As Spotify (NYSE:SPOT) expands to more markets and increases the number of people on its student and family plans, its average revenue per user, or ARPU, has declined substantially. ARPU fell to 4.89 euros in the fourth quarter for Spotify's premium subscribers, down 7% year over year.
For a company that's already struggling to turn an operating profit, declining revenue per user might seem like a bad sign. But there are a few important factors to consider beyond ARPU that indicate Spotify's financials are still trending in the right direction.
What's behind the decline?
The first factor to consider is: What's behind the decline in ARPU? There are two reasons.
First, Spotify is experiencing greater growth from markets where it charges less per month for its service compared to growth in countries like the U.S. where it charges more per month. As a result, the average price paid is going down.
While ARPU is generally lower in those markets, licensing costs can also be lower in those regions as well, as users stream more local market content. As a result, Spotify is able to keep relatively stable gross margins.
Second, Spotify is growing the number of users that sign up for the service via student plans or family plans. Spotify offers U.S. students a heavily discounted bundle of streaming services with the intent of getting them to switch for life after they leave college. Spotify's family plan allows up to six people to pay $15 per month for access to the service. In both cases, customers could be paying less than $3 per month for Spotify.
But Spotify says student and family plans have lower churn rates compared to single subscribers. It's a pattern seen in nearly every subscription service: The more people tied to an account, the harder it is to cancel.
Speaking of churn
Spotify CFO Barry McCarthy noted expectations for increased churn in the first quarter this year after heavy promotions in the fourth quarter. Over the longer run, however, churn is trending downwards as result of initiatives including pushing more family plans and increasing engagement with content like podcasts.
In the letter to shareholders, McCarthy said the decrease in churn completely offsets the decline in ARPU. That's to say, subscribers might be paying less per month, but they're paying for more months. The lifetime value per customer is steady.
Meanwhile, the subscriber acquisition costs are down. So Spotify is gaining leverage from its marketing expenses by pushing more student and family plans instead of trying to get each individual to sign up for a $9.99 per month (or equivalent) account. McCarthy says the ratio of lifetime value to subscriber acquisition costs increased 40% year over year.
Expanding gross margin
One final factor to consider is Spotify's gross margin expansion. Gross margin expanded 220 basis points to 26.7% in the fourth quarter, 25.8% excluding non-recurring items. So, with lifetime value holding steady, each subscriber is generating significantly more gross income over the life of their subscription than a year ago.
Combined with lower operating expenses, Spotify is starting to show signs of long-term operating profitability. Its operating income turned positive for the first time last quarter.
Spotify does expect gross margin to decline significantly in the first quarter. McCarthy attributed the decline to investments in podcasts during the company's fourth-quarter earnings call. It acquired Gimlet and Anchor and plans to buy more podcasting companies in the near future, setting aside as much as $500 million for such acquisitions. McCarthy says looking solely at non-podcasting gross margin, it continues to expand.
Management expects the investments in podcasting to reduce churn in the long run and come with lower overall costs than licensing music. That should enable even greater gross margin expansion in the long term.
As long as churn continues to fall in response to declining ARPU, enabling Spotify to produce steady lifetime values for its subscribers, investors don't have anything to worry about.