. Losses are shrinking, users are growing, conversion of free users into subscribers is high, churn among existing customers is low, and the company has a swathe of growth opportunities in both audio and video, as well as in advertising.

Expectations may have been set high for Spotify, which has been regarded as the most notable new addition to the NYSE this year. Some tech firms are expected to deliver exponential growth and while Spotify has so far delivered, momentum is likely to slow.

Apple is fairly tight-lipped on the growth of its individual digital content arms like Apple Music. Investors will be right to worry about the threat that Apple (and others) presents, and Spotify will have to continue to demonstrate its lead over the competition in order to allay any fears.

Still, Spotify looks like it could turn to profit much quicker than some previous tech firms, despite facing some unique challenges, and the sooner investor’s expectations are more aligned with that of the company then the sooner they will all be humming to the same tune.