Spotify’s ARPU and the Story Behind the Metrics

In this Industry Focus: Tech segment, host Dylan Lewis and Motley Fool contributor Evan Niu explain why Spotify's decreasing average revenue per user trend probably isn't as bad as it sounds, how Spotify was actually losing money on its ad-supported customers, and why it's so important to see the forest as well as the trees when you're looking at metrics.

A full transcript follows the video.

This video was recorded on March 9, 2017.

Dylan Lewis: Something that's incredible to me, Evan, looking at the breakouts of their different user types is, up until 2017, Spotify was actually losing money on their ad-supported customers.

Evan Niu: That's pretty standard, considering the industry that we're talking about. Music streaming is notoriously an industry that has really tough economics. And Spotify, because they've had these direct licenses with the record labels for many years, those costs are higher than what a company like Pandora faces, because Pandora uses statutory licenses as a way to minimize their costs. Since Spotify has direct licenses, which they've also recently negotiated, which we'll talk about later on, the costs are just huge. Then, when you're trying to monetize a service with ads, it's not a good experience for the users, because listening to ads constantly is really kind of obtrusive. At the same time, you're not really making a lot of money, either. So, it's not really a great solution for anyone.

Lewis: There have been times when I've been at someone's house and we've been hanging out, cooking dinner or something like that, and we've been listening to Spotify on their account, and you immediately know when it's a free account when you're listening to two or three songs and then all of the sudden you're blasted with an ad for something that has nothing to do with the music you were just listening to.

Niu: Like tires. [laughs] It's just random.

Lewis: [laughs] Yeah. It's certainly a different user experience. And when you think about that price point of $10 a month, it's a pretty compelling offering, given how big their library is.

One of the other metrics, and this one might have people scratching their head a little bit with Spotify, is premium ARPU. This is something that's actually trending down for them. It helps to look at the mechanics of how these numbers are calculated, though. In 2015, we saw just under 7 euros a month for ARPU. 2017, we're at just over 5 euros per month. And I think this calculation, as well as some of the user growth that we talked about earlier, are classic examples of why it's good to read the prospectus and read company conference calls, because you get the explanation of how these numbers are calculated and what is going on with these metrics.

Niu: Right. Certainly, a lot of these bundled plans have helped them really grow their premium subscriber base, particularly these family plans, because any person that's a part of a family plan is included as a separate premium user.

Lewis: Yeah. They might have one family plan with three, even up to six, people on the account, which would all count as premium users for them. So, that might be something that warps an ARPU number, just because you have more users in that denominator. And that's something that management has been super open about and talked about plenty in the prospectus.

One number that's maybe most impressive to me in the prospectus is their churn. It's obvious to me that Spotify has put together a business that people love, and people are not leaving.

Niu: Right. They've put up some really good improvements with bringing churn down, which really helps their retention numbers. These are all related. In the statement, the filing, they note that while ARPU has come down as a result of them introducing these other products like family plans and student discounts, the natural effect is that ARPU is going to come down a little bit.

But the upside is, not only are they helping grow their service because they're getting more people in, their retention of those products is really high. Overall, those products are helping them improve retention across premium overall. And if you think about it, think about a cellphone family plan, the retention for those are really high, too, because it's a pain, it raises the switching costs, if you're trying to switch everyone over from one service to another. But, unlike cell plans, which are still mostly commoditized, Spotify is heavily personalized. Each person has their own very personal account. The more you use it, the more it knows you, the more personalized it is, and the more entrenched you become with it over time, because it understands your music preferences. Now, multiply that by four or six people in your entire family, and now it's a huge cost to switch an entire family plan to a completely different music streaming service that you have to get to know completely again, you have to retrain their algorithms and all that stuff. So, I think it's good for the business in that sense. It does bring down ARPU a little bit, but I think it's well worth the benefit of higher retention.

Lewis: Yeah, it keeps things sticky. And when you're talking about a product that costs $15 a month, you'd have to be saving a lot of money to overcome all of the painful switching costs that we mentioned. If you want the actual churn figure, it was 5.5% in 2017, down from 7.7% in 2015. So, less people are cancelling relative to the overall number of premium subscribers out there.