Welcome to Spotify's 4th Quarter 2018 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 and an archived replay will be available I will now turn the call over to Paul Vogel, Head of Investor Relations and FP and A. You may now begin your conference.
Great. Thanks, Josh. Thank you, and welcome to Spotify's Q4 fiscal 2018 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 the last few quarters.
Daniel will give a few 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 and 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. Our 4th quarter results were strong and outperformed our expectations. During Q4, our footprint expanded to 78 countries from 65 as we launched our service across 13 countries in the Middle East and North Africa in mid November. We also reached an important milestone as users listened to more than 15,000,000,000 hours of content on the platform, and we surpass more than 200,000,000 monthly active users worldwide.
That's very impressive growth, but we have a much bigger vision for what this business can become. And that is why I've shared a blog post outlining our vision as an audio first company and our mission to become the world's leading audio platform. Today, audio is only oneten of the size of the video market. So there is a massive opportunity here for audio to evolve into a more personalized, more immersive experience, much like how the video industry has evolved. We believe that over time, more than 20% of all listening on Spotify will be non music content, and we strongly believe that this opportunity in audio starts with podcasting.
I believe podcasts will continue to evolve in endless ways to tell stories that entertain, educate, challenge, inspire, and bring us together and break down cultural barriers. We've only just dipped our toe into the podcasting space, and already, Spotify has become the 2nd biggest podcasting platform in the world in just under 2 years. We're still considerably smaller than our largest competitor, which means that there's tremendous opportunity for continued fast growth. Our users love having podcasts as part of their Spotify experience, and our podcast users are almost twice as engaged as non podcast listeners on our platform, and as a result, spend even more time listening to music. While podcasting is still a relatively small business today, I see incredible growth potential for the space and for Spotify.
Today, in addition to our earnings, we announced the acquisition of 2 podcasting companies, Gimlet and Anchor. Gimlet is one of the best content creators in the world with unique celebrated podcast shows like Homecoming, which was recently adapted into a critically acclaimed show on Amazon Prime, and the Internet culture hit Reply All. Anchor is the leading publishers for new podcasts globally and has completely reimagined the path to audio creation and enabling distribution for the next generation of podcasters worldwide. We're really excited to welcome these incredible, creative and talented companies to Spotify. And with these acquisitions, we will offer the best content, the best discovery and the best user experience for consumers.
And we're also positioned to become the leading platform for podcast creators as well as the leading producers of podcast globally. As I hope you can tell, we're very confident about our path forward and we strive to become the world's number one audio platform. And with that, let's open the floor for questions.
Great. Thanks, Daniel. Our first question comes from Justin Patterson at Raymond James. Daniel, your For the Record blog today mentioned that the competitive set could evolve to face other forms of entertainment and informational services over time. Please elaborate on that point and how that influences long term engagement.
Should your goal to have non music content represent 20% of listening hours be perceived as purely incremental to listening
Well, there's this huge space today, which is radio, which currently is about 2 hours of listening globally every single day. And in that space, much like in the video space, we're going from a linear world to an on demand world. So that listening is moving online. And as part of that, Spotify is already a huge part just with music alone. And what we're seeing with podcasts is that the users who are listening to podcasting on the platform is almost twice as engaged on the platform too.
So we do think there's a huge opportunity not just to get new users onto the platform, but get our existing users to engage way more with the platform as well.
Great. Our next question comes from Michael Pye at Bally Gifford. For Daniel, please may you offer some color on how you progress your mission of enabling 1,000,000 artists to live off their art? By that, I mean both numerically, I. E.
What metrics do you consider to be most important, or also qualitatively through artist engagement and tools like Soundtrap and direct upload?
Well, it's a metric that we track internally quite a lot. We look at specifically how many of artists that are reaching more than 10,000 fans per month, how many of them that are reaching over a 1000000 listeners per month as well. And that number has shown very, very steady progress across both of those groups of artists. Obviously, the lower end of this tier may be the difference between whether you're a part time musician or full time musician, and the upper end of this tier is whether you're becoming a global superstar or potential superstar. So that's a sort of quantitative way of doing this, but we're also obviously trying to reduce the barriers because the truth of it, as I've mentioned on previous calls today distributing a record while in theory it's very cheap to put it on the Internet, The reality is it's just way more competition to get heard and it's harder than ever, which means that record labels, publishers and everyone in this industry has to spend a lot more capital in order to promote and market these acts.
And we want to bring that cost down, make the system more efficient
for everyone.
Our next question comes from Ross Sandler of Barclays. 1Q 2019 gross margins are being guided down year on year and this is likely before the signing of the new label agreements. Any color on what is driving this decline given the expansion experienced throughout 2018? Is that just a 30 basis points from acquisitions or anything else you can call out? What are the factors driving gross margin to decline in 2019?
Mos, let me answer it this way. If the question is, what's the gross margin structure of the business at the core business ex podcast and related investments and related acquisitions post the new label agreements, we see it unchanged from the margin structure in Q4 of 2018. So in Q4 2018, the margin was 26.7 points of onetime nonrecurring items. So think of the base business gross margin as, what would that be, 24.8? 25.8.
Excuse me, 25.8. Think I'd be able to do that in my head, 25.8 on a go forward basis post label renegotiation. So what you're seeing in our the delta that you're seeing in our forecast consists of all the costs associated with the acquisition, the cost of running their business, plus some of the transaction related expenses that find their way into the P and L, plus increased investments we're making on our own independent of the acquisitions in the to originate podcast content on the platform.
Our next question comes from Doug Anmuth at JPMorgan. On the heels of the acquisitions announced today, can you talk more about your podcast strategy? What have you learned thus far around how podcasts attract the users on the platform? Do they listen to music more than the average Spotify user? What does the model look like for podcast exclusivity in terms of upfront costs, ad revenue sharing and contract duration?
Well, I will want to say that we're still kind of early on in this game. That said, in Q4 alone, we had 14 shows exclusive to Spotify. And what we're seeing from those is a few different things. We're seeing, as I mentioned earlier, that people engage almost twice the rates than non guest listeners. We're seeing that there are users who wouldn't have considered Spotify otherwise that are now signing up to the platform.
And then thirdly, you could probably guess over time that, that may have an implication on churn, although we don't know that at this point. So I think we're encouraged by the early results. I think in terms of the deal structure on these podcasts, it's still something that we are experimenting with. But we are certainly in the game of producing more of that content ourselves.
Next question comes from Rich Greenfield at BTIG. While the high end of your guidance assumes a meaningful acceleration in net adds, curious where the bottom end of K sub guidance before it gets a slowdown in net adds versus 2018? What are the key swing factors?
We have 2 Rich, there are 2 objectives in giving guidance. 1 is to help you understand where we think the business is going to land and the other is defensive. So the ranges are in there for defensive reasons. In terms of expectations of performance, we've told you our intention is to land at the 70th percentile of the range of the guidance we give. So sometimes shit happens.
When that happens, we might end up at the bottom end of the range. It's not likely. It's not the expected outcome, but it could. And so we build it into a forecast.
Our next question comes from Anthony DiClemente at Evercore ISI. You talked about churn increasing sequentially in Q1, but that this was seasonal given Q4 campaigns. Can you talk more broadly about promotional activity? Is it possible that these promotions are encouraging consumers to jump in and out of competing
services? Let me jump in here, Anthony. The year over year trend in churn is down. There are seasonal churn effects associated with, let's say, the holiday campaign in our business just like there was at Netflix. But the macro trend here is increased engagement, increased retention, lower churn.
And I want to talk about the implications for lifetime value as a result. We frequently get questions about ARPU, and I know investors have lots of concern about the continued decrease in ARPU. But from where I sit, when we look at the three-dimensional chessboard, factor in the better user experience we've provided, we don't see a decrease in revenue. In fact, the subscribers who are paying us at a lower ARPU are earning exactly the same lifetime revenue in Q4 of 2018 that they earned in Q4 of 2017 because churn has decreased. The 1 divided by the lower churn rate is more months of service at a lower ARPU is exactly to the dollar the same lifetime revenue.
Now it also happens that we have higher gross margin on a year over year basis. So the contribution profit from that same revenue stream is actually higher. The labels are earning the same amount of revenue they earned a year ago even though the price is down. We're growing faster and subscriber acquisition costs are down on a per subscriber basis and the LTV to SAC ratio on a year over year basis is up by 40%. So point being, this is about driving a virtuous cycle, improving the user experience, podcast is another dimension and driving more lifetime value and driving more profit as a consequence by investing in the user experience.
Our next question comes from Matt Thornton at SunTrust. Any color on early impacts on the Samsung partnership, the Google Home promotion, student plan bundle, etcetera? How prominent will new distribution partners and promotions be going forward?
Well, as we said during our Investor Day, ubiquity and being on all platforms is an important part of the Spotify strategy. We're already on over 500 different devices, including, of course, TV screens, voice speakers, cars, etcetera. So it's a hugely important part for us to try to do those types of partnerships. I can say that with the breadth of partnerships that we have that can single out any of those partnerships over time. That said, Samsung obviously remains a very important partner to us as does Amazon and Google and others in the space.
Our next question comes from Ben Swinburne at Morgan Stanley. Given the guidance for gross margin compression in 2019, can you explain what drives it to your long term gross margin guidance of 30% to 35% and what that timeline looks like? Additionally, what's driving the gross margin pressure implied in the guidance?
Well, let's just kind of level set. Nothing has changed in terms of our long term guidance of getting there. As Barry mentioned, this primarily is about our investment in original content and then it is primarily about driving virtuous cycle. What we see very clearly, yes, we're investing in more podcast content as engagement goes up. As engagement goes up, we both broaden the appeal to new users, but we also increase the engagement of the existing ones on the platform, which drives down churn, which in turn makes the business overall much stronger.
That's the continued path. And if that happened and if you also layer on top of it our marketplace business and the trend where gross margin on the core business keeps increasing, that's our expectation that this will happen over time as well.
If I could draw a Netflix analogy, and remember when we launched streaming at Netflix 1st year, we spent $50,000,000 and then every year after that, we doubled it. And it came right out
of the margin structure of
the business, but it greatly enhanced the value proposition for users. And over time, it shifted the cost structure from variable to fixed. There are many similar analogies that have the opportunity to play out here as well. And in addition, there's an ad revenue dimension to this because currently, ads are embedded in podcast to both free and paid user
base. Our next question comes from Jon Egbert at Stifel. In your first two podcast acquisitions, it looks like one was about technology and the other about content. In regards to the $400,000,000 to $500,000,000 you have earmarked for acquisitions in 2019, do you expect to be more focused on acquiring content or technology? And more broadly, can you explain why it makes more sense to take ownership of spoken word content when you're historically been hesitant to own music content?
I think they're 2 very, very different businesses. We've spoken in the past about the music industry not being a space where exclusivity makes sense for a number of different reasons, but including one of them that music radio can put any piece of music up, so exclusivity won't have the same effect as you won't be able to keep it exclusive. And the second thing obviously is the artists and the label have the incentive to push the content out in as many places as possible because so much of an artist revenue derives from touring. I think in audio and certainly in podcast, the dynamics is very, very different. And what we're doing here and what we're excited about is really building the market.
It's at a very, very different stage of maturity. So we're investing in that and we think we can be one of the tentpole players in that space. And as Barry mentioned too, that affords us a very different economic model long term.
Jon, the only other point I'd like to make is that out of the $400,000,000 to $500,000,000 in which we have a line of sight, the 2 acquisitions we announced today are included in that number. The number is not additive to the cost of the acquisitions we announced today. More likely than not, any additional acquisitions will be in the podcast space. We're not commenting on whether it's infrastructure content.
Okay. Our next question comes from Mark Kelly at Instinet. What's embedded into your full year guidance in terms of premium ARPU declines and ad supported ARPU growth?
ARPU decline of about 5 percentage points. Sorry, the second part of the question was?
Growth in ad supported ARPU.
Yes, we don't break out that level of detail. I will say that on a CPM basis, we saw pretty strong growth across the ad business in Q4, particularly in the video space where the growth was significant.
Next question comes from Heath Terry at Goldman Sachs. What are your goals around royalty rates, product offering, content or geographic access, data and marketing sharing, etcetera, in your negotiations with the labels? What do you believe their goals are in these negotiations beyond royalty rates?
Well, as I've said before, I think the primary focus of these upcoming renewals is really around the marketplace strategy. The marketplace strategy is important because it's not a win lose scenario, but it's truly a win win scenario. By building tools and services for the music industry, we can make the music industry more efficient, thereby jointly benefiting together with the music industry at that. That also happens to be one of the bigger points for the music industry. But if I would boil it all down to one thing, it's continued top line growth being the number one focus for everyone in the music industry.
Next question comes from Lloyd Walmsley at Deutsche Bank. Your release underscored the importance of smart speakers for driving audio content. Do you think this was a core driver of premium sub ads engagement or both? What more can you do here beyond the Google Home promotion?
I'll let Daniel talk about growth in the audio speaker ecosystem and our strategy for success there. With respect to the Google Home promotion, as I think we said previously, that plus the holiday campaign were big drivers of growth in Q4 and we see additional opportunities for growth and bundling in the hardware space.
Yes. I think my only addition is it's a fast growing segment for us. We see meaningful engagement from the customers that are using it. We're well positioned on all these platforms. Customers are asking for Spotify and want to use Spotify, whether on an Amazon Alexa or on a Google Home Speaker.
And obviously, because of our ubiquity strategy, we want to be on all of these places and we're working with all of these partners and getting there.
Next question comes from Michael Morris from Guggenheim. Do you pay the all in copyright royalty rate as established by CRB last year? If you pay less, as we assume, can you share why and help quantify the rate that Spotify pays?
Well,
it so happens that when the CRB rate was retroactively applied in Q4, It was a net benefit for us. Importantly, the question is what happens on a go forward basis, and it's roughly neutral in our guidance for 2019 and by 2020 it starts to incrementally erode the margin.
Next question comes from Mark Mahaney at RBC. Can you provide more color on the traction for the recent launches in EMEA?
Yes. We're pleased with the early results, as I mentioned in the introductory remarks. We launched mid November, so we have about 2 months now of data. All of the markets are looking good. We're seeing good take up rates and we're seeing customers be very excited about Spotify.
Next question comes from Jessica Reif from Bank of America. What is the path to making podcast acquisitions and podcast investments accretive to gross margin beyond 2019?
Having great content is the long and the short of If we can drive a virtuous cycle, we'll win. If we can't, we won't. And virtuous cycle means investing in content that people engage in, seeing overall engagement increase. As a result, the increased engagement, they find more value, so they stay longer. So retention's up, churn's down.
Because they're excited, they tell more friends about the service. So your mix of pay versus free acquisition shifts in favor of free. So your subscriber acquisition cost goes down. Even if your gross margins remain constant in that scenario, lifetime value is increasing, you're driving more contribution profit to the bottom line against your cost base. Plus, over time, you're shifting your cost base from variable to fixed, which created an enormous amount of operating leverage at Netflix, you may recall, with the growth in streaming.
That won't be true for us initially, but I think that will become part of the equation over time.
Next question comes from Victor Hovland at SEB. On the 2 M and A done today, are you paying in cash or equity or debt or combined? Any indication on users revenue and price? Is this mainly a user intake potential or churn potential or combined?
I'll let Daniel talk about the potential piece of it just in terms of the numbers. It's cash. The price will be disclosed in the fullness of time in our SEC filings.
I'm
not commenting on that today because we have other transactions in the works and I don't want the transactions we're closing to bleed over into deals we may be negotiating.
I think my addition is it's really just both here. Why we're doing this is obviously to get a larger library of content and that content is attractive to new users coming onto the platform. But as we're also seeing very clearly from our data, it's also attractive to the people who are currently using Spotify as they're engaging with them. As Barry mentioned, if they're engaging more, that drives this virtuous cycle.
Okay. Our next question comes from Eric Sheridan at UBS. When a new region launches Middle East or India, how should investors or analysts think about the upfront cost and investment? How the sub base might scale in medium term margin structure, especially versus other developed markets?
Well, it's pretty straightforward. Initially, we're out of pocket. So growth is a net drag on profitability. The size of the initial investment informs us about how big a drag it is. Quite often, there are minimum guarantees that are negotiated with labels.
Sometimes gross margins are negative as we scale the business. You see a change in the margin structure as a result. We saw that quite dramatically with respect to the free business This past quarter, the investor letter talks about the significant growth in gross margin resulted from scaling of the free user base. So over time, we move from negative gross margin to positive gross margin to more positive gross margin in the acquisition. Cost improves as well.
Great. And a follow-up from Rich Greenfield. You cannot do exclusives in music, but you can in podcasts. How important is that to your strategy to differentiate from your peers?
Exclusive is definitely an important part of our strategy. Just to be very clear though, the goal is not with GIMLITH nor with Anchor to make any of their existing content exclusive, but to focus on the content that we're developing at Spotify and make more exclusive deals going forward.
Next question comes from Maria Ripps at Canaccord. Does India's heightened focus on promoting a homegrown tech industry change your view on how you approach that market? Is there anything in that new set of rules that would require you to change your normal practices if you do launch in the market in the near term?
We obviously investigate and look at a lot of different factors when we're evaluating which markets we're launching in, specifically related to the Indian market. I think we're seeing it's a very healthy ecosystem of both homegrown players, but also international players being successful in the marketplace when it comes to other sectors. As such and combined with the level of user interest that we're seeing for the Spotify brand makes us feel comfortable that we have a good chance of being a very, very strong player in the Indian market.
I will take a couple more questions. Next one from Matt Cee at Melvin Capital. Can you drive faster sub growth by increasing sales and marketing spend? Sales and marketing was down in Q4. In other words, how should we think about sales and marketing?
Is efficiency holding up? Is that a huge lever for user and sub growth?
Yes, we have the opportunity to drive faster growth by spending more money efficiently. We know from the LTV to SAC ratio that we've got lots of headroom to drive faster growth. You see our current best thinking about those opportunities reflected in the guidance. If we see our way to faster growth as the calendar year unfolds, You will see us update our thinking about the asset allocation decisions we're making in the marketing funnel in order to drive faster growth.
Maybe this is an obvious comment to add to it as well, but if you look historically at the company, we've predominantly invested in R and D to drive faster growth. That obviously is a fixed investment that we can amortize across the whole base of our users. And what you're really seeing now is that we're now also adding content as another kind of lever of that investment. So while we are investing in sales and marketing, it is an important part where certainly the weight of all the investments is in R and D and more content that we can amortize over the base of our platform.
And we explained that rationale at the Investor Day when we reminded you there are in general 3 ways to grow. 1 is geographic expansion. We're pursuing that. 1 is marketing on a percentage of revenue you saw a decline. And the third is invest in the user experience and drive a virtuous cycle.
That's been very successful for us. You know from today's guidance that we continue to double down to fund those investments. I do want to say, by the way, that our guidance assumes all of the costs that we anticipate to incur in the calendar year associated with both the acquisitions that we announced today and the acquisitions that we hope to close that are part and parcel of the $400,000,000 to $500,000,000
And we'll take one last question, a follow-up from Ben Swinburne. Did 2018 advertising revenues meet your expectations? Are the investments in self serve and programmatic able to accelerate growth in 2019?
Programmatic is growing super fast and we're seeing shifts in our most developed markets like the U. S. And the U. K, Australia, New Zealand from direct to programmatic. Self serve is our fastest growing channel.
So in that way, it's additive to the overall performance of the business. But even notwithstanding that fact, it's still relatively small in the grand scheme of things. So we continue to invest aggressively from an R and D perspective in growing that channel. We need that channel to be successful for us over time in order to right size our cost structure. We're starting off a very small base.
Great. And with that, everyone, we'll close our Q4 call. If you have any additional questions, we'll be around all day. Please feel free to email the IR team at irsbotify.com. And we look forward to speaking with everyone again real soon.
Thank you.
This concludes today's conference call. You may now disconnect.