Behind the Music, Spotify's Inaugural Earnings Report Fell a Bit Flat

In this segment from MarketFoolery, host Chris Hill and Motley Fool Rule Breakers' David Kretzmann dig into the background behind Spotify Technology's (SPOT 2.77%) first earnings release as a public company. With 65 million paid subscribers, it remains the undisputed leader in the streaming-music space, and its 170 million monthly active users give it a rich vein of listeners to mine for subscription growth.

Also important: Its finances are solid. Still, Spotify's report was uninspiring, and questions remain about how it might build itself a competitive moat.

A full transcript follows the video.

This video was recorded on May 3, 2018.

Chris Hill: Happy first earnings report ever to Spotify. Spotify's first quarter wasn't great. [laughs] But, they have 170 million users. They have 75 million people who are paid subscribers. When you looked at the quarter, what stood out to you?

David Kretzmann: They continue to grow both their free ad-supported users and those premium subscribers, like you mentioned. They have 75 million premium subscribers. That still puts them soundly in the No. 1 position in that streaming music space. Apple, in their quarter earlier this week, they reported that they have over 40 million paid subscribers with Apple Music. So, Spotify has almost twice the number of paid subscribers as the No. 2 player there. Their leadership position is impressive. They're guiding to hit somewhere between 92-96 million paid subscribers in 2018.

So, when I look at Spotify, I think the near-term outlook over the next one or two years is pretty bright, because they really have a nice funnel with their 170 million monthly active users, a lot of people who are their ad-supported users, so they're not paying anything for the platform. But, that's a nice funnel to potentially upgrade those people to the premium subscription. That gives them a nice tailwind or runway for growth over the next one or two years.

I think the longer-term question, or the clouds hanging over the business, people might be having a harder time figuring out, where does Spotify go from here? If Apple, Amazon, Google, YouTube are rolling into the streaming music space, what can Spotify do to create some sort of sustainable differentiator from those other services? I think the challenging thing with the music category, to have a music streaming service, you can't just have a small selection of songs. You need to have basically every song that's out there and more. And that "and more" piece is, I think, what people are waiting for. Do they go into exclusive contracts with artists, do they have original music? I think right now, if you're an artist or a label, you don't necessarily want to limit yourself to one platform. At this point, you want to be on as many platforms as you can.

But, the ultimate question here is, can Spotify get to a point where they have more leverage in that relationship, and they're the one place where artists or labels want to go to? I think, if you're thinking about buying Spotify, you really have to believe that they can get to that point.

Hill: This quarter wasn't really all that much of a surprise in the sense that we've seen this from a lot of companies, particularly in the tech space, where, they go public, and that first quarterly report just isn't all that great. And as we've said many, many times, it's so much more challenging to be a public company than it is to be a private company.

That being said, I think that one of the advantages Spotify now has as a public company is, it's very easy to compare them side-by-side with Pandora. Because, for the longest time, if you heard one name, the other name followed immediately, and those were the two comparisons. Now that Spotify is a public company, and you can compare it to others, you can just look at it and say, "Oh, no! Spotify is so much bigger than Pandora."

Kretzmann: Bigger and better. [laughs]

Hill: Bigger and better. It's a $30 billion company. Pandora is not even a $2 billion company. So, I think, in terms of the narrative, and to your point about musical talent and what they are considering, Pandora is way off to the side, and it's really much more about Apple Music, Spotify, and you could probably throw Amazon Music in there as well, although that's just kind of an add-on with Prime.

Kretzmann: And supposedly, Amazon Music has tens of millions of users. I think that's the latest number that Bezos and Amazon put out. So, they might be a No. 3 or No. 4 player. There's no doubt that Pandora dropped the ball when it came to launching an on-demand subscription package. For such a long time, Pandora was just dependent on that ad-supported platform, and I think they're still below 10 million premium subscribers -- well behind Spotify, Apple, Amazon.

Spotify, compared to Pandora, is in a far better situation. Pandora, I don't think, has ever been profitable or free cash flow positive. They continue to burn cash and mount up some pretty substantial losses. Spotify is free cash flow positive. They have no debt, over $500 million in cash, which is why they were able to do this direct IPO where the company itself wasn't actually raising money when it went public, it was just giving liquidity to insiders and shareholders.

So, Spotify has flexibility here. It's not like they need to scramble for a solution. But I think, for Spotify, they need to figure out over the next three years or so how they can differentiate themselves, and that's really the question I think investors or potential investors should be watching.