Welcome to Spotify's second quarter 2018 financial results question and answer session. A copy of the company's shareholder letter, issued before the market opened today, is available on the investor relations website, investors.spotify.com. This call is being recorded and an archived replay will be available on the IR site after the event concludes. I will now turn the call over to Paul Vogel, Head of Investor Relations and FP&A. You may now begin your conference.
Great. Thanks, Josh. Thank you. Welcome to Spotify's second quarter 2018 earnings conference call. With us today are Daniel Ek, Spotify CEO, and Barry McCarthy, Spotify CFO. The format of today's call will be similar to last quarter. 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 ir@spotify.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 in 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 and on the financial section of the investor relations page on our website, and also furnished today on Form 6-K. With that, I'll turn it over to Daniel.
Thanks, Paul, and thanks, everyone, for joining today's call. I think second quarter results showed continued strong growth, in all of our core metrics. Our goal is to each quarter deliver within our stated guidance and most of our key metrics finish towards the top end of our forecast ranges. As I said at the Investor Day, we believe we're still in the very early stages of the global streaming market with a very large opportunity still in front of us. Before we begin the question and answer session, I did want to address one thing that's been written about a lot over this past few weeks around Spotify signing direct licensing deals with artists. As we spoke about at our Investor Day, we're really building a two-sided marketplace that provides tools and services for labels and artists focused on promotion and marketing.
As a platform, we've always licensed music from rights holders, both large and small, and we will continue to license music from whomever owns the rights. We have been doing this for years because our goal is to get as much music onto the Spotify platform as we possibly can. The long-term success metrics for this platform is growing the number of creators on our platform, growing the number of creators using our promotion, marketing, and career management tools, and three, the number of artists and labels paying us to use those tools and services. Licensing content does not make us a label, nor do we have any interest in becoming a label. We don't own any rights to any music, and we're not acting like a record label. Our agreements are specific to Spotify and are not exclusive.
We want to grow the number of labels and creators on the platform, as well as the number of creators using our tools and services. In some cases, we license from labels, and in others, artists if they own the rights to their own music. We believe there's been some confusion regarding our intention, and for us, it's really about providing the largest opportunity for the widest group of creators and artists to bring their music to Spotify. Thanks. Now we can begin the question and answer session.
Great. Thanks, Daniel. We'll start with our first question from Ross Sandler at Barclays. Can you unpack what drivers you see over the next few years to bridge the gross margin increase from today's mid-20s to the 30%-35% range?
Let's kind of up level it and talk strategy for a moment. As I kind of alluded in the opening remarks, the overarching goal for us is to build a marketplace for all creators and labels, on how they better interact with Spotify. If you think about that means that we're really trying to grow the number of creators that are on our platform. We're trying to grow the number of creators that are using our tools. Then thirdly, trying to increase the number of those people that then are paying us to use those tools and services. That's essentially the strategy through which we're going about growing our gross margin. It will be less about ongoing licensing discussion and much more about inclusion of the services that our marketplace is providing.
Let me add, I would like to remind our listeners that at our Investor Day, we included a slide on the long-term margin structure for the business. That included gross margins in the 30%-35% range. That remains our vision and objective for the business. If we're successful in building a two-sided marketplace and developing the tools to own demand creation, I think we'll land comfortably in that range.
Barry, just a quick follow-up because this one came in. You mentioned in the letter that your long-term gross margin target is 30% plus. You mentioned 35% at the Investor Day. Is there any change?
No. No change. Our objective remains 30%-35% for gross margins.
Great. Thanks. Next question is from Matt Thornton at SunTrust. Any update on progress on the artist label side of the two-sided marketplace?
Well, I think, as been clear in our earnings remarks, we are seeing really, really good remarks. We're seeing overall growth of 5% or more number of artists being heard, and Spotify for Artists is growing very nicely and has hit a new milestone of over 200,000 artists monthly. Both of those are incredibly positive and are ahead of where we expected.
Next question is from Rich Greenfield at BTIG. Podcast and non-music audio appear to be a relatively minor portion of listening time today. We presume 1%-2%. Is that fair? What are you doing to grow that share over time, and what timeframe should we look for progress?
It is fair that music is still the vast majority of all listening on our platform. That said, we're very encouraged with the growth of podcast. It's growing really, really fast, obviously from a small base today. It's unclear long term how big that opportunity is. I think everyone in the entire industry is trying to figure that out. We're certainly of the belief that it's going to be a significant portion of what we do going forward and are investing to make both the product experience better and driving the number of creators on board our platform.
The next question comes from Anthony DiClemente at Evercore. Can you talk about churn in the quarter, at least directionally, and is it continuing to come down as much as expected as the tenured subscribers ages and as family student plans grow as a percentage of the subscriber mix?
The short answer is yes and yes. Let's see. Let's talk about the business overall, the global business. The churn in the quarter was down year-over-year about 900 basis points. Secondly, I want to talk specifically about the U.S. since I've seen a couple of news articles reported an increase in churn, as a result, I think of Apple competition. It, in fact, is not what happened. We also have seen improvement in the U.S. and in the most recent quarter in the U.S., saw a three handle on churn rate. Very encouraged by the business overall on a global basis and in the U.S. in particular.
Great. Our next question comes from Eric Sheridan at UBS. Data analytics. Should investors think of this as a standalone business or one that makes the music industry smarter and could play a constructive role in the commercial dialogue with the music industry?
Well, data and insights is definitely part of the platform, and a key fundament for how we view the marketplace. As mentioned, Spotify for Artists today, if we just up level for a second and look at what it is, it's amazing insights for artists and labels today about how they're doing and who their audience is. We've never before been at a place in time where you could make as many informed decisions and understand your audience as well as you can do now, as an artist. We're seeing a lot of these artists making much smarter decisions on the basis of this. As an example, you have an artist like Metallica who changes their setlist on a city-by-city base just by looking at Spotify data to see which of the most popular songs happen to be in that city. There are many other examples.
Our view is if artists and labels have better data and can make better insights, they're going to also take action on those insights, that's key fundament that's also been prevalent on the rest of the Internet.
Our next question comes from Amy Yong at Macquarie. As free cash flow piles up, how should we think about priorities of cash? What types of organic, inorganic opportunities do you see? Any updated views on balance sheet optimization?
No updates on balance sheet optimization. It's steady as things go. Want to remind everyone that our overarching objective for the business, in addition to our strategic goals, is to continue to generate positive free cash flow, ex the CapEx investments in new office space in New York, Boston, L.A., et cetera. Our goal with respect to cash is to manage it smartly like we do all of the other asset allocation decisions we make in the business. If in the fullness of time, we decide or it becomes clear that the business is over-capitalized, you should expect us to use that cash productively to buy back shares in the marketplace. We're nowhere near deciding that we can't constructively deploy the cash we've raised. The biggest single investment opportunity in front of us is to acquire technology that helps us achieve faster the strategic objectives for the business.
You've seen us make several acquisitions over time, which have contributed to the success of the business, and we are continuing down that path.
Our next question is from Jessica Reif Ehrlich at Bank of America Merrill Lynch. UMG was reported in the press to be considering a move to monthly accounting for royalties owed to artists versus the current quarterly or semi-annual basis. Should this shift happen, how would this impact your working capital profile and free cash flow prospects?
Shouldn't affect the free cash flow of the business at all. We remit to labels monthly.
Our next question is from Michael Morris at Guggenheim. Why is your direct artist relationship business not an incremental threat to your relationship with the labels? A recent FT article described labels as withholding rights in India due to your licensing music directly from artists. Is this accurate? How can you grow your direct business without creating risk of poor relationships with the major labels?
Again, I think the goal of the marketplace is to create tools for all sizes of artists and labels. If you just look at a label today, and you look at how labels are investing, one of the largest costs for them is to figure out how to effectively market and promote an artist. As we talked about in our marketplace strategy, the key objective that we're pursuing is taking the data and insights that we're generating on our platform and creating tools that allow artists and labels to better market themselves in the marketplace. As I look at that, I think that this is a huge opportunity for all labels to become more effective.
If they become more effective, that will allow them to sign even more talent, invest even more, and further growing our mission as a company, of course, which is to allow 1 million creators to be able to live off of their art. This is kind of a key component to make labels more effective than they are today. To address specifically your question in regards to India, I think the truth of the matter is when you deal with licensing, and in our case, not just one company, but you deal with local publishers, local record companies, global record companies, global publishers, it is always a complicated maneuver. As much as I would like to say that we can accurately and timely estimate on the day when we're going to launch a market, there's always local considerations that get added.
This has been true not just in India, but it has been true in, I think, pretty much every market that we've ever entered into as well. Delays, unfortunately, when it comes to licensing for various reasons, is just commonplace in this industry and nothing related to our overall strategy.
Our next question comes from Mark Mahaney at RBC. Any more color on Hulu bundle and whether we could see other bundle deals?
Well, as we outlined in the remarks as well, we're very encouraged by the early results on both launches, both the Hulu student plan and now the Hulu standalone plan. This is a huge part of what we're doing, which is trying to find more ways to bring more value to our members on the subscriber base. We don't have anything to announce, but you should look at it as part of our strategy, just like we've said before, to look at more ways to add more value for our members.
Next question is from Nick Delfas at Redburn. My Amazon Echo keeps trying to sell me Amazon Music Unlimited even though I have selected Spotify. What are your plans on speakers in home or in car?
As we outlined in our investor day, one of our key strategic objectives is to be ubiquitous on all platforms. Music is one of those things that are used not just in your home, like video, but really on mobile, in your car, and in home. Our strategy is to look at all the major platforms, try to make sure that we have a best-in-class experience on all of those platforms, work with the platform providers of those to enable that experience. We're seeing great results in the home and particularly in the connected speaker segments. It's still a pretty early market, I would say. Just specifically to address the car too, that's a longer-term investment from our perspective. We're both working with manufacturers enabling so that you can connect your phone via Bluetooth.
Of course, we are a huge part of Android Auto, which is Google's car initiative, and CarPlay, which is Apple's car initiative. This is part of our overall strategy of being in all places where people might want to have music.
Next question is from Rob Sanderson from MKM Partners. The adjusted MAU metric looks to have been at the low end of guidance. Did GDPR have an impact? Is the revamp of the ad-supported product performing to expectation? Also, can you offer early observations from the new product?
Let's see. At a high level, particularly from a revenue and margin perspective, the business is performing towards the high end of our expectations. I think it's clear that the top of funnel MAU growth in the quarter, given The Street consensus expectations, was a couple million light, a million and a half light. The question is, what are the implications of that for the future growth of the business? The answer is not much. Different than what we told you to expect last quarter. The question is, why? The answer is because we're seeing great conversion in the paid business. We're seeing faster growth in the paid business than we were expecting, and we're seeing super strong retention in the paid business. GDPR was an issue for a couple of weeks, and we were past that speed bump.
If it had an impact on revenue in the quarter, it was less than EUR 1 million. Quite small in the grand scheme of things. If the Premium business grows faster than our expectations, we're going to have fewer free MAUs than we were expecting, which creates a headwind for the free business. Question: Is the overall business better off or worse off? The answer is the business is better off. It means if the paid business is growing faster than we expected, we will have more revenue than we expected, and we will have higher margins than we expected because the paid business has higher gross margins than the free business does. Net-net, it has meant good things for the business, as compared with our expectations. You know from our guidance we're expecting that trend to continue.
Great. From Ben Swinburne from Morgan Stanley. Barry, is Premium Family mix pressure moderating? How should we think about organic ARPU declines in the second half?
I commented on ARPU last quarter. We've seen a sort of seasonal pattern of fluctuation in ARPU last year and expecting a similar pattern this year. Decline in Q1, up in Q2, down in Q3, up in Q4. Expect that pattern to continue. Point 1. Point 2, when we launched the Premium Family, we sold it across the entire base. During that launch, there was more downward pressure on ARPU generally because of growth in Premium Family than you will see this year and going forward, because the installed base has already been sold to. The only incremental pressure is at the margin. Be mindful of the seasonal pattern, and then be mindful of the dynamic change 2017 versus 2018 because there's no installed base to sell across.
Next question is from Peter Stabler from Wells Fargo. Does your recent hiring of Dawn Ostroff signal an intention to aggressively pursue original video production?
The easy answer on that one is no. Our primary focus, as we've said many times over, is audio and music in particular. That remains our focus today.
The next question's from Heath Terry at Goldman Sachs. What kind of progress are you seeing in monetizing your ad-supported business? How much of that is ad load, and how much is achieving higher eCPMs on your ad units? What's the appropriate long-term level of monetization to assume for ad-supported?
It's mostly about increased sell-through. The ad business is a tale of two growth rates. Relatively slow growth on desktop and very fast growth on mobile. Increasingly, it's a mobile-first business. We have relatively high margins in our five largest markets. Think of them as the developed world: U.S., Western Europe, Australia, New Zealand, Canada, by way of example. Then significantly lower margins in emerging markets. Where we're quite small, so if you're an advertiser, a limited opportunity for you to buy reach. The dynamics of those markets are changing pretty quickly as we continue to grow quite rapidly. The challenge in those markets is sell-through rate. As they get larger, the challenge diminishes.
The next question is from John Egbert at Stifel. It looks like your subscriber growth remains quite healthy. Could you give us any color on specific countries or geographies where you're seeing strong momentum? Perhaps any emerging markets where you're seeing growth traction that could meaningfully influence subscriber growth down the road?
I wouldn't single out any particular country or territory with respect to growth in the premium business. We're growing strongly across the board. Premium Family is a big driver of growth.
Next question is from Eric Sheridan at UBS. How has the price increase in Norway been received? Are you planning to launch HD products? If so, how big is the market opportunity?
Let me up level it and say you should not expect to see price increases from us across markets. We're playing a market share game. We're not playing a margin game. There may be opportunities for us in individual markets to test price elasticity like we're doing in Norway. Don't expect a shift in strategy. Specifically with respect to Norway, we saw a brief slowdown in growth, and then a few weeks later, growth was right back to its historic level with no adverse change in churn. It appears to have been well-received in the marketplace.
Next question from James Cordwell at Atlantic Equities. Can you provide more detail on the data policy change you called out in the letter, and what impact it had on ad revenue for Q2? When do you expect ad revenue growth to have fully recovered to the trend you were seeing prior to the change?
Let me just jump in and say it's fully recovered, which is what really matters.
Our next question is from Ashwin Kesireddy at J.P. Morgan. Can you comment on GDPR disruptions during the quarter? Any color on whether this was driven by advertisers taking a wait-and-see approach, or whether this was a compliance process disruption which would not repeat going forward?
Well, not everybody was equally prepared in the marketplace, that caused some fallout. There were some examples of some advertisers who sought to use GDPR as an opportunity to leverage the renegotiation of data sharing in the marketplace. That friction cleared the market in a couple of weeks, relatively quickly. I would say the overall impact from GDPR, just ignoring the confusion in the moment when it went live, is relatively short-lived.
Another question for Barry from Justin Patterson at Raymond James. How should we think about the impact of the new self-serve Ad Studio platform and the pace of the rollout? What are your early learnings from Ad Studio?
Well, I'm not sure how to answer this. I'm not sure what the question is. I'm not sure if it's a question about Australia and New Zealand or if it's a question generally about the launch of Ad Studio. Let me take them sequentially. In Australia and New Zealand, we are trying to discover whether or not we can have a more successful business for us and for advertisers by testing pay per listen, pay per view, as an alternative to pay per CPM. We're in the very early stages. Let's talk about growth in automation. This is an automated platform. If it's successful, it will have a large following in the SMB marketplace, which would significantly expand monetization opportunities for our business. If executed well, will result in an important shift in the overall cost structure of the business, dramatically expanding margins.
Next question is from Lloyd Walmsley from Deutsche Bank. Can you give us an update on the competitive environment in the U.S. and otherwise? Is there a phenomenon you have observed where new entrants in a market can actually stimulate broader demand in a way that helps you?
Yeah. Well, our global subscriber growth continues to be really strong. We continue, of course, to meet our growth goals for the business, which you've seen over the last two quarters. In the U.S., in particular, we're also performing well and growing rapidly, and U.S. churn continues to decline year-over-year and is now below 4%. We continue to see a large opportunity for future growth. Our growth is really coming both from the increased paid and ad-supported users in the U.S. I think a good metric is to look at the total amount of Spotify users we have, and we are now at 2x the size of our nearest competitor in regards to that.
Just to level set again, the streaming market really is still very much in its early stages and we're the largest global streaming music platform, and we expect our leadership to continue going forward.
Next question is from Erland Lewin. Finance costs in Q2 increased to EUR 343 million from EUR 154 in Q1, and EUR 148 in Q1 of 2017. What is the reason for this increase, and do you expect higher finance costs to continue?
It relates to the two things. One is revaluation of the convert, which is now gone. Secondly, accounting for the cost of warrants. We'll stop.
I'll try and get one or two more questions here. From Heath Terry at Goldman Sachs. What's your strategy for exclusive content, such as your podcast deal with Amy Schumer? How do you expect the economics of exclusive content to compare to your deals with the labels and publishers?
Well, first off, let's level set for everyone. In music, we don't believe in exclusivity and haven't participated in that. In podcasts, we do see that that marketplace works differently, and that there is room for exclusivity and there's room for original content production to seed the marketplace. This is probably something that you should expect us to test and experiment with. Some marketplaces are more well-developed than others. I think interestingly, as we kind of look at the market, we have a very young audience. Typically, there aren't that much podcasts available for them, certainly when you look at a global space. Hence, we're very encouraged about seeding that and helping and develop that. As a cost basis, we think, again, it fits really well into our dual monetization strategy of both ad-supported and subscription.
I'll take 2 more questions. One from Ben Swinburne from Morgan Stanley. Can you give us a sense for engagement trends? Are content hours per user still growing at levels disclosed in the prospectus?
We're not going to break it out, but we continue to feel quite good about the levels of engagement in the service. As we get better at developing the two-sided marketplace and driving discovery, and as we add new forms of content to the platform, like podcasts, offering consumers a better service, we expect to continue to be able to drive increases in hours consumed.
I'll take 1 last question from Louis Citron at Arete Research. You said last quarter that the launch into new markets was built into your 2018 guidance. Could you give us an update on those, especially India, Russia, and Africa, and how important those geographies were for your 2018 guidance? Any comments around ongoing discussions with the labels? Which I think we already addressed.
Yeah. I think we addressed the conversations with the labels. We're still looking at opportunistically launching in more markets across the world. Obviously, it's the big markets, like Russia, India, that probably will contribute the most. I don't have any further comments on any specific launch dates on those things. I would say, however, that any impact on our forecast will be minor or immaterial.
Great. With that, I'll turn it over to Daniel for just some final closing comments.
Yeah. I would just say thanks again, everyone, for participating in our second earnings call as a public company. I really hope that you found the earnings call and the answer sessions helpful. We will continue to be as open, as transparent as possible in providing insights into our business. Of course, as always, we welcome any feedback you have in making the earnings call better, and I look forward to speaking with everyone again next quarter. Thank you, everyone.
Great. Thank you.
This concludes today's conference call. You may now disconnect.