Welcome to Spotify's first quarter 2018 financial results question and answer session. A copy of the company's shareholder letter, issued after the market closed 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. Thank you. Good afternoon. Welcome to Spotify's first quarter 2018 earnings conference call. With us today are Daniel Ek, Spotify's CEO, and Barry McCarthy, Spotify's CFO. Hopefully, by now everyone has had a chance to read our shareholder letter. The format of today's call will be 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 risk 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 and on the financial section of the investor relations page of our website and also furnished today on Form 6-K. With that, let me turn it over to Daniel for a few brief opening remarks.
Well, thanks, Paul. Before we begin with questions, I wanted to start by sharing a few thoughts. I think it might be helpful to remind everyone how we view long-term value creation here at Spotify. As I said at our investor day, there are really three key strengths that are fundamental to our growth today and in the future. First, it's the premium offering. Our free product drives premium subscription growth, and it leads to better personalization and drives use among younger demographics with greater potential lifetime value. Second, our unique embrace of ubiquity across all platforms. We see the world dividing into multiple platforms, and Spotify is really the only player that works across all of them globally. This makes it easier for us to grow our business in both existing and new markets. Then thirdly, personalization.
This is our ability to deliver a personalized user experience that enables us to build deeper engagements and enable more demand creation. These factors allow us to execute on our two-sided marketplace strategy that serves both artists and fans. With that in mind, we'll start by taking your questions.
Great. Thanks, Daniel. Our first question comes from Eric Sheridan at UBS. How should investors think about the current and future state around advertising and creator services as a driver of revenue growth and gross operating margin expansion, and with respect to creator services as a possible value-add layer to the broader music industry business model?
Well, let's start with the first premise. I think radio is a massive business that's now moving online. Spotify has a significant amount of those ears. This, of course, represents a huge opportunity both for Spotify and for the broader music industry, as they today get very little of that revenue. Then when it comes to the second part of the question, creator services, there are really huge inefficiencies in how you break, market, and distribute apps today. We think we can, with our tools and platform, make the system more efficient, which of course, will enable labels to sign more artists and obviously, over time, increase the share that Spotify receives of that.
Great, thanks. Our next question comes from Matthew Thornton of SunTrust Robinson Humphrey. Regarding the price increase in Norway, any early learnings? What's the pricing strategy overall as it relates to tactical increases? Will the incremental revenue come in at a meaningfully higher incremental margin?
Well, first off, we experiment a lot. At any given point, there are really hundreds of ongoing tests with products, price points, and variations of the product. This test just happened to be a bit more public. Regarding pricing strategy, we really look at price and value ratio. I think it's too early to say what we'll learn from this test, but price increases isn't a focus in the near term for us.
Our next question comes from Mark Mahaney at RBC. Do you believe you have experienced any impact from the reported recent surge in Apple Music subs? It appears that Apple is being more aggressive in terms of promoting its music service on Apple devices. Is this having an impact?
When I look at our business, I look at two factors to judge competition. One is how we're behaving compared to our own forecast and growth. From that angle, I think we're looking pretty good. The second thing is how we're looking from a churn perspective. As we've stated before and said again, the churn trend line is actually trending downwards. We don't see any kind of meaningful impact of competition. In fact, when we look at this, we don't really think that this is a winner-takes-all market. In fact, we think multiple services will exist in the market, and we're all kind of in a growing market. We're just focused on growing that market and capturing more market.
Great. Next question comes from Rich Greenfield at BTIG. Could you explain the ARPU impact from shifting from a 30-day free trial to a 60-day free trial? How do we think about trial users in a given quarter and how this change impacts ARPU?
Hey, Rich. Barry. The 60-day trial was inconsequential in terms of its impact on ARPU. The trend here on ARPU, if this is modeling related, has largely been felt as a result of the rollout of the family plan. You'll see in our quarterly filing with the SEC tomorrow, a breakdown of that impact on a year-over-year basis in the quarter. That will be substantially less on a go-forward basis because, as I said, family plan has already been launched.
Great. Our next question comes from Victor Höglund at SEB. On churn, you say the churn is below 5%. Can you maybe give a little bit more color on this?
Sure. Couple things to know, though. There is seasonality to churn, particularly following periods of rapid growth related to promotional campaigns. Notwithstanding the overall trend, which, as Daniel pointed out, is downward, there will be periods of time when churn kicks up sequentially on a quarterly basis. As long as we're seeing that the individual cohorts by month of subscriber life are maintaining the trend line, then we can be confident in the overall health of the business. The average monthly churn for the quarter reached a all-time historical low of 4.7%. Now, we saw a decline in ARPU. Previously at Investor Day, you heard us speak about the relationship between lifetime value and subscriber acquisition cost and the importance we ascribe to maintaining that ratio. ARPU was down, churn was down substantially, and that ratio of 2.7 to one has held constant.
Great. Next question comes from Heath Terry at Goldman Sachs. First quarter gross margins have historically been down from 4Q to 1Q. This quarter they were up and the year-over-year expansion was considerably higher in 1Q than 4Q. What drove that? Should we expect margins to be less seasonal in the future?
Well, in our SEC filings and at Investor Day, we spoke about the seasonality of gross margin, and we expect it to be down seasonally as a result of promotional campaigns we run. The downtick happens in Q1 and Q3. Now, in this particular quarter, we made some adjustments to estimates that related to out-of-period expenses that accounted for about 128-
124.
124 basis points of margin improvement. On an adjusted basis, it would've been 23.7, down from 25 Q over Q. On adjusted basis, we saw the seasonality.
Our next question's from Barton Crockett at B. Riley. Amazon highlighted voice-activated speakers as a key element of its growth in music. Is that a structural advantage for Amazon that is a pressure point for Spotify?
We certainly, through our [Ubique] play, view it more as an opportunity. Voice is growing. There are more and more connected speakers in people's home. Spotify is an application that's both available on Alexa speakers and Google Home, and we're doing fairly well there. We actually do see our share of voice growing, and we view that long term as an opportunity, not a threat.
Our next question comes from Rob Sanderson at MKM Partners. Collaboration with music labels to promote new artists, new content seems to be picking up in frequency. If labels typically allocate 15%-20% of revenue to marketing, can this be thought of as a benchmark for sizing the long-term opportunity to Spotify Technology in providing promotional support to the music industry?
As I mentioned previously, we do think that there's huge inefficiencies in the way that acts are being taken to market today and the amount of money that labels and the whole ecosystem have to invest in creating viable artists. Because Spotify Technology already sits on the data, sits on consumers, sit on the preferences, we think we can play a huge role in connecting more artists with more fans, and thereby obviously capture a big share of that, too. We're excited about the area.
The next question comes from Jessica Reif at Bank of America Merrill Lynch. Where is the growth in advertising coming from? The U.S.? Other markets? Global advertisers? What are your expectations on programmatic?
Yes. Super fast growth. Programmatic grew, I think 94% year-over-year. The growth is coming principally from the developed markets. The U.S. is by far and away our largest and most profitable market. We had strong outperformance in the U.S. market, in Q1. The only piece of our business that is growing relatively slow is desktop advertising. That grew at a year-over-year rate of 6%. As that gets increasingly smaller with the growth of mobile, overall growth rates should accelerate. I think on an FX-adjusted basis, the growth rate in advertising was 55% year-over-year. The business is clipping along quite nicely.
Great. The next question comes from Doug Anmuth from JP Morgan. Can you talk about your product plans around spoken word content and how the economics differ versus other content?
Well, right now the main focus is on adding more to our library of non-music content. We're adding more and more podcasts by the day. You could see through today's announcement that we got a music podcast called Dissect exclusive to Spotify on our platform. We keep doing those deals. It still represents a fairly small % of our overall listening, but it's growing really rapidly, we keep on expanding our catalog here.
The next question comes from Ben Swinburne from Morgan Stanley. Can you talk about the major hurdles to launching into new markets? How quickly can you add new territories, and what should investors expect on this front over the next several years?
We primarily look at a number of different factors as we evaluate what markets to go into. Those include things like 4G penetration, data plans, whether or not the ad market is a growing ad market and viable one. Then of course, factor in local licensing and what we have to do to enter a market there. It's usually those variables that weigh into a prioritization of markets. While I can't comment on any specific markets at specific times here, we are looking at adding more new markets during the remainder of 2018.
Which is baked into our full-year guidance.
The next question comes from Anthony DiClemente from Evercore ISI. Your 2018 gross margin guidance is for 23%-25%, and at the analyst day, you talked about long-term target of being 30%-35%. Can you again talk about the longer-term drivers of expanding gross margins?
I'll comment, and then I think Daniel will finish. Our ability begins and ends with the success in the growth of our two-sided marketplace. One, as we know from having observed the history of Netflix, our success in coming to own demand creation and the margin associated with driving demand creation. The growth in the two-sided marketplace, and the expansion of non-music audio content, both present interesting opportunities for margin expansion, some of which we outlined at investor day. Daniel, do you want to add anything there particular?
I think as Barry said, it's both in the music and the non-music side, but specifically related to the music side. The ability to help labels and artists with promotion and marketing remains a huge opportunity where we can see a need and a huge interest from the community to be more helpful here.
Our next question is from John Egbert, from Stifel. Did the extended functionality of free listeners announced last week impact cost for the ad-supported tier in any way? How did Spotify management and the music labels get comfortable that giving free users more control would not negatively impact subscriber conversion in a material way?
Well, I can start with the conversion piece. I think one of the things we touched at Investor Day and certainly what we've seen throughout the life of the company is the more engaged our users are, the more likely they are to convert. It's been a good business decision continuously to enhance the experience for our customers because the more of those customers that today aren't paying customers, the music end up coming into the ecosystem. The more engaged they are, then the more likely they are to convert. Since we have a very long track record of that, the music industry has been receptive to work with us on enabling more growth for Spotify and therefore more growth for the music industry.
I would say from an advertising perspective, one of our overarching objectives for the business amongst new free users is increased engagement, which drives growth and impressions and opportunities to monetize those impressions. All indications are that the new free product offering will accomplish those objectives. Net positive for us from a margin perspective, I think.
Next question from Michael Morris of Guggenheim Securities. Can you talk about the ARPU progression for the year and beyond? There are a couple of moving parts, guide seems to imply you expect ARPU to stabilize over the course of the year. Is this accurate with respect to your expectations? How should we think about the trend in the family and student plans relative to the shift in the lower ARPU markets?
We don't guide on ARPU, but thematically, you are more right than wrong. There will be some variability on a quarterly basis, within a range of maybe EUR 0.15, that I would expect we would finish the year more or less in line with where we started the quarter.
Next question comes from Michael Klenk from Tremblant Capital. How does Spotify management expect the newly redesigned free service to impact subscriber growth as 2018 progresses? Any early indications on how the new free product is resonating with users?
Early customer feedback has been really good. We have seen through Twitter and other social platforms, people being really excited about it. Just to recap the changes, this includes more on-demand playlists now available for free and a data saver mode, which has been particularly hugely helpful for younger demographics and emerging markets where data costs are often a quite significant part of consumer spend. We are very excited about the early response and are excited to see how that leads to more growth in the future.
Our next question comes from Matthew Harrigan at Buckingham Research. Does your belief that music streaming is not a winner-take-all market alongside your 25%-35% long-term Spotify sales growth assumption imply that analysts are chronically underestimating the eventual size of the global music streaming market?
Music is one of the largest art forms in the world there is. Already today, if you would look at radio as a proxy for it, there are billions of people who listen to radio, of which the primary reason to listen to radio is music. We think that the online opportunity in music is billions of people, and that a quite significant chunk of those could meaningfully contribute back to the music economy. Yes, we think this is a huge opportunity.
I think if you look at the history of video, you would say the bias is to underestimate the size of the market.
Next question comes from Maria Ripps at Canaccord. The Hulu bundle, it's nice to see you expanding it. Can you talk about any impact that it's having on retention or lifetime value? Do you see potential for other similar bundling deals?
Yeah. We're really excited about it. Just to recap again, the Hulu bundle was introduced in our student plan, we've seen both great uptake and much greater retention among those customers that are taking that offer. I think the lesson learned from that, obviously, is that when you contribute something that customers are excited about, they not only remain more loyal customers, but they also tell their friends about it.
It's a net positive on lifetime value and a contributor to the improvements we're seeing in churn.
Next question comes from Chris Harrell at Capco Asset. "I understand that the focus is to rapidly build a subscriber base. Today's various pricing configurations are reducing the effect of price per sub dramatically, which ties into the strong sub growth. Do you believe pricing power and higher prices per sub will be a component of future growth at some point?
I think we're playing a market share game. We discussed it at some length at the Investor Day. Reason being, engagement drives usage. Usage drives data insights. Data insights drives a better user experience. Better user experience drives longer lifetime value and faster growth. We just discussed, we think the global market opportunity is quite large and that we anticipate we will be in fast growth mode for a period of time. So it's in our longer-term strategic interest to play for market share, not for short-term pricing power and improved margins.
The next question comes from Louis Citroen. "You talk about the potential impacts of the Music Modernization Act on Spotify. Any specific impacts to have in mind on gross margins?
No specific impacts on gross margin. Good for the industry, good for copyright owners, good for licensors of content like us. Helps dramatically in the remittance of license fee payments, enables us to know who to pay. Full stop.
Great. We have a follow-up question from John Egbert at Stifel. "Disclosure of cost of revenue related to biannual free trials in the prospectus was extremely helpful. How should we think about growth in these costs over time? Do you expect them to grow in line with gross subscriber additions? At your current scale, do you think you'll see leverage in these costs going forward?
I would say I've already commented on the trend in gross margin, and I'm not expecting a shift in the seasonality resulting from the engagement in these promotional programs. I don't think I have anything additional to contribute.
A follow-up from Barton Crockett at B. Riley. "How should we think about the contribution margin of ad growth, and where is the gross margin for ad revenues going?
The answer kind of depends on what we decide to do in terms of new markets, and then over time, our ability to monetize those new markets. There is a very highly developed advertising market in the U.S., of course, and in Western Europe. The ad markets are less well-developed in parts of Southeast Asia, by way of example. Not everywhere, but in some markets. The ad business is much less profitable in those markets as a consequence. We'll see how that plays out.
Another one from Michael Morris at Guggenheim. "One of the most frequent investor questions we receive is confidence in your ability to achieve long-term gross margin targets. We believe this is largely tied to future negotiations with record labels. Can you answer what makes you confident and what investors should be considering in evaluating your potential success?" Are there key incremental revenue streams that don't have direct labor costs that are a material part of the expansion?
Well, let me just say growth. I think we're looking at a different dynamic going forward than we have seen historically. Daniel's vision of a two-sided marketplace and the services that we're developing, both for labels and for artists, is a value-added play for them and for us, and we're building services that haven't previously existed that drive marketing efficiency, as Daniel spoke about earlier, that are good for artists, good for labels and good for the margin structure at Spotify. That's a whole lot different than we earn more, they earn less. Which, honestly, was most of what we saw in the renegotiation of the license agreements that moved margins from 15%-25%.
Next question follow from Ben Swinburne at Morgan Stanley. Can you talk about your strategy to penetrate auto OEMs with a more integrated experience for consumers on Cadillac? Is that tethered by a smartphone or in-dash?
As to come to autos, we really have three strategies. The first strategy is to enable your existing phone to work really well with it. That means Bluetooth. As mentioned during our investor day, we already have a lot of those users active, tens of millions who are listening to Spotify in the car. The second part of it is in-dash partnerships like the one we did with Cadillac. Primarily, those are where there is an internet connection that comes with the car. Tesla is another example of those that we are doing. I'm seeing more and more of those deals coming through as new cars are starting to roll out.
Thirdly, it's the combination where it's through Android Auto and Apple CarPlay, where you use your existing smartphone as the display on the car dash and the data from the phone acts as the modem to reach the music. We are obviously on both Android Auto and Apple CarPlay available in those as well. Those are the three modes that we are going after the car opportunity, and we are seeing some good growth in all three.
Next question from Brad Arlington from XCM. What is causing your premium sub forecasts to remain the same as last quarter while your total MAU guidance is ticking higher?
Total isn't enough of a change to trickle down through the funnel to drive increased premium subs is the answer to the question. If we continue to outperform on the MAU line and it grows significantly faster in the top of the funnel, then it will inevitably translate into faster sub growth. It's not our expectation that we will see that come to pass during this calendar year based on what we are seeing so far.
Another question from Ben Swinburne from Morgan Stanley. When should investors expect Spotify's R&D intensity to reach the long-term target provided at the Investor Day?
Over the long term. The more successful we are at expanding gross margin, the more you'll see us increase our investment in R&D along the lines that I outlined at Investor Day. If we're not as successful in expanding the margin, then you'll see us continue to spend at the current % of revenue.
We'll take one final question from Jessica Reif from B of A Merrill. What is the driver of elevated uptake in Japan, which is still largely a physical market?
Well, I'm not sure we've actually made any comments about Japan. That said, it is a strategic market for us, and much like many of our other strategic markets, like the U.S., U.K., Germany, to name a few, our expectations is that it looks a little bit like an S-curve in the sense that you fairly early have very little traction in the market, but it's growing in absolute terms fairly well. Then you hit this sort of peak of the growth curve, then that's where the market catches on and everyone gets excited about streaming. Then it kind of gets more into the mature state. Japan is a longer-term opportunity for us, and as you said, it's primarily a physical market. It takes a while for that market to transition, but it's a very big market, and it's a market that we're excited about.
Great. Thanks, everyone for your time. With that, I'll turn it back over to Daniel for just a few closing comments.
Yeah, I just want to take a moment to thank everyone for participating in this earnings call. We hope that the shareholder letter and this Q&A were informative to you. Our goal is to continue to be as transparent as possible. We welcome any feedback you have on how we can continue to make the earnings process useful for investors and analysts. I also want to take a quick second to thank all of the Spotify employees, both past and present, who have helped us get to where we are today. As I mentioned at the Investor Day, we believe we're only in the second inning of the Spotify journey, and I look forward to sharing our future growth in upcoming quarters. Thanks again for listening.
Great. Thanks, everyone. We'll talk to you next quarter.
This concludes today's conference call. You may now disconnect.