Spotify Technology (SPOT) Q2 2019 Earnings Call Transcript

Spotify Technology (SPOT -4.62%)
Q2 2019 Earnings Call
Jul 31, 2019, 8:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Welcome to Spotify's 2019 second-quarter 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. An archived replay will be available on the IR site after the event concludes.

I'll now turn the call over to Paul Vogel, head of investor relations and FP&A. You may now begin your conference.

Paul Vogel -- Head of Investor Relations and FP&A

Great. Thank you, Denise, and welcome to Spotify's second-quarter 2019 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 brief opening remarks followed by an online question-and-answer session. Question can be submitted either through the widget alongside the webcast or by emailing directly to [email protected]. We'll get through 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 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 -- Chief Executive Officer

All right. Thanks, Paul, and thanks, everyone, for joining today's call. Overall, the business performed well in the second quarter. A key metric that illustrates the health of our business is user engagement and this quarter, our users listened to more than 17 billion hours of content on the platform, up 35% year over year.

And as you saw in our shareholder letter, all of our key metrics finished within or at the high end of our forecast except for quarter-ending subs. Our goal is to land at roughly the 78th percentile of our guidance, and we missed on subs. That's on us. The good news is the shortfall was execution-related rather than softness in the business, and we expect to make up the lost ground before year end.

At our investor day in April of last year, we said that we're still in the early innings of the growth of the streaming audio market, and we still believe that true's today. As you can see from our second-quarter results, we're really expanding the top of our funnel. Ad-Supported MAU growth accelerated in this quarter for the second consecutive year and was our fastest year-over-year growth rate since 2016. In Q2, we also delivered 31% year-over-year subscriber growth, which we believe is roughly twice the rate of growth of our nearest closest competitor.

We have also reached agreements with two out of our four of our major label partners on the renewal of our global sound recording licenses, and we're in active discussions with the other two. And this is the sixth round of label negotiations that we worked through in our 13-year history. And while it's typically a long drawn-out process, it's really part of our normal cadence. To reiterate, one of the primary goals for this round of negotiations is about enabling our two-sided marketplace strategy.

Our development of the strategy is well under way, including testing and prototyping products with a few key partners. We see a tremendous potential and there will be more to come in 2020. Now let's open the floor for questions.

Paul Vogel -- Head of Investor Relations and FP&A

Great. Thanks, Daniel. Our first question comes from Mark Mahaney at RBC. Could you talk a little more about the key drivers behind churn reaching record low levels? How should we think about this churn percentage trending over time? Should it hold relatively steady from here or continue to move downward?

Barry McCarthy -- Chief Financial Officer

Hey, Mark, Barry. Well, look, as we continue to make investments in improving the overall quality of the user experience, both from a content perspective and with respect to the features and functionality of the app and our ability to understand people's likes and dislikes and deliver content to them that they will engage with, we ought to continue to see that higher customer sat leads to lower churn. So on a year-over-year basis, we were at 5% monthly average churn in Q2 of last year down to 4.6 this year. I expect that trend will continue unless there's some dramatic shift in product mix, say away from some of our lower-value plans to higher-value plans, and we're not expecting that to happen.

So the strategic goal of the business is to continue to invest aggressively in improving the user experience. And if we make wise investments, then we will continue to see longer lifetime value. So today, users are worth more than they were a year ago principally because of the LTV-to-SAC ratio, which at the time of the investor day, was sitting at two and a half times to one, is now sitting at about 3.1 to one.

Paul Vogel -- Head of Investor Relations and FP&A

Great. Thanks. Our next question comes from Eric Sheridan at UBS. How should investors think about the framework of investments, content, M&A, gross and operating margin impact, the long-term opportunity in podcasts? And how are you thinking about the long-term return in terms of driver of subs engagement and monetization?

Daniel Ek -- Chief Executive Officer

Well, I can answer that. I think overall, we're still, to level set, in the growth phase of the business and very early on, as I mentioned in my opening remarks, of the streaming audio market. And there are a number of levers we can pull when it comes to growth. So one is, of course, investment in product capabilities, and you saw a number of those over the course of this quarter.

The second one of those is, of course, improving our content portfolio and just the range of content that we have on the service. And you saw a bunch of that happening over the course of the quarter 2. And then third is pricing, and pricing obviously ends up being a function where we said for a long time that we believe in the current pricing strategy that we have in order to drive future growth. But we're actively investing a lot in both improving our product capabilities and the content mix on the service.

Paul Vogel -- Head of Investor Relations and FP&A

Great. Our next question comes from John Egbert at Stifel. Great news on reaching agreement with two of your major label partners. Are you able to discuss whether your new deals offer more flexibility for bundling services with partners and/or carving out revenue attributable to podcasting? In general, how do your label partners feel about podcasting becoming a bigger part consumption on the platform?

Daniel Ek -- Chief Executive Officer

I can't disclose specifics about the deal terms that we have with any single partner. What I can say is that the primary focus for this round of negotiations has really been about enabling the marketplace strategy. And that marketplace strategy enables more from each and every one of our content partners and creators to do on the platform. You can see already early evidence of that when we have vertical videos, where creating the Spotify Singles is a great example where it's a format with -- where artists are covering songs of other artists, including some of their own in acoustic settings.

So the whole purpose of that is just enabling artists to directly connect with fans in much bigger ways than what they're doing today. So that's definitely part of that mix. And then as it relates to podcasting and the impact it's having on the overall platform, we've said it before, but I'll say it again. What we're seeing right now in terms of podcasting is it's really accretive well, both in terms of the overall user experience.

And we find that the people who are listening to podcasts are also listening to more music, i.e., really good news for the whole industry.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Doug Anmuth at J.P. Morgan. With marketplace services set to launch in early 2020, do you expect this product to be revenue-generating or cost-reducing? Meaning are they incremental revenue or more closely tied into label deals and a way to improve label economics?

Barry McCarthy -- Chief Financial Officer

This is Barry. For the most part, Doug, we expect them to be margin-enhancing.

Paul Vogel -- Head of Investor Relations and FP&A

Next question comes from Nick Delfas at Redburn. You recorded 30% revenue growth, and no label records that high in streaming revenue. UMG was 23%; Sony, 27%. Are the majors losing share? Or is it about geographical mix?

Daniel Ek -- Chief Executive Officer

I can't speak to exactly what our label partners' growth rates we're looking at. But what I would say it's probably a mix of their overall business, so remember, not the entirety of the music industry is streaming yet. We are obviously hoping that streaming becomes an even bigger part of the music industry, but they are still very much physical businesses, streaming businesses and many other parts that makes up the total revenue mix. So that probably explains the delta.

Paul Vogel -- Head of Investor Relations and FP&A

Next question from Ben Swinburne at Morgan Stanley. You called out execution on Student plan as a driver of net ad shortfall and not demand or competition issue. Can you give us some more color on your conviction it was execution? Separately, do you think this new higher advertising growth rate is sustainable through the second half?

Barry McCarthy -- Chief Financial Officer

Let me take them in reverse order. Our guidance reflects our expectations about the ad business. I think that our year-over-year growth rate will come down slightly. I think we'll sustain 34% year over year on the ad business, particularly if you recall that we had exceptionally strong Q3s and Q4s a year ago and from a year-over-year growth perspective.

I'm sorry, can you repeat the first part of the question?

Daniel Ek -- Chief Executive Officer

It was about the missed student.

Barry McCarthy -- Chief Financial Officer

On students, as well, we can see what the results were versus our own forecasts on a kind of by line-by-line basis, which is why we know where we missed and how much we missed by. It was less than a million in aggregate. I think the consensus -- seen two consensus forecast 108.8 million, 108.5 million, which is how I know we missed by less than a mill. The problem with the execution was we didn't tell anything about -- anybody about it, so it was only a few who'd stumbled across it randomly by chance.

If you were a user, that you would have known it was in the marketplace. It had no marketing support for it at all. So that's on us. It's a relatively easy fix.

It just want to cut away from us in the quarter. And I think there was question about competition and how we're growing relative to comps. And we said we think we're growing at roughly twice the rate on a monthly basis. That's based on the last public disclosure from our next-largest competitor, how they are tracking as compared with their previous public statements as compared with our own.

I know relative market growth was a concern for investors a couple of quarters ago. I think at least the most recent comparison shows that we've got very strong traction in the business.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Brian Russo at Crédit Suisse. Regarding the direct upload and artist distribution offering you reacently shut down. Can you discuss the motivation to exit this business, if you have not already? And could you also give us some perspective on how material the investment in this area has been?

Daniel Ek -- Chief Executive Officer

Well, the first thing, just to -- as a bit of an education. We do have a lot of experiments at Spotify when it comes to our product capabilities. And so as you saw in the general consumer sense, you've seen us now expand on Spotify Lite going from beta into a formal one, and now Spotify Stations being in beta rolling out to more markets. So the direct upload capability was one of those beta programs.

And as it happens with some of those experiments, they just don't pan out to the same extent that we originally believed. And therefore, we made the call to refocus our efforts elsewhere. Now as it relates to what we're focusing on, we are very much focusing on the marketplace side of the business. And in there, we are actively prototyping away new products together with our partners.

And we're really excited about that, and we hope to come back in early 2020 with more data on that.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Matt Thornton at SunTrust. You guys have mentioned that one of the things you want to get out of the label renegotiations is the ability to optimize ad load by user. How impactful would this be to engagement retention and monetization, i.e., would this be a needle movers?

Barry McCarthy -- Chief Financial Officer

Barry. Not clear yet, based on our experience in the marketplace. So it's still a hypothesis that we embrace. We don't have data to prove or disprove it yet.

Paul Vogel -- Head of Investor Relations and FP&A

Justin Patterson at Raymond James. You mentioned reinvesting the podcasting at -- reinvesting in the podcasting ad experience by building out a new tech stack. Can you talk a little bit more about the challenges you need to overcome? And what extent you can leverage your existing tech stack for music?

Barry McCarthy -- Chief Financial Officer

Well, the tech stack in podcasting today is as embedded in RSS feeds. They don't know anything about your likes or dislikes. It's like an FM radio ad. Maybe best you know something about the demo of the audience you're delivering against.

And we think we can do considerably better with digital ad and searching technology that enables us to have a much more targeted user experience. So that's what we strive for.

Paul Vogel -- Head of Investor Relations and FP&A

Next question comes from Ross Sandler at Barclays. What new geographies could you move into over the next few years that you aren't in today? Secondly, how has the India launch gone compared to your expectations?

Daniel Ek -- Chief Executive Officer

Well, in terms of markets, obviously our ambition is to be in every market in the world. And we're currently in 79, so there's still some room left to grow. Primarily, that relates to Africa, Russia, South Korea among a few. And we did mention India specifically in the shareholder letter.

It's grown in line with expectations. And just to level set, the outperformance on MAU is not related to India. We're pleased with the progress of India, but that's not the explanation to the outperformance.

Paul Vogel -- Head of Investor Relations and FP&A

I think more -- why don't you give them a little more explanation on what we're -- why the upside in MAU for the quarter?

Daniel Ek -- Chief Executive Officer

Yeah, I mean as I mentioned in terms of the rate of experiments that we're doing here at Spotify. I know everyone wants to know that -- the single sort of attributing thing that caused the outperformance. The truth of the matter is it's not one thing. It's a lot of small things that adds up to a much better experience.

And that better experience then translates into higher user growth, better engagement and lower churn. So you saw us shift a number of large initiatives, like Spotify Lite and Spotify Stations in the quarter. You also would have been able to see probably 50 to 100 minor experience changes that all in all leads to higher engagement, which leads to higher retention in the business. And that's for me the exciting thing right now is that there is a lot of those kind of small tweaks that we can do that in aggregate, really compounds into an overall better experience and increases engagement.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Heath Terry at Goldman Sachs. Given the slight shortfall in subscribers and the profitability leverage you saw elsewhere in the model and the reason you aren't investing more in subscriber acquisition, is it a function of SAC limitations? If so, how does lower churn impact the way you're thinking about SAC? Are you willing to accept -- the SAC you're willing to accept in the business?

Barry McCarthy -- Chief Financial Officer

Nothing has changed in terms of the way we think about marketing. We remind you there a couple of different ways to grow the user base. One is to invest in marketing and two, is to invest in the user experience. The two forms of user experience investment are: one, investing in the amount of content available on the platform.

Think podcast, and we're very aggressively investing there. The other is the quality of the user experience. Examples include what Daniel just described. And it's basically about enabling users to have a better user experience because we have a better understanding of what kinds of content they will want to be exposed to and engage with.

And we are investing very aggressively there, primarily technology-related investments, which is people and engineering know-how. So there's nothing about the current performance of the business that is causing us to rethink the asset allocation decisions we've made to drive growth. And those are principally the user experience, engineering know-how and content.

Paul Vogel -- Head of Investor Relations and FP&A

The next question comes from Maria Ripps at Canaccord. Your full-year gross margin outlook implied upside from prior guidance. Can you talk about the key drivers there and whether the two label agreements you mentioned in the press release are expected to bring some leverage? Can you also refresh us on your long-term content cost structure for music and nonmusic?

Barry McCarthy -- Chief Financial Officer

So the new label agreements are not contributing. Our expectation is that the other two agreements, when completed, will also not contribute, which is consistent with the expectations we told you to have for the label agreements. But we have made -- so where we -- why are we outperforming? A couple of things. One is our P&L expense related to podcast investments is a little bit lower than we were expecting it to be at this stage in the calendar year.

We're spending as aggressively as we thought we would on pods, but it's not finding its way to the P&L as quickly as we thought it would. And then secondly, we have been pursuing a number of investments to reduce our cost of delivering content to users. Some of these are collaborated-related costs, and we had good progress there. And we've seen some savings as compared with our expectations.

Paul Vogel -- Head of Investor Relations and FP&A

Next question comes from Jessica Reif Ehrlich from Bank of America. Can you give us color on the markets that are shifting from physical to digital, like Japan and Germany?

Daniel Ek -- Chief Executive Officer

Yeah. I mean as it relates -- I think it's -- there are some markets that are more physical than others and have sort of a longer lag in terms of adopting to that. And there are some that are much quicker. I honestly wouldn't be able to say what's the contributing factors to that other than to say that typically what we found is that broadband matters tremendously.

Smartphone penetration matters tremendously. And so to the effect that there are new developments like 5G and so on, we expect all of those catalysts, including other services progress like video subscription services, et cetera, to educate people that paying for content online is a much better value proposition. And I think that's what we're seeing in some of those markets now. It's just a general acceptance that ownership is not the prevailing form, and that shifts the industry and the norm.

And then eventually, what happens is that the artist and creators start embracing that and start marketing that as the primary way for people to enjoy their content as well. And I think we're starting to see that happen in a big way in Germany and much earlier so in Japan, but I expect that trend to continue.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Mark Kelley at Instinet. Can you discuss the long-term view on form podcast content might take? What's the right way for us to think about the mix of longer shelf life content versus more news-oriented content that will have to refresh consistently?

Daniel Ek -- Chief Executive Officer

Well, overall, I would just say this is an entirely new medium, not unlike maybe in the past radio and just general audio services. So the number of verticals, while the general perception today is that it's typically pretty male-dominated, very techy talk shows, the engagement that we're seeing in terms of our content is we're seeing good progress across scripted content, true crime being a massive category for us and growing very, very fast. But we're also seeing, of course, music podcasts growing very fast, which if you look historically in podcasting, that's not been a big category, but that's becoming a much bigger one. So news actually ends up being -- with short shelf life, ends up being a smaller part of the overall mix.

But we expect the ranges of categories of content to be broadened as new creators find its way to the medium.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Lloyd Walmsley at Deutsche Bank. As you think about integrating better ability for music labels and musicians to promote their music within playlists or otherwise as part of the two-sided marketplace strategy, how does your focus on user experience constrain what you're willing to do here over the near and longer term? How do consumers feel about this in your survey work?

Daniel Ek -- Chief Executive Officer

Yeah. Overall, I would just say that there -- typically, when we look at these type of developments on products, we look at things as in polar oppositions. So if it's good for one side, it has to naturally be bad for the other side. That's not at all what we're finding.

Instead what we're finding is it's actually enhancing. So if you look at the No. 1 thing our customers are saying is help me find more great music. And the No.

1 thing our artists are telling us is help me connect with my fans. And so it's actually the same question both are asking us to help solve. So we believe that we can do something that's net positive from a user-experience point of view, while at the same time also helping labels and artists with the real pressure point for them, which is that they today have to participate in the marketplace by spending a lot of money, going onto other digital platforms, marketing that content in a non-native environment, where you then have to click a couple of links and then end up a minute or two later listening to that content. So if you really think about it from a user point of view, it's a much better experience to have content being promoted to you next to where you're actually listening to that content.

So we think it's a net positive for the user experience and a net positive for the music industry.

Barry McCarthy -- Chief Financial Officer

I think Lloyd wants to know if you're going to promote content that, say, Paul doesn't care about in order to drive revenue. The answer to that is no.

Daniel Ek -- Chief Executive Officer

Yes.

Paul Vogel -- Head of Investor Relations and FP&A

Our next question comes from Kevin Rippey at Evercore. In the release, you note if and when you commercially launch the two-sided marketplace products, specifically on the if part of that phrase, what would be the factors that would prevent a commercial launch?

Daniel Ek -- Chief Executive Officer

We don't see anything at this point that would prevent us from launching products. We may tweak what those products are. We may evolve them, and you should probably expect that. This is really just generally as we look at product and tech developments, it's an iterative approach, and we learn based on the feedback we get from customers and partners alike.

So you're going to find that whatever we're launching with, that's going to evolve over time. But it's more around a when rather than an if.

Paul Vogel -- Head of Investor Relations and FP&A

Next question comes from Giasone Salati from Macquarie. What is Spot's view on audiobooks?

Daniel Ek -- Chief Executive Officer

Overall, interesting segment. Again, my view is it's obviously massively growing. I would say though that when you look at the podcast that we have seen, true crime, there really isn't that much of a difference between those and some of the audiobooks that are available. So I think in the future of audio, we're going to have an interesting development where we need to think long and hard about what are the optimal formats for consumers.

Are we talking about an eight-hour type of programming or two-hour programming? And there's is going to be a ton more experimentation, I think, across the board. 

Paul Vogel -- Head of Investor Relations and FP&A

Can you update us on the Samsung partnership? When did it launch? Did it have an impact on 2Q? Thoughts on the second half impact and how is SAC accounted for? Comes to us from Jason Helfstein at Oppenheimer.

Daniel Ek -- Chief Executive Officer

I can start with the first part of that. So the partnership is going well. We are actively rolling out more and more, obviously being on more and more Samsung devices being the sort of key partnership. It is contributing to our growth.

I wouldn't say it's a super-material part of the overall growth numbers yet, but it's an important partnership for us. We're happy with the future product road map that we have together with Samsung.

Paul Vogel -- Head of Investor Relations and FP&A

Next question is from Michael Morris at Guggenheim. Given that gross margin expansion in 2Q was is driven by operating efficiencies, why is this -- why does guidance not imply similar expansion in 3Q and 4Q?

Barry McCarthy -- Chief Financial Officer

It wasn't just driven by operating efficiencies, although that was a contributing factor to it. We also saw lower promotional-related expense find its way into the P&L, one month of promotion instead of two. And we also had lower content costs related to regions and product growth. So all the three factors were drivers.

Paul Vogel -- Head of Investor Relations and FP&A

Ou next question comes from Thomas Singlehurst at Citi. There have been reports that you overpaid royalties to songwriters and publishers. Have you quantified this? And will this one-off be resolved one way or another by the end of 2019?

Barry McCarthy -- Chief Financial Officer

No, we haven't quantified it.

Paul Vogel -- Head of Investor Relations and FP&A

Next question comes from Mark Zgutowicz at Rosenblatt. Please discuss outbound marketing plans for podcasts, timing and relative spend. And rate your curation of podcast content and importance -- and important correlations for rising podcast listenership.

Barry McCarthy -- Chief Financial Officer

We don't actually talk about marketing spend related to individual types of content, so don't have any comments there. In terms of curation, or -- I think I misunderstood the question. How do we promote content to individual users based on our understanding of likes and dislikes?

Paul Vogel -- Head of Investor Relations and FP&A

I believe so. It's about curation of podcasts.

Daniel Ek -- Chief Executive Officer

Yeah. I mean, overall, I would just say we're still in the early innings. We have some raw capabilities, but we are actively developing better and better machine learning models that help us specifically as it relates to podcasting. And we expect over time that it will contribute a lot more than what it currently does in terms of our ability to drive further engagement in podcasting.

Paul Vogel -- Head of Investor Relations and FP&A

Next question, what is Spotify's view on other monetization methods such as micro payments and tipping by fans on the platform?

Daniel Ek -- Chief Executive Officer

It's something that we're overall interested in. We definitely look at it as part of the scope of the marketplace types of tools and services that you can expect. I don't know the specifics around which one of those things you should be expecting. But again, the genesis really in the company is to experiment a lot.

And based on the feedback that we are going to see, we are going to roll it out more broadly or we won't. And so you should expect us to try a lot of different things, among some of them, the things that you're asking about. And it certainly could be very interesting specifically for a lot of artists.

Paul Vogel -- Head of Investor Relations and FP&A

We'll take two more questions. This one from Richard Kramer, Arete. What do you think has allowed Apple's success and about them overtaking Spotify in the U.S.? Can you address this?

Daniel Ek -- Chief Executive Officer

Well, I don't know the specifics about what numbers they claim to have in the U.S. relative to ours. The only thing we can say and do is really that we're focusing on our own growth. And we're still seeing great numbers in North America and across the board.

As mentioned, we are seeing an increase in the top-line growth of the funnel, which typically correlates to stronger engagement. The stronger engagement typically then correlates to stronger conversions to pay subscribers, and that in turn means also, in this case, that we have lower churn. So that's the predominant way of -- focus that we have. All of our competitors have their relative strengths.

Ours is our investment in premium, in personalization and in ubiquity, which means we want to partner with all players out there in all of the different verticals. And some of those are Microsoft, Samsung and others, and you should expect us to keep investing in all of those pillars.

Paul Vogel -- Head of Investor Relations and FP&A

OK. And our last question, do you have any update on the status of your complaint against Apple at the European Commission?

Daniel Ek -- Chief Executive Officer

Really no update at this point. It's a process that takes quite a lot of time. so you shouldn't expect a speedy sort of response back on that. This is really kind of a multi-year effort.

Paul Vogel -- Head of Investor Relations and FP&A

Great. We do a lot of questions this time. I think folks are starting to figure out our earnings calls. So if we didn't get your questions directly, we'll try to get to you individually.

Or you can always email the IR box, and we'll try to get back to you. And with that, I'll turn it over to Daniel for a quick closing comment.

Daniel Ek -- Chief Executive Officer

Yes. I just want to say again I'm really excited about this quarter. Very pleased to see the engagement increasing and the top of the funnel increasing. And yes, we look forward to coming back to you all for the third quarter.

Paul Vogel -- Head of Investor Relations and FP&A

Thanks, everybody.

Questions & Answers:

Operator

[Operator signoff]

Duration: 35 minutes

Call participants:

Paul Vogel -- Head of Investor Relations and FP&A

Daniel Ek -- Chief Executive Officer

Barry McCarthy -- Chief Financial Officer

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