Spotify Technology SA

NYSE:SPOT

Earnings Call Transcript 2018-Q3

[Operator]

Welcome to Spotify's Third Quarter 2018 Financial Results Question-and-Answer Session. A copy of the company's shareholder letter issued premarket 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, executive]

Great. Thank you, and welcome to Spotify's Third Quarter 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 prior 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 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'll 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 Financials section of Investor Relations page of our website and also furnished today on Form 6-K.

And with that, let me turn over to Daniel for a few brief opening remarks.

[Daniel Ek, executive]

All right. Thanks, Paul, and thanks, everyone, for joining today call. Our third quarter results demonstrated continuing strong growth across our business, and most of our key metrics finished towards the top end of our forecast ranges. As we have discussed on prior calls and at the Investor Day, we continued to be focused on building out our 2-sided marketplace. In this quarter, we launched a number of new tools and services for artists, including a direct upload feature for independent artists, a playlist submission for creators looking for ways to get their music onto our editorial playlist and enhanced functionality really across all of Spotify for Artists. And today, approximately 250,000 creators use Spotify for Artists on a monthly basis. And we expect these tools to help us continue to provide the largest opportunity for the widest group of creators and artists.

This quarter, we also announced several important partnerships that represent significant opportunities for growth and additional value for new users and existing subscribers. In the U.S., just yesterday, we announced a new partnership with Google where new and existing Spotify Family plan master account holders can receive a Google Home Mini as part of their subscription. And we see great potential in this partnership. And as we've said before, we made an early strategic bet on connected speakers back in 2014 when we were on the very first Google Home voice speakers to be shipped. Now as connected speakers become more and more important to consumers, we're excited to be adding to our momentum with speakers and voice, and we will continue to build on our partnership with Google over the coming months.

In the quarter, we also announced a long-term agreement to be the out-of-the-box music service on Samsung devices, and we introduced our first multi-partner bundle in the U.S. with Hulu and Showtime. And we entered into a partnership with Sky, which is Europe's largest pay TV service, to allow users in the U.K. and Ireland to add Spotify directly to their cable bill. And we announced a partnership with DAZN, a fast-growing sports subscription streaming service in Japan.

We remain very confident in the growth ahead for Spotify, and you can expect to continue to see us manage for growth over profitability as we strive to create an ecosystem of discovery and benefits for millions of artists, billions of consumers and really the entire music industry.

And with that, let's open the floor for questions.

[Paul Vogel, executive]

Great. Thanks, Daniel.

So our first question comes from Matt Thornton at SunTrust. "The commentary from the letter around accelerating investment in R&D and content in 2019 and the pressure it would cause on operating margin, is this pressure relative to the overperformance or the -- the overperformance in operating margin in 2H '18? Or is this a signal of the operating margin outlook has changed? Given you're still looking for positive free cash flow, we presume the operating margin pressure would not be that different versus 1H '18 run rate."

[W. McCarthy, executive]

Well, let me begin with an answer and then see if Daniel wants to supplement. So we saw increased operating margins in the current quarter more than we were anticipating because we weren't able to deploy investments in R&D as rapidly as we had hoped, which means that the pace of product innovation is slower than we had anticipated. And we meant to signal our intent to reverse course and accelerate the pace of investment, which will pressure operating margins more than they are currently being pressured by the rate of R&D investment, which is what we were trying to signal.

[Paul Vogel, executive]

Great. Our next question comes from Ben Swinburne at Morgan Stanley.

"You recently revamped the Premium app (I'm a fan, some are not.) Can you talk about what in your view were the key changes, the strategic objective and if there has been any impact on engagement trends or churn?"

[W. McCarthy, executive]

Well, let's really take 2 steps back. We continue to make updates to our product and the user experience, both for our free tier and our Premium tier. Historically, what has happened is that those updates [ are shipped by ] -- every couple of weeks or so with new changes. What we continue to do is that we continue to look at ways where we can streamline the user experiences and make it more easy to use and more beneficial to users. And this is one of those changes that we had priorly shipped with very good results to our free users, and we're now consolidating the code base by also putting the same functionality to our Premium subscribers as well. But all in all, this is something that we had tested for months before, and we're seeing really good results.

[Paul Vogel, executive]

Great. Our next question comes from Mark Kelley at Instinet. "Can you please talk about the hiring constraints you mentioned in the letter? Are there certain skill sets or particular geographies where this is particularly pronounced?"

[W. McCarthy, executive]

Well, I think overall, I mean, it's not a big surprise to know that in particular, when you look at engineering, machine learning, big-scale engineering, those are all skills that are widely demanded in the marketplace. And for us, it's not really about volume, it's about finding the right quality. And that's not something that's, I think, different to Spotify than really any other technology company in the world. And we're certainly looking at that, scaling up both in Europe and in U.S., and we'll continue to make improvements to how we hire and onboard and activate our workforce.

[Paul Vogel, executive]

Our next question comes from Rich Greenfield at BTIG. "In your release, you stated advertising margins will benefit from the shift to self-serve, Programmatic. Over what time frame should we think about the shift to [ track from a direct sales-focused model ] you have today?"

[W. McCarthy, executive]

Many years is the short answer. Programmatic, those kind of automated solutions account for between 20% and 24% of revenues currently and are growing at almost twice the rate of direct. We recently launched a new automated feature. It's still quite early. It's growing extremely fast but off of a very small base, so one. Two, the market is moving aggressively towards programmatic solutions and faster in Europe than they are in the U.S., U.K. in particular. So we've made it a point of tactical emphasis from a product development standpoint, and it's important that we be successful in order to find the operating leverage that the business requires long term in order to generate attractive financial returns. So the market is heading there, and we are driving there as fast as we can.

[Paul Vogel, executive]

Our next question comes from Justin Patterson at Raymond James. "Spotify for Artists beta features, please talk about music uploading and playlist submission. Are there any early learnings on how that's helping artists promote their music better? Additionally, could you explain how these features could benefit labels over time?"

[Daniel Ek, executive]

Yes. I mean, again, we're very encouraged with the early results of this beta test in the U.S. And so far, we've now seen on the new music submission more than 67,000 artists that have submitted their works through that product and over 10,000 new artists that have been added to editorial playlists for the very first time, connecting their music with thousands of new fans. So we're very encouraged by the early results of this.

[Paul Vogel, executive]

The next question comes from Heath Terry of Goldman Sachs. "With the reduction at the top end of your guidance and the increase in operating profit expectations, is there a reason that incremental profit isn't being used to drive subscriber growth? Does this say something about the incremental cost of subscriber additions? What are you seeing in the cost of acquiring customers?"

[W. McCarthy, executive]

Heath, Barry. There -- if you think back to our commentary during Investor Day, we made 2 important points. One is profit margin as a managed outcome is a byproduct of the pace we choose to invest in new features and functionality to drive growth. Second point is the 3 ways to invest in growth: one is marketing; two is geographic expansion, which we're pursuing aggressively; and three is investment in features and functionality that drive a better user experience, which drives more engagement, which drives more customer sat, which drives more word-of-mouth and organic growth, improves LTV and, importantly, improves the LTV-to-sat ratio. So I guess the third point I'd make is, for those who aren't familiar with the company, it's an engineering-driven org. Very product focused. And so the incremental investments are all about building features and functionality that make for a better user experience. And the point is to accelerate the growth of the business as a consequence, as a consequence of those product investments and as a consequence of the investments we're making in geographic expansion. So in terms of the commentary in the letter, because you could see the expanding -- the margins expanding faster than we had forecast, they would -- we were concerned that your expectations would get ahead of ours in terms of the future trend line. So we added some cautionary language. We've given you an incomplete picture of the future and not yet commented on 2019 and any benefits that might result from the investments we're making. So appreciate your patience. That will come on the next call.

[Paul Vogel, executive]

Next question comes from Mark Mahaney at RBC.

"Can you talk about progress -- can you talk about the progress of Spotify's integration with Samsung devices? This has appeared to be leading to a meaningful adoption of Spotify and a ramp to Premium subs."

[Daniel Ek, executive]

Well, again, it's a very recent announcement that we made with Samsung. It's a multiyear partnership, and it's something that we're actively rolling out as we speak, so I think it's too early to talk about the progress. That said, taking a step back, I think when you look at the landscape, we are an independent player in this, and one of our key strategies is to partner with as many players as we possibly can. And by being an independent player in all of this, that opens up for that strategy where we can be on every device, which we know that our customers really enjoy. Because the truth of the matter today is that there's a lot of customers out there that have devices of many of these ecosystems, whether it be Amazon, the Google or Apple ecosystems. And Spotify's goal is to be the topnotch user experience on all of those devices.

[Paul Vogel, executive]

Next question comes from John Egbert at Stifel.

"How should we think about podcasts and how significantly you're investing in that format? What are some of the challenges you face in building out the contact for podcasts? And how do you approach negotiations with content owners? Is there an opportunity to strike fixed-cost deals or more advantageous variable licensing agreements from podcasts relative to music content?"

[Daniel Ek, executive]

I think we're still in the very much early days of how the whole podcast marketplace will evolve. So right now, we're experimenting with different [ deal types ] , both fixed and variable. But I think over time, the way we are looking at this is that this is an integral component. When you look at the landscape overall and you think about something like radio, the truth is that the vast majority of the minutes that are being spent on radio today haven't yet moved online. So our opportunity really is gigantic when you look at that, and there aren't too many companies in the world that are focused on that opportunity of bringing audio online. And as part of that, obviously, we think non-music content has a very important place, and we're really investing in both improving the user experience around that but also improving monetization for creators in that space.

[Paul Vogel, executive]

Next question comes from Ross Sandler of Barclays.

"What pace of ARPU decline do you expect to see in 2019 compared to the current decline [ in ] between? And how does it impact your international mix, Family plan and FX? And what are the biggest drivers?"

[W. McCarthy, executive]

The biggest driver will be growth in Student and Family plan, bigger than geographic expansion and -- one. Two, the rate of decline will continue to decelerate, and I think that's what we're going to say about ARPU at the moment.

[Paul Vogel, executive]

Next question comes from Michael Morris from Guggenheim. "Can you provide more detail on the Google Home partnership? How is it accounted for? And how does it impact margin? Would Spotify be in some way prioritized as a streaming service for users relative to Google and YouTube Music?"

[Daniel Ek, executive]

Well, let's talk about the user experience first and foremost. Yes, it's a great partnership that we have with Google. On the devices that are shipped to customers, Spotify definitely is an integral part and preinstalled on that experience. So we're very excited about it, and I'll let Barry comment on the financial impact.

[W. McCarthy, executive]

We're -- actually appreciate the opportunity to comment. No comment.

[Paul Vogel, executive]

Next question comes from Doug Anmuth at JPMorgan.

"Can you talk about the new Ad-Supported user interface and added functionality you rolled out in the Ad-Supported version [ of it ] earlier this year? Is it already having a positive impact on engagement and retention? And what are you seeing in terms of conversion rates to Premium subs?"

[Daniel Ek, executive]

I think it's really too early yet to say. The early signs are encouraging, but there's still lots of noise in the data. The noise in the data mostly relates to the fact that this is being rolled out in many different geographies with slightly different user characteristics depending on where you are in the world. But so far, the early test result that we did prior to launching this seems consistent with the results that we're seeing out [ in the wild ].

[Paul Vogel, executive]

Next question comes from Eric Sheridan at UBS.

"How should we think about the e-commerce opportunity, ticketing and merchandising, et cetera, on the platform in the coming years? What are some of the friction points at Spotify, their product partners, et cetera, that Spotify needs to solve to achieve their goals?"

[Daniel Ek, executive]

Well, I think if we kind of up-level it and not just talk about the sort of specifics of merchandising and ticketing and instead talk about the fact that at Spotify, our goal is to connect artists and fans, and as part of that, for many, many artists, they have a huge audience on Spotify, and we have a better ability, we believe, over time to discern who are our real fans versus not. And as part of that, you could expect us to enable opportunities as part of our marketplace strategy to create more opportunities for creators to up-sell those super fans' various products.

[Paul Vogel, executive]

Our next question comes from Jessica Reif from Bank of America. "Can you talk about traction in some of your newer or larger markets like Japan? When do you expect to launch in India? And what are the main challenges in launching?"

[Daniel Ek, executive]

Well, we don't break out performance on any specific market. But so far, the results in Japan has been encouraging, and we're -- we keep on investing in that market and believe over time that it will be a very significant market to us. As it relates to market launches, there's a number of different factors that we look at both as we value -- launch in new markets but then coupled with, of course, the industry. India specifically is a very fragmented marketplace with lots of different local labels, lots of different local publishers. Whenever we deal with licensing situations, it's very hard for us to predict the accurate timelines on the basis of multi, multi-partnerships. Just the sheer scale of number of partnerships makes it very hard to predict that. But there's nothing that we see that prevents us from launching in India.

[Paul Vogel, executive]

The next question is from Nick Delfas at Redburn.

"Do you have any plans to charge artists for data or for promoting work on the paid service in any way?"

[Daniel Ek, executive]

Our strategy in our marketplace outside of the business is the same as we have on the rest of the Spotify, which is it's a freemium business, meaning there will be a certain amount of products which artists and labels can get for free and there are others which we will charge money for. So that's an evolving strategy when it comes to our product portfolio. Data specifically is very unlikely to be one of those things that we'll charge for.

[Paul Vogel, executive]

Next question from Lloyd Walmsley at Deutsche Bank.

"Do you expect the path for gross margin improvement towards your long-term targets to be fairly linear? Or should we expect it to be a bit volatile where some years' gains are more substantial than in other years? How should we think about the path in the near term?"

[Daniel Ek, executive]

Well, I certainly would expect, and we've said this before, that the gross margin -- the vast majority of all the gross margin improvements will come from our marketplace strategy. So as we look at the marketplace strategy over time, it is not a function of what previously used to happen, which was 1 or 2 negotiated deals. But instead, more likely, lots and lots of deals that will happen [ on individually as ] artists and labels are purchasing more services.

[W. McCarthy, executive]

And I would add that if over time, let's say, podcast becomes a significant component of the business, that will have its own margin structure separate from music biz and the revenue stream different from the music biz. Today, we observe advertisements on subscription as well as Ad-Supported businesses, and we expect that to also be true on our platform as well. And that business will grow gradually over time, and the effects of that margin structure will grow gradually over time.

[Paul Vogel, executive]

Next question comes from Maria Ripps at Canaccord.

"With the Music Modernization Act signed into law last month, what are the incremental costs for Spotify? Is there an impact on your licensing fees? Could you give us some color on any incremental cost related to creating or maintaining your licensing database?"

[W. McCarthy, executive]

We mostly think there is good news for us in the passage of the act. It makes it easier for us to know who the rights holders are and how to pay them. So I think of it over the long term as a margin-enhancing opportunity, not an added cost.

[Paul Vogel, executive]

Next question from Amy Yong at Macquarie.

"Can you help us through some of the major factors in your current label negotiations? And what's different this time around? Are the labels looking for more data?"

[Daniel Ek, executive]

I can't comment on the specific of any ongoing negotiation with any party. But what I can say is that the primary focus for us is our strategy, which is around the 2-sided marketplace, and that's what we're working with all of our partners on.

[Paul Vogel, executive]

Next question comes from Alan Gould at Loop Capital.

"How does the competitive landscape change with Sirius' plan to acquire Pandora and Apple potentially striking a deal with iHeartMedia?"

[Daniel Ek, executive]

Again, if we take 2 steps backs and look at the landscape and the earlier commentary I made, we believe that the vast majority of minutes that are in radio today hasn't yet moved online. It's quite natural that we're not going to be the only player that wants to get those minutes as it comes online, but we feel really good about our strategy, which is ubiquity, personalization and superior user experience, and that's where we're continuing to invest in.

[Paul Vogel, executive]

Next question from Thomas Singlehurst at Citi.

"There's been some speculation you might be the potential buyer of a stake in UMG now that the asset is formally up for sale. Can you talk about the pros and cons of potentially being an owner of recorded music business and all that might entail?"

[Daniel Ek, executive]

I really can't make any comments on any deal negotiations at this point.

[Paul Vogel, executive]

Next question from Matt Harrigan at Buckingham.

"Given the higher-than-anticipated growth in smart speakers relative to expectations a year ago, and with about 30% of new smart speaker users taking a streaming service, did you feel that you did a more accurate job of incorporating this into your projections than outside analysts? Otherwise, you presumably would have been -- you would have beat subscriber numbers unless there were a shortfall in other areas. Or are smart speakers vastly less important than Student and Family plan?"

[Daniel Ek, executive]

Well, from what we're seeing in our data, it's definitely a rising segment, and it's a very fast growing segment for us. But that said, as the scale goes, all of our other product lines are vastly larger.

[Paul Vogel, executive]

Next question from Barton Crockett at B. Riley.

"Can you give us a sense of the size of the lease expense that will be eliminated from the transition to a new accounting standard next year and the size of lease obligations that will move on to the balance sheet?"

[W. McCarthy, executive]

The contingent liability footnote will give you a sense of the size of the obligations that will move onto the balance sheet. Not anticipating a reduction of expense, just gets carved up into different categories, depreciation and interest expense.

[Paul Vogel, executive]

A follow-up question from Heath Terry at Goldman.

"There seems to be a disconnect between the way the press reports your ambitions for direct distribution relationships with artists and the way you talk about those plans. Can you clarify what you've done to date in direct distribution relationships or direct music content acquisition and what your strategy is for leveraging direct distribution or licensing relationships in music?"

[Daniel Ek, executive]

Well, I think, again, to kind of take 2 steps back, I made some commentary around this on the last earnings call as well. But we don't view our strategy to be in opposition of any of our partners. In fact, we view the strategy really to be enhancing to our partners as well. So if you think about it from the standpoint of the investments that labels, publishers and everyone else makes in the ecosystem today, it's quite substantial in order to bring a new artist to the masses. So there's an enormous amount of marketing and promotion costs associated with that. One way you should view our marketplace strategy is that we want to make that a lot more efficient. And if we can bring down the cost for that, we should see a lot more artists being successful, and we should see a lot more labels be successful in the marketplace as well. But we don't view this as Spotify has to win, labels lose but instead as a win-win, and I think that's the fundamental difference. And then obviously, the point being also is I think everyone kind of looks at what has previously happened in the industry and kind of looks at the -- Netflix being the prime example here. But I think as I've said many times before also publicly, Netflix on the surface is a very similar business to ours. But underneath that surface, it's very, very different in the case of our marketplace strategy and their original content strategy.

[Paul Vogel, executive]

We have a follow-up question from Rich Greenfield at BTIG. "In the U.S., Spotify's podcast market share appears to be high single digits. However, overseas, you are the dominant player in many markets. How do you close the U.S. gap?"

[Daniel Ek, executive]

Well, we're continuing to invest in our user experience and are continuously shipping new updates to our product. Among them, things that you should expect of a great podcast player like the ability to fast-forward, the ability to speed up the content and discovery, of course, being prime among them. And we believe that there's still an enormous amount of potential in improving the user experience. And as we do that, we have a great opportunity of growing our share in podcast.

[Paul Vogel, executive]

And this will be our last question. We're coming up on half an hour. The question is from Greyson Clymer from Melvin Capital. "Can you provide some clarity on why Q4 subscriber growth was lower than top end versus prior expectations? Any clarity on gross net adds or churn trajectory would be helpful."

[W. McCarthy, executive]

Yes. We basically just reverted back to guidance we had previously. If we left that alone, there would have been no change. So my observation was The Street was starting to run to the high end of the range of our guidance, and our objective is to land at about the 70th percentile range of the guidance we give. So I wanted to avoid us being in a situation where we had exceeded our own performance expectations, but we had underperformed The Street's expectations in Q4.

[Paul Vogel, executive]

Great. And with that, we will close the call. If anyone has any follow-up questions, please email the IR inbox at [e-mail]. And we look forward to speaking with you guys next quarter. Thanks, everyone.

[Operator]

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