Spotify's (SPOT) CEO Daniel Ek on Q4 2018 Results - Earnings Call Transcript

Spotify (NYSE:SPOT) Q4 2018 Earnings Conference Call February 6, 2019 8:00 AM ET

Company Participants

Paul Vogel - Head of IR and FP&A

Daniel Ek - Co-Founder, Chief Executive Officer, and Chairman

Barry McCarthy - Chief Financial Officer

Conference Call Participants

Justin Patterson - Raymond James

Michael Pye - Baillie Gifford

Ross Sandler - Barclays

Doug Anmuth - JP Morgan

Rich Greenfield - BTIG

Anthony DiClemente - Evercore ISI

Matthew Thornton - SunTrust

Benjamin Swinburne - Morgan Stanley

John Egbert - Stifel

Mark Kelley - Instinet

Heath Terry - Goldman Sachs

Lloyd Walmsley - Deutsche Bank

Michael Morris - Guggenheim

Mark Mahaney - RBC

Jessica Reif - Bank of America

Victor Hoglund - SEB

Eric Sheridan - UBS

Maria Ripps - Canaccord

Matt See - Melvin capital

Operator

Welcome to Spotify's Fourth 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 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.

Paul Vogel

Great, thanks Josh. Thank you and welcome to Spotify's fourth quarter and 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 [e-mail]. We'll get through 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-K.

And with that, I will turn it over to Daniel.

Daniel Ek

All right. Thanks, Paul, and thanks everyone for joining today's call. Our fourth 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 billion hours of content on the platform, and we surpassed more than 200 million 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 one tenth of the size of the video market, so there is a massive opportunity here for audio to evolve into 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 podcast. 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 second biggest podcasting platform in the world in just under two years.

We're still considerably smaller than our largest competitor, which means that there is 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 this space and for Spotify.

Today, in addition to our earnings, we announced the acquisition of two 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 publisher for new podcasts globally and has completely reimagined the path to audio creation and now enabling distribution for the next generation of podcasters worldwide. We are really excited to welcome these incredible, creative, and talented companies to Spotify.

Now with these acquisitions we will offer the best content, the best discovery, and the best user experience for consumers, and we are also positioned to become the leading platform for podcast creators as well as the leading producers of podcasts 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.

Question-and-Answer Session

A - Paul Vogel

Great, thanks Daniel. Our first question comes from Justin Patterson at Raymond James.

Justin Patterson

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 truly incremental to listening hours?

Daniel Ek

Well, there’s this huge space today, which is radio, which currently is about two hours of listening globally every single day. And then, 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 few to get new users on to the platform, but get our existing users to engage way more with the platform as well.

Paul Vogel

Great. Our next question comes from Michael Pye at Baillie Gifford [ph] for Daniel.

Michael Pye

For Daniel, please may you offer some color on how you progress your mission of enabling 1 million artists to live off their art,? By that I mean both numerically, i.e., what metrics do you consider to be most important, but also qualitatively through artist engagement and shows like Soundtrack and Direct Upload?

Daniel Ek

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 1 million listeners per month as well, and that number is showing 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 are a part-time musician or a full-time musician, and the upper end of this tier is whether you are 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 mentioned on previous calls, today distributing a record while in theory, it is 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 the record labels, the publishers, and everyone in this industry has to spend a lot more capital in order to promote and market these assets, and we want to bring that cost down and make the system more efficient for everyone.

Paul Vogel

Our next question comes from Ross Sandler of Barclays.

Ross Sandler

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 decline in 2019?

Daniel Ek

Ross, let me answer it this way. If the question is what’s the gross margin structure of the business at the core business, ex-podcasting-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% or about 90 basis points of one-time, nonrecurring items. So think of the base business gross margin as, that will be 24.8, excuse me, 25.8, you'd 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&L, plus increased investments we're making on our own independent of the acquisitions, and to originate podcast content on the platform.

Paul Vogel

Next question comes from Doug Anmuth at JP Morgan.

Doug Anmuth

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? You know, 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?

Daniel Ek

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 we're seeing from those is a few different things. We're seeing, as I mentioned earlier that people engage almost twice the rate than non-podcast 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, but 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.

Paul Vogel

Next question comes from Rich Greenfield at BTIG.

Rich Greenfield

Well, the high end of your guidance assumes a meaningful acceleration in net adds, curious where the bottom ends [indiscernible] guidance which forecasts a slowdown in net adds versus 2018, what are the key swing factors?

Daniel Ek

Rich, there are two objectives in giving guidance, one 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 on performance we've told you our intention is to land at the 70^th percentile of the range of the guidance we give. So, sometimes [indiscernible] 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’ve built it into our forecast.

Paul Vogel

Next question comes from Anthony DiClemente of Evercore ISI.

Anthony DiClemente

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?

Barry McCarthy

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 factoring the better user experience we have 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 2018 that they earned in Q4 2017 because churn has decreased.

So, one divided by lower churn rate is more months of service at a lower ARPU is exactly to the dollar the same lifetime revenue, and now, it also happens that we have a 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.

Paul Vogel

Great, our next question comes from Matt Thornton at SunTrust.

Matthew Thornton

Any color on early impacts from the Samsung partnership, the Google Home promotion, student plan, bundle, et cetera, how prominent will new distribution partners and promotions be going forward?

Daniel Ek

As we said during our Investor Day, ubiquity and being on all platforms is an important part of Spotify’s strategy. We're already on over 500 different devices, including of course TV screens, voice speakers, cars, et cetera. So, it's a hugely important part for us to try to do those types of partnerships. I can’t say that with the breadth of partnerships that we have that I 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.

Paul Vogel

Next question comes from Ben Swinburne at Morgan Stanley.

Benjamin Swinburne

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 time line looks like? Additionally, what's driving the gross margin pressure implied in the guidance?

Daniel Ek

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 that virtuous cycle. What we see very clearly as we're investing in more podcast content is engagement goes up, as engagement goes up we both broaden the appeal to new users, but we also increase the engagements 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.

Barry McCarthy

If I could draw a Netflix analogy, remember when we launched streaming at Netflix first year, we spent 50 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 is an ad revenue dimension to this because currently ads are embedded in podcasts to both free and paid user base.

Paul Vogel

Our next question comes from John Egbert at Stifel.

John Egbert

In your first two podcast acquisitions, it looks like one was about technology and the other about content. In regards to the $400 million to $500 million 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 [ph]content when you’ve historically been hesitant to own music content?

Daniel Ek

I think they’re two very, very different businesses. We’ve spoken in the past about the music industry and 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 exclusively it won't have the same effect, plus 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 many places as possible because so much of an artist's 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 are investing in that and we think we can be one of the handful [ph] players in that space, and as Barry mentioned too, that affords us a very different economic model long term.

Barry McCarthy

John, the only other point I'd like to make is that out of the $400 million to $500 million in which we have line of sight, the two 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 or content.

Paul Vogel

Our next question comes from Mark Kelley at Instinet.

Mark Kelley

What's embedded into your full-year guidance in terms of premium ARPU declines and ad supported ARPU growth?

Daniel Ek

ARPU decline of about 5 percentage points. Sorry, the second part of the question was?

Paul Vogel

Growth in ad supported ARPU?

Daniel Ek

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.

Paul Vogel

Next question comes from Heath Terry at Goldman Sachs.

Heath Terry

What are your goals around royalty rates, product offering, content or geographic access, data and marketing sharing, et cetera in your negotiations with the labels? What do you believe their goals are in these negotiations beyond royalty rates?

Daniel Ek

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.

Paul Vogel

Next question comes from Lloyd Walmsley at Deutsche Bank.

Lloyd Walmsley

Your release underscored the importance of smart speakers for driving audio content, do you think this was a core driver of premium sub add engagement or both, what more can you do here beyond the Google Home promotion?

Barry McCarthy

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, I think we said previously that plus the holiday campaign were big drivers of growth in Q4, and we see additional opportunities for growth in bundling in the hardware space.

Daniel Ek

Yes, I think my only addition is, it's a fast growing segment for us. We see meaningful engagements 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 in getting that.

Paul Vogel

Next question is from Michael Morris from Guggenheim.

Michael Morris

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?

Daniel Ek

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.

Paul Vogel

Next question comes from Mark Mahaney at RBC.

Mark Mahaney

Can you provide more color on the traction for the recent launches in EMEA?

Daniel Ek

Yes, we’re pleased with the early results as I mentioned in the introductory remarks. We launched mid-November, so we have about two 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.

Paul Vogel

Next question comes from Jessica Reif from Bank of America.

Jessica Reif

What is the path to making podcast acquisitions and podcast investments accretive to gross margin beyond ‘19?

Daniel Ek

Having great content is the long and the short of it. 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 of the increased engagement, they find more value, and so they stay longer, so retention is up, churn is down. Because they're excited, they tell more friends about the service, so your mix of paid 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, life time value is increasing. You're driving more contribution profit to the bottom line against your cost base, plus over time you are 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.

Paul Vogel

Next question comes from Victor Hoglund at SEB.

Victor Hoglund

On the two M&A done today, are you paying in cash or equity or debt or combined? Any indication on users' revenue and price? Is it mainly a user intake potential or churn potential or combined?

Barry McCarthy

I'll let Daniel talk about the potential piece of it. Just in terms of the numbers, its 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.

Daniel Ek

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 on to the platform. But as we're also seeing very clearly from our data, it is also attractive to the people who are currently using Spotify as they are engaging with us more. As Barry mentioned, if they're engaging more, that drives this virtuous cycle.

Paul Vogel

Our next question is from Eric Sheridan at UBS.

Eric Sheridan

Well in new region launches, Middle East or India, how should investors or analysts think about the upfront costs and investment? How the sub base might scale and medium term margin structure especially versus other developed markets?

Daniel Ek

Well, it is 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 it 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 margins and the acquisition cost improves as well.

Paul Vogel

Great and a followup from Rich Greenfield.

Rich Greenfield

You cannot do exclusivity in music, but you can in podcast. How important is that to your strategy to differentiate from your peers?

Daniel Ek

Exclusivity is definitely an important part of our strategy. Just to be very clear though, the goal is to not with Gimlet 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.

Paul Vogel

Next question comes from Maria Ripps at Canaccord.

Maria Ripps

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?

Daniel Ek

We obviously investigate and look at a lot of different factors when we are 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, it makes us feel comfortable that we have a good chance of being a very, very strong player in the Indian market.

Paul Vogel

Let me take a couple more questions. Next one is from Matt See at Melvin Capital.

Matt See

Can you guys 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 sub growth?

Daniel Ek

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.

Barry McCarthy

Maybe this is an obvious comment on tax rate as well, but if you look historically at the company, we've predominantly invested in R&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, it’s another kind of lever of that investment. So, while we are investing in sales and marketing, there is an important part where certainly the weight of all the investments is in R&D and more content that we can advertise over the base of our platform.

Daniel Ek

And we explained that rationale at the Investor Day when we reminded you there are sort of in general three ways to grow: one is geographic expansion, we're pursuing that; one 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. From today's guidance, 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 million to $500 million.

Paul Vogel

And we will take one last question, a follow up from Ben Swinburne.

Benjamin Swinburne

Did 2018 advertising revenues meet your expectations? Are the investments in self-serve and Programmatic able to accelerate growth in 2019?

Daniel Ek

Programmatic is growing super fast, and we are seeing shifts in our most developed markets like the U.S. and the UK, 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&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, but we're starting off a very small base.

Paul Vogel

Great, and with that everyone we will 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 [e-mail]. And we look forward to speaking with everyone again real soon. Thank you.

Operator

This concludes today's conference call. You may now disconnect.