Spotify (NYSE:SPOT) has seen its average revenue per user (ARPU) decline considerably over the last couple of years. ARPU declined 12% year over year in the second quarter to 4.89 euros. The main culprit has been the simplification of its family plan to a flat fee per household, the growth of its student plan, and the introduction of bundled streaming services such as Hulu.

But CFO Barry McCarthy said he doesn't want to increase pricing despite pressure from record labels to do so. At an investors conference last month, McCarthy said it's better to show total revenue growth, and there are a lot more effective ways to do that than by increasing the price subscribers pay each month. He points to the success of Netflix, where McCarthy was CFO from 2004 to 2010, which managed to grow rapidly without increasing prices for a very long time.

To that end, investors should expect Spotify to invest in growing revenue in other ways than increasing price. Here's how that could impact the company.

Spotify's Discover Weekly playlist on a desktop computer.

Image source: Spotify.

Keep on scaling

Spotify has over 180 million monthly active listeners, 83 million of whom pay for a subscription. That makes it twice as big as Apple's Apple Music on a paid-subscriber basis and over twice as big as Pandora in terms of total listeners.

Spotify's position as the largest music streaming service outside of China gives it considerable advantages. First, it gives it negotiating leverage with music labels when it comes to renegotiating contracts. More importantly, scale provides Spotify with a lot of data, which it uses to enhance music discovery on the platform. That can be a key factor in improving customer retention in a market where most competitors have access to the same product catalog.

What can drive scale and revenue?

Spotify outlined several growth strategies in its registration filing with the SEC. They include:

  • Continually enhancing the core platform. That includes investing in the development of new discovery capabilities, as well as the improvement of the overall user experience. Spotify may also look to acquire technology and talent as it has in the past.
  • Further penetrating its existing markets. It can do this by increasing marketing spend, adding features to the ad-supported service, and increasing the number of artists on the platform.
  • Expand to new geographies. This is pretty self-explanatory. Spotify currently operates in 65 countries, but it has an opportunity in about 120 more. Before entering a market, however, it usually needs to obtain the rights to popular local music and hire local curators for discovery.
  • Expand non-music content. Spotify is building out a catalog of podcasts that could provide yet another reason to sign up for a premium subscription.

Each growth initiative sacrifices profits in the short term for long-term user growth. Over time, Spotify expects the moves to pay off as it improves its ad platform (another area of investment), increases conversions from free listeners to paid listeners, and continues to leverage the value of its increasing scale.

While Spotify has made progress in improving its gross margin, it's not showing improved operating leverage. In fact, where gross margin improved 2.8 percentage points in the second quarter, operating margin improved just 0.7 percentage points. In other words, operating expenses as a percentage of revenue are increasing.

So how will investors know if the strategy is working?

McCarthy says the one metric that will show the strategy to scale the business despite rising costs is working is an improvement in the ratio between the lifetime value of a subscriber and the average subscriber acquisition cost.

As of the end of 2017, the ratio stood at 3.6 times for premium subscribers. That means Spotify is bringing in 3.6 times the amount in subscription revenue as it spends to convert that person into a paid subscriber. Of course, part of that conversion process is operating an ad-supported service. When factoring in the costs associated with the ad-supported service, that ratio fell to 2.7 times. Management said that ratio stayed steady in the first quarter, but didn't provide an update in the second quarter.

One of the main drivers of that ratio is the subscriber churn rate. And it appears Spotify's investments in family plans and bundles are paying off, as churn fell from 6.9% in the first quarter of 2016 to 5.1% in the fourth quarter of 2017. Management said churn continued to fall in the 2018 second-quarter letter to shareholders.

Management might not provide an update on lifetime value and subscriber acquisition costs and churn every quarter, but investors need to pay attention to anything they do say, as it's the best indicator of Spotify's long-term health.

Adam Levy owns shares of Apple. The Motley Fool owns shares of and recommends Apple, Netflix, and Pandora Media. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.