Spotify (NYSE:SPOT) produced better-than-expected subscriber growth in the third quarter. Total listeners reached 248 million, with paid subscribers at 113 million. In just three months, Spotify added 16 million net new listeners. That's about one-quarter of Apple's (NASDAQ:AAPL) entire user base.

Management points out it's adding twice as many subscribers per month as Apple Music, according to publicly available data. It also says it's adding more total listeners than Amazon (NASDAQ:AMZN) on an absolute basis, and Amazon's listeners skew more toward ad-supported than Spotify's user base.

Additionally, management says engagement on Spotify is twice as high as Apple Music and three times as much as Amazon's streaming options. It also says it exhibits a churn rate half that of Apple Music for its premium subscribers.

Those numbers indicate Spotify has built a real competitive advantage. Not even the big tech companies are cutting into its growth.

A person standing at a reception desk in Spotify's offices.

Image source: Spotify.

How Spotify keeps adding new users

Spotify has seen a lot of success in attracting new users in developing markets recently. The percentage of total listeners coming from outside North America and Europe has increased by 6 percentage points since the start of 2018. 

But Spotify isn't seeing conversion rates to premium subscribers in developing markets keep up with its more established markets. Around 70% of premium subscribers still come from North America and Europe, practically the same as in the first quarter of 2018.

That is to say, Spotify is doing a great job of converting users in North America and Europe. That's particularly notable considering both Apple and Amazon are dominant forces in those regions, and have much smaller presences in most other markets.

Spotify's competition in developing markets is considerably less intense, which bodes well for its long-term potential to retain ad-supported listeners and convert them to paid subscribers. If Spotify can improve conversions in markets where the iPhone and Amazon Prime are already popular, it should be able to do the same in markets where Android dominates.

Improving engagement and retention

Spotify is making a few moves to improve engagement among its users with the thesis that more engagement leads to better subscriber retention. 

To that end, it's had a lot of success investing in podcasts. Management says podcast listeners spend more time listening to music, and they're more likely to convert to premium subscribers. Spotify's podcast revenue consists of ad sales for its in-house produced podcasts, and accounted for less than 10% of ad revenue last quarter. That said, there's a lot of potential for Spotify to develop advertising solutions for third-party content providers.

There's still a lot of room to increase engagement with podcasts. Just 14% of monthly users listened to podcasts last quarter. Increasing that percentage should improve total engagement and conversions, according to Spotify's data.

Spotify is also trying to increase engagement with in-car and in-home listening. The company is already popular on mobile, and it uses additional mobile functionality as a key selling point for its premium subscription.

For in-car listening, Spotify introduced new playlists geared toward listening during a commute. "Daily Drive" includes both music and podcast recommendations in a single personalized playlist.

To promote more in-home listening, Spotify has repeatedly partnered with Alphabet to offer premium subscribers a free Google Home smart speaker. That's an area where Spotify stands at a stark disadvantage to Amazon, which is able to bundle its Music Unlimited subscription with its popular Echo smart speakers.

Growing engagement across a rapidly expanding user base has led to strong user growth at Spotify. Even while its competitors have the big advantage of built-in user bases, the music-streaming leader continues to outpace their growth. Management's execution has been excellent, creating a strong foundation for long-term gross margin expansion, which is ultimately a sign of competitive advantage and the financial measuring stick Spotify investors need to keep an eye on.

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