Welcome to Spotify's 2019 Second Quarter Financial Results Question and Answer Session. A copy of the company's shareholder letter issued pre market open today is available on the Investor Relations website, investors. Spotify.com. This call is being recorded. An archived replay will be available on the IR site after the event concludes.
I'll now turn the call over to Paul Vogel, Head of Investor Relations and FPA and A. You may now begin your conference.
Great. Thank you, Denise, and welcome to Spotify's Q2 2019 earnings conference call. With us today are Daniel Ek, Spotify's CEO and Barry McCarthy, Spotify's CFO. The format of today's call will be similar to prior quarters. Daniel will give brief opening remarks followed by an online question and answer session.
Questions can be submitted either through the widget alongside the webcast or by emailing directly to irspotify.com. We'll get to as many questions as we can. The call will last approximately 30 minutes. Before we begin, let me quickly cover the Safe Harbor. During this call, we will make 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 and in our letter to shareholders and filings with the Securities and Exchange Commission. During this call, we will refer to certain non IFRS financial measures. Reconciliations between our IFRS and non IFRS financial measures can be found in our letter to shareholders on the Financial section of the Investor Relations page of our website and also furnished today on Form 6 ks. And with that, I will turn it over to Daniel.
All right. Thanks, Paul, and thanks, everyone, for joining today's call. Overall, the business performed well in the Q2. A key metric that illustrates the health of our business is user engagement. In this quarter, our users listened to more than 17,000,000,000 hours of content on the platform, up 35% year over year.
And as you saw in our shareholder letter, all of our key metrics finished within or at the high end of our forecast except for quarter ending subs. Our goal is to land at roughly the 70th percentile of our guidance and we missed on subs. That's on us. The good news is the shortfall was execution related rather than softness in the business and we expect to make up the lost ground before year end. At our Investor Day in April of last year, we said that we're still in the early innings of the growth of the streaming audio market, and we still believe that's true today.
As you can see from our Q2 results, we're really expanding the top of our funnel. Ad supported MAU growth accelerated in this quarter for the 2nd consecutive year and was our fastest year over year growth rate since 2016. In Q2, we also delivered 31% year over year subscriber growth, which we believe is roughly twice the rate of growth of our nearest closest competitor. We have also reached agreements with 2 out of 4 of our major label partners on the renewal of our global sound recording licenses, and we're in active discussions with the other 2. And this is the 6th round of label negotiations that we worked through in our 13 year history.
And while it's typically a long drawn out process, it's really part of our normal cadence. To reiterate, one of the primary goals for this round of negotiations is about enabling our 2 sided marketplace strategy. Our development of this strategy is well underway, including testing and prototyping products with a few key partners. We see a tremendous potential and there will be more to come in 2020. Now let's open the floor for questions.
Great. Thanks, Daniel. Our first question comes from Mark Mahaney at RBC. Could you talk a little more about the key drivers behind churn reaching record low levels? How should we think about this churn percentage trending over time?
Should it hold relatively steady from here or continue to move downward?
Hi, Mark, Barry. Well, look, as we continue to make investments in improving the overall quality of the user experience, both from a content perspective and with respect to the features and functionality of the app and our ability to understand people's likes and dislikes and deliver content to them that they will engage with. We ought to continue to see that higher customer set leads to lower churn. So a year over year basis, we were at 5% monthly average churn in Q2 of last year down to 4.6% this year. I expect that trend will continue unless there's some dramatic shift in product mix, say, away from some of our lower value plans to higher value plans, and we're not expecting that to happen.
So the strategic goal of the business is to continue to invest aggressively in improving the user experience and if we make wise investments, then we will continue to see longer lifetime value. So today users are worth more than they were a year ago, principally because the LTV to SAC ratio, which at the time of the Investor Day was sitting at 2.5x to 1. It's now sitting at about 3.1:one.
Great. Thanks. Our next question comes from Eric Sheridan at UBS. How should investors think about the framework of investments, content, M and A, gross and operating margin impact, the long term opportunity in podcasts? And how are you thinking about the long term return in terms of driver of subs engagement and monetization?
Well, I can answer that. I think overall, we're still to level set in the growth phase of the business and very early on, as I mentioned in my opening remarks of the streaming audio market. And there are a number of levers we can pull when it comes to growth. One is, of course, investment in product capabilities. And you saw a number of those over the course of this quarter.
The second one of those is, of course, improving our content portfolio and just the range of content that we have on the service and you saw a bunch of that happening over the course of quarter too. And the third is pricing. And pricing obviously ends up being a function where we've said for a long time that we believe in the current pricing strategy that we have in order to drive future growth. But we're actively investing a lot in both improving our product capabilities and the content mix on the service.
Great. Our next question comes from John Egbert at Stifel. Great news on reaching agreement with 2 of your major label partners. Are you able to discuss whether your new deals offer more flexibility for bundling services with partners and or carving out revenue attributable to podcasting? In general, how do your label partners feel about podcasting becoming a bigger part of consumption on the platform?
I can't disclose specifics about the deal terms that we have with any single partners. What I can say is that the primary focus for these round of negotiations has really been about enabling the marketplace strategy. And that marketplace strategy enables more from each and every one of our content partners and creators to do on the platform. You can see already early evidence of that when we have vertical videos, we're creating the Spotify Singles is a great example where it's a format where artists are covering songs of other artists, including some of their own in acoustic settings. So the whole purpose of that is just enabling artists to directly connect with fans in much bigger ways than what they're doing today.
So that's definitely part of that mix. And then as it relates to podcasting and the impact it's having on the overall platform, we've said it before, but I'll say it again. What we're seeing right now in terms of podcasting is it's really accretive both in terms of overall user experience. And we find that the people who are listening to podcasts are also listening to more music, I. E, really good news for the whole industry.
Our next question comes from Doug Anmuth at JPMorgan. With marketplace services set to launch in early 2020, do you expect these products to be revenue generating or cost reducing, meaning are they incremental revenue or more closely tied into label deals and a way to improve label economics?
This is Barry. For the most part, Doug, we expect them to be margin enhancing.
Next question comes from Nick Delphast at Redburn. You record 30% of revenue growth and no label records that high in streaming revenue. UMG was 23%, Sony 27%. Are the majors losing share or is it about geographical mix?
I can't speak to exactly what our label partners' growth rates we're looking at. But what I would say is, it's probably a mix of their overall business. So remember, not the entirety of the music industry is streaming yet. We are obviously hoping that streaming becomes an even bigger part of the music industry, but they are still very much physical businesses, streaming businesses and many other parts that makes up the total revenue mix. So that probably explains the delta.
Next question from Ben Swinburne of Morgan Stanley. You called out execution on student plan as a driver of net add shortfall and not demand or competition issue. You give us more color on your conviction and with execution, definitely do you think this new higher advertising growth rate is sustainable through the second half?
Let me take them in reverse order. Our guidance reflects our expectations about the ad business. I think the year over year growth rate will come down slightly. I don't think we'll sustain 34% year over year on the ad business, particularly if you recall that we had exceptionally strong Q3s and Q4s a year ago and from a year over year growth perspective. I'm sorry, can you repeat the first part of the question?
It was about the missed student.
Oh, no. On students. Well, we can see what the results were versus our own forecast on a kind of by line basis, which is why we know where we missed and how much we missed by. It was less than $1,000,000 in aggregate. I think the consensus I've seen 2 consensus forecasts, 108.8, 108.5, which is how I know we missed by less than a 1,000,000.
The problem with the execution was we didn't tell anything about anybody about it. So it was only if you stumbled across it randomly by chance. If you were a user that you would known it was in the marketplace, we had no marketing support for it at all. So that's on us. It's relatively easy fix.
It's just one that got away from us in the quarter. And I think there was a question about competition and how we're growing relative to comps. And we said we think we're growing at roughly twice the rate on a monthly basis. That's based on the last public disclosure from our next largest competitor about how they're tracking as compared with their previous public statements as compared with our own. I know relative market growth was a concern for investors a couple of quarters ago.
I think at least the most recent comparison shows we've got very strong traction in the business.
Our next question comes from Brian Russo of Credit Suisse. Regarding the direct upload and artist distribution offering you recently shut down, can you discuss the motivation to exit this business, if you have not already? And could you also give us some perspective on how material the investment in this area has been?
The first thing, just to as a bit of an education, we do a lot of experiments at Spotify when it comes to our product capabilities. And so as you saw in the general consumer sense, you've seen us now expand on Spotify Life going from beta into a full Formula 1 and now Spotify stations being in beta rolling out to more markets. So the direct upload capability was one of those beta programs. And as it happens with some of those experiments, they just don't pan out to the same extent that we originally believed and therefore we made the call to refocus our efforts elsewhere. Now, as it relates to what we're focusing on, we're very much focusing on the marketplace side of the business.
And in there, we're actively prototyping away new products together with our partners. And we're really excited about that and we hope to come back in early 2020 with more data on that.
Our next question comes from Matt Thornton at SunTrust. You guys had mentioned that one of the things you want to get out of the label renegotiations is the ability to optimize ad load by user. How impactful would this be to engagement retention and monetization, I. E. Would this be a needle mover?
Barry, not clear yet based on our experience in the marketplace. So it's still a hypothesis that we embrace. We don't have data to prove or disprove it yet.
Justin Patterson at Raymond James. You mentioned reinvesting the podcasting at reinvesting in the podcasting ad experience by building out a new tech stack. Can you talk a little bit more about the challenges you need to overcome and what extent you can leverage your existing tech stack from music?
Well, the tech Shack and podcasting today is ads embedded in RSS feeds. I don't know anything about your likes or dislikes. It's like an FM radio ad. Maybe at best you know something about the demo over the audience you're delivering against. And we think we can do considerably better with digital ad insertion technology that enables to have a much more targeted user experience.
So that's what we strive for.
Next question comes from Ross Sandler at Barclays. What new geographies could you move into over the next few years that you aren't in today? Secondly, how is the India launch gone compared to your expectations?
Well, in the terms of markets, obviously, our ambition is to be in every market in the world and we're currently in 79. So there's still some room to left to grow, primarily that relates to Africa, Russia, South Korea among a few. And we did mention India specifically in the shareholder letter. It's growing in line with expectations and just to level set the outperformance on MAU is not related to India. We're pleased with the progress of India, but that's not the explanation to the outperformance.
While we're at it, would you want to give a little more explanation of why they upset MAU for the quarter?
Yes. I mean, as I mentioned, in terms of the rate of experiments that we're doing here at Spotify, I know everyone wants to know that the single sort of attributing thing that caused the outperformance. The truth of the matter is, it's not one thing. It's a lot of small things that adds up to a much better experience and that better experience then translates into a higher user growth, better engagement and lower churn. So you saw us ship a number of large initiatives like Spotify Lite and Spotify Stations in the quarter.
We also would have been able to see probably 50 to 100 minuteor experience changes that all in all leads to higher engagement, which leads to higher retention in the business. And that's for me the exciting thing right now is that there's a lot of those kind of small tweaks that we can do that in aggregate really compounds into an overall better experience and increases engagements.
Our next question comes from Heath Terry at Goldman Sachs. Given the slight shortfall in subscribers and the profitability leverage you saw elsewhere in the model, any reason you aren't investing more in subscriber acquisition? Is it a function of SAC limitations? If so, how does lower churn impact the way you're thinking about SAC? And are you willing to accept the SAC you're willing to accept in the business?
Nothing's changed in terms of the way we think about marketing. By way, a reminder, there are couple of different ways to grow the user base. 1 is to invest in marketing. 2 is to invest in the user experience. The two forms of user experience investment are 1, investing in the amount of content available on the platform, sync podcasts, and we're very aggressively investing there.
The other is the quality of the user experience. Examples include what Daniel just described. And it's basically about enabling users to have a better user experience because we have a better understanding of what kinds of content they will want to be exposed to and engage with. And we're investing very aggressively there, primarily technology related investments, which is people and engineering know how. So there's nothing about the current performance of business that is causing us to rethink the asset allocation decisions we've made to drive growth and those are principally the user experience, engineering know how and content.
The next question comes from Maria Ripps at Canaccord. Your full year gross margin outlook implies upside from prior guidance. Can you talk about the key drivers there and whether the 2 label agreements you mentioned in the press release are expected to bring some leverage? Can you also refresh us on your long term content cost structure for music and non music?
So the new label agreements are not contributing. Our expectation is that the other two agreements when completed will also not contribute, which is consistent with the expectations we've told you to have for the label agreement. So we have made so why are we outperforming? Couple of things. One is, our P and L expense related to podcast investments is a little bit lower than we were expecting it to be at this stage in the calendar year.
We're spending as aggressively as we thought we would on podcast, but it's not finding its way to the P and L as quickly as we thought it would. And then secondly, we have been pursuing a number of investments to reduce our costs of delivering content to users. Some of these are cloud related costs and we've had good progress there and we've seen some savings as compared with our expectations.
Next question is from Jefferies Ehrlich from Bank of America. Can you give us color on the markets you're shifting from physical to digital like Japan and Germany?
Yes. I mean, as it relates, I think it's there are some markets that are more physical than others and have sort of a longer lag in terms of adopting that. And there are some that are much quicker. I honestly wouldn't be able to say what's the contributing factors to that other than to say that typically what we found is that broadband matters tremendously. Smartphone penetration matters tremendously.
And so to the effect that there are new developments like 5 gs and so on, we expect all of those catalysts, including other services progress like video subscription services, etcetera, to educate people that paying for content online is a much better value proposition. I think that's what we're seeing in some of those markets now. It's just a general acceptance that ownership is not the prevailing form and that shifts the industry and the norm. And then eventually what happens is that the artists and creators start embracing that and start marketing that as the primary way for people to enjoy their content, as well. And I think we're starting see that happen in a big way in Germany and much earlier so in Japan.
But I expect that trend to continue.
Our next question comes from Mark Kelly at Incinet. Can you discuss the long term view on what form podcast content might take? What's the right way for us to think about the mix of longer shelf life content versus more news oriented content that we'll have to refresh consistently?
Well, overall, I would just say, this is an entirely new medium, not unlike maybe in the past radio and just general audio services. So the number of verticals, while the general perception today is that it's typically pretty male dominated, very techie talk shows the engagement that we're seeing in terms of our content is we're seeing good progress across scripted contents, true crime being, a massive category for us and growing very, very fast. But we're also seeing, of course, music podcasts growing very fast, which if you look historically in podcasting, that's not been a big category, but that's becoming a much bigger one. So news actually ends up being, which were shelf life, ends up being a smaller part of the overall mix. But we expect the ranges of categories of content to be broadened as new creators find its way to the media.
Next question comes from Lloyd Walmsley at Deutsche Bank. As you think about integrating better ability for music labels and strain what you're willing to do here over the near and longer term? How do consumers feel about this in your survey work?
Yes. Overall, I would just say that there's typically when we look at these type of developments when the products we look at things as in polar oppositions. So if it's good for one side, it has to naturally be bad for the other side. That's not at all what we're finding. Instead what we're finding is it's actually enhancing.
So if you look at the number one thing our customers are saying is help me find more great music. And the number one thing our artists are telling us is help me connect with my fans. And so it's actually the same question both are asking us to help solve. So we believe that we can do something that's net positive from a user experience point of view, while at the same time, also helping labels and artists with a real pressure point for them, which is that they today have to participate in the marketplace by spending a lot of money going on to other digital platforms, marketing that content in a non native environment where you then have to click a couple of links and then end up a minute or 2 later listening to that content. So if you really think about it from a user point of view, it's a much better experience to have content being promoted to you next to where you're actually listening to that content.
So we think it's a net positive for the user experience and a net positive for the music industry.
I think Boyd wants to know if you're going to promote content that say Paul doesn't care about in order to drive revenue? The answer to that is no. Yes.
Next question comes from Kevin Rippey at Evercore. In the release you note if and when you commercially launched the 2 sided marketplace products, specifically on the if part of that phrase, what would be the factors that would prevent a commercial launch?
We don't see anything at this point that would prevent us from launching products. We may tweak what those products are. We may evolve them and you should probably expect that. This is really just generally as we look at product and tech developments, it's an iterative approach that we learn based on the feedback we get from customers and partners alike. So you're going to find that whatever we're launching with, it's going to evolve over time.
But it's more around a when rather than an if.
Next question is from Gia Son Salati from Macquarie. What is Spot to View on audiobooks?
Overall, interesting segment. Again, my view is, it's obviously massively growing. I would say though that when you look at the podcast that we have, say, in True Crime, there really isn't that much of a difference between those and some of the audiobooks that are available. So I think in the future of audio, we're going to have an interesting development where we need to think long and hard about what are the optimal format for consumers. Are we talking about an 8 hour type of programming or 2 hour programming and there's going to be a ton more experimentation I think across the board.
Can you update us on the Samsung partnership? When did it launch? Did it have an impact on 2Q? Thoughts on the second half impact and how is SAC accounting for? I'm sorry, that's from Jason Helfstein at Oppenheimer.
I can start with the first part of it. So the partnership is going well. We are actively rolling out more and more, obviously being on more and more Samsung devices being the sort of key partnership. It is contributing to our growth. I wouldn't say it's a super material part of the overall growth numbers yet, but it's an important partnership for us.
We're happy with it. We're happy with the future product roadmap that we have together with Samsung.
Next question from Michael Morris at Guggenheim. Given that gross margin expansion in 2Q was driven by operating efficiencies, why does guidance not imply similar expansion in 3Q and 4Q?
It wasn't just driven by operating efficiencies, although that was a contributing factor to it. We also saw lower promotional related expense find its way into the P and L 1 month of promotion instead of 2. And we also had lower content costs related to regions and product growth. So all those three factors were drivers.
Next question is from Thomas Singlehurst at Citi. There have been reports that you overpaid royalties to songwriters and publishers. Have you quantified this? And will this one off be resolved one way or another by the end of 2019?
No, we haven't quantified it.
Next question comes from Mark Gutowitz at Rosenblatt. Please discuss outbound marketing plans for podcasts, timing and relative spend and rate your curation of podcast content and importance an important correlation to rising podcast listenership.
We don't actually talk about marketing spend related to individual types of content. So I don't have any comments there. In terms of curation or I think I misunderstood the question is how do we promote content to individual users based on our understanding of likes and dislikes?
I believe so. It was about curation of podcasts.
Yes. I mean, overall, I would just say, we're still in the early innings. We have some raw capabilities, but we are actively developing better and better machine learning models that help us specifically as it relates to podcasting. And we expect over time that it will contribute a lot more than what it currently does in terms of our ability to drive further engagement in podcasting.
Next question. What is Spotify's view on other monetization methods such as micropayments and tipping by fans on the platform?
It's something that we are overall interested in. We definitely look at it as part of the scope of the marketplace types of tools and services that you can expect. I don't know the specifics around which one of those things you should be expecting. But again, the genesis really in the company is to experiment a lot and based on the feedback that we're going to see, we're going to roll it out more broadly or we won't. And so you should expect us to try a lot of different things among some of them the things that you're asking about.
And it certainly could be very interesting specifically for a lot of artists.
I'll take 2 more questions. One from Richard Kramer, Arit. What do you think has allowed Apple's success and about them overtaking Spotify in the U. S? Can you address this?
Well, I don't know the specifics about what numbers they claim to have in the U. S. Relative to ours. The only thing we can say and it's really that we're focusing on our own growth and we're still seeing great numbers in North America and across the board. As mentioned, we're seeing an increase in the top line growth of the funnel, which typically correlates to stronger engagement.
The stronger engagement typically then correlates to stronger conversion to paid subscribers and that in turn means also in this case that we have lower churn. So that's the predominant way of focus that we have. All of our competitors have their relative strengths. Ours is our investment in freemium, in personalization and in ubiquity, which means we want to partner with all players out there in all of the different verticals. And some of those are Microsoft, Samsung and others and you should expect us to keep investing in all of those
pillars. Thanks. And our last question, do you have any update on the status of your complaint against Apple at the European Commission?
Really no update at this point. It's a process that takes quite a lot of time. So you shouldn't expect a speedy sort of response back on that. This is really kind of a multiyear effort.
Great. We did a lot of questions this time. I think folks are starting to figure out our earnings call. So if we didn't get to your questions directly, we'll try and get to you individually or you can always email the IR box and we'll try and get back to you. And with that, I'll turn it over to Daniel for a quick closing comment.
Yes. I just wanted to say again, I'm really excited about this quarter. I'm very pleased to see the engagement increasing and the top of the funnel increasing. And yes, look forward to coming back to you all for the Q3.
Thanks everybody.
This concludes today's conference call. You may now disconnect.