1 Number That Should Concern Spotify Investors

Spotify (SPOT -7.28%) shared a lot of good news with investors when it released its first-quarter earnings report. Most notably, it surpassed 100 million premium subscribers and beat analysts' expectations for revenue growth.

Spotify's gross margin even came in above its own guidance at 24.7%. Still, that figure was down slightly from last year's 24.8% gross margin in the first quarter.

Gross margin is one of the most important metrics for Spotify. The fact that it declined year over year isn't concerning in itself -- the company is investing in promotions and content -- but the way it declined is very concerning. Here's a breakdown of Spotify's gross margin profile, management's commentary, and what investors can expect in the future.

Spotify CEO Daniel Ek. Image source: Spotify.

A closer look

Spotify breaks down its gross margin further in its earnings report.

Data source: Spotify.

The decline in ad-supported gross margin was massive, but could be explained by the company's expansion into India. Spotify had to pay up-front guarantees to record labels in the Indian market. It's managed to quickly attract 2 million listeners in just a couple months, but it's likely most of them are using the ad-supported plan, and its premium pricing is much lower in India than in developed markets like the U.S.

That said, CFO Barry McCarthy notes that while prices vary by region, margin is a function largely independent from pricing -- both its premium pricing and its ad revenue. Most of Spotify's contracts with record labels pay out a certain percentage of revenue. So India can't completely explain away the big drop in margin, especially considering Spotify's massive presence outside of the country.

What management had to say

In management's letter to shareholders, the execs wrote gross margin came in higher than expected for three reasons: "outperformance of Premium Subscribers, slower than anticipated release of original podcast content, and supply constraints of Google Home Mini devices relating to our Family Plan promotion."

Spotify benefited from a greater mix shift of premium subscribers versus ad-supported listeners. That's very healthy, and the company can certainly afford to sacrifice a little bit of margin on its premium business if it means more subscribers. Growth in premium subscribers continues to outpace the growth in total listeners, but the gap is closing.

Meanwhile, the company's lower expenses for podcast productions and promotions simply pushed that spending out to a later date. When those expenses do hit, that's when investors will see the margin impact.

When will margin expand again?

If Spotify is ever going to turn a consistent profit, it needs to expand its gross margin. It was able to do so most recently by renegotiating its contracts with record labels in the U.S. to offer more favorable terms.

CEO Daniel Ek explained the next round of negotiations aren't likely to produce the same bump in gross margin -- at least not immediately. The current set of deals Spotify is trying to negotiate involve concessions to enable Spotify to push forward its marketplace strategy. Spotify wants to offer ancillary services to the labels to help them grow audiences for their artists. It just needs the labels to buy in.

The marketplace strategy will produce better gross margin in the long run as Spotify is able to offer services to help labels improve their marketing, promotion, artist discovery, and other aspects of their business at very low marginal expense. It's merely providing tools for labels to access the data Spotify already collects on its listeners.

In the meantime, gross margin doesn't appear to be going anywhere. Management's outlook for the full year is for gross margin between 22% and 25%. That's down from 25.7% last year. Gross margin will notably be impacted by the company's investment in podcasts.

Overall, the gross margin outperformance in the first quarter isn't something investors should rely on. The short-term outlook for Spotify's gross margin is weak. If its renegotiations with labels pan out, and it's able to ramp up its high-margin marketplace services, the long-term picture gets a lot brighter. For now, investors need to keep a close eye on the business's gross margin.