In this episode of Industry Focus: Tech, host Dylan Lewis chats with Fool contributor Evan Niu about some big news from Spotify (NYSE:SPOT) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). Spotify's quarterly update revealed a huge increase in podcast hours streamed, while Alphabet's fourth-quarter results didn't impress investors. Alphabet broke out its YouTube and Google Cloud divisions for the first time, and Dylan and Evan discuss why tech companies are reluctant to disclose revenue by segment. Finally, they answer some audience questions.
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This video was recorded on Feb. 7, 2020.
Dylan Lewis: It's Friday, Feb. 7, and we're talking about Spotify's striking another deal, and some disclosures from big tech. I'm your host, Dylan Lewis, and I'm joined by Fool.com's Evan Niu. Evan, what's up?
Evan Niu: Not too much. We're just celebrating in my household, because my wife just got a new job, and she's getting a pretty massive 50% raise from the new opportunity. So we're pretty happy about that.
Lewis: Congratulations, Evan, that's awesome. I, unfortunately, have money kind of going in the other direction, because I think I'm buying a house and so in the process of trying to finalize some numbers there. And I'm getting used to the pinch now. I'm starting to feel it a little bit.
Niu: Oh, yeah. Especially when things start to break, that's all on you.
Lewis: I get horror stories from our producer Austin Morgan all the time. I know exactly what that life looks like. Unfortunately, I'm a glutton for punishment, and I'm buying a place that needs a considerable amount of work in Washington, D.C. So I'm going to be dealing with a lot of contractors. Listeners, if you know any really good contractors in Washington, D.C., let me know, because I certainly will need one.
But you know what, I'll be listening to some music and doing some of the home repairs myself, Evan, and I'll be listening on Spotify. We're talking about Spotify today. That seems like a nice, easy transition right there. We have a quarterly update from them with their earnings, but we also have a major news item from this company. You are a shareholder and someone who writes about them all the time. We want to have you talk about what we saw this quarter.
Niu: Yeah. So they reported fourth quarter earnings this week, and we saw total revenue increasing 24% to a little over $2 billion -- $2 billion when translated from euros, since they report in euros. It was actually a little bit below the Street's expectation. As is always the case, the premium subscriber segment is really the bulk of this business, which was almost 90% of revenue during the quarter. They added a record 11 million payment subscribers during the quarter, which is the most they've ever added in a quarter in their history, which is a pretty big testament, particularly when we start to talk about this podcasting stuff here in a little bit.
So right now they have a total of 124 million premium subscribers. And what they're also noticing, that user growth is accelerating across a lot of important markets, which is pretty impressive when you consider the fact that they're already the largest paid music streaming company in the world. So they have the largest paid subscriber base. And they're still seeing growth accelerate again, which is pretty impressive.
And on the ad-supported side, monthly active users increased to about 153 million. So there's now a total of 271 million users on this platform.
Lewis: We talk about it all the time -- the bigger the denominator gets for a business, the harder it is to find that growth. If you see a business that already has a fairly mature market and they are able to find that reacceleration, that's obviously a good sign and something that investors want to see.
Now, listeners may remember, we've talked about Spotify and some of their podcast acquisitions in the past. They made a huge commitment to podcast purchasing Gimlet Media, Anchor, and Parcast back in 2019. And all told, that was about a $400 million spend for them. We got news this week that they are going even further into podcasts, and this is where we're getting some of this user growth from.
Niu: All right. So they announced that they're acquiring The Ringer, which is a media company started by Bill Simmons, I think in 2016, mostly focusing on sports content. But there's also some kind of broader entertainment and pop culture stuff. But the real thing that they're after here is the sports content, particularly their sports podcast.
Lewis: Yeah. And I think they have like 30 podcasts or something crazy like that. Their lineup is huge. They cover a ton of different stuff. And from what I've read, it seems like The Ringer is profitable. This is a small enough acquisition that we don't get really a ton of details on what's going on; hopefully, as time goes on, we'll get some more details. But Bill Simmons said, back in 2019, this a profitable business.
I think the natural question that a lot of people have is, this was probably a fairly decently sized acquisition. They spent $400 million in 2019. What's the plan with podcasts?
Niu: Right, so they did not disclose how much they paid for The Ringer, so it's a little bit hard to say, how big of an acquisition this was. But yeah, they definitely bet huge last year. But yeah, I think the whole strategy is -- to the extent that they can really expand the podcasts, particularly with, when it comes to exclusive content. I mean, there's a lot of parallels you can make to Netflix, but there's also some limits to that comparison.
But one thing that is true for both Netflix and Spotify is that when you're buying this additional content, it's essentially a fixed cost, then you can really scale that out to your user base in a really efficient way. And you get some leverage there on the cost side, compared to the core music streaming side, where, you know, those royalties are all variable, based on how much people listen, which is one of the challenges that we talked about before at length about why Spotify does have some trouble scaling, which is also the flip side of why podcasting is so promising.
Lewis: Yeah, we haven't seen anybody really crack the nut on making music exclusive to a platform. We talk about all these different companies that are playing in streaming music. Sometimes you'd have a major platform go out there and get the exclusive rights to an album for two weeks before all the other platforms got it. But by and large, if you can get something on Apple Music, you can probably get it on Spotify, and vice versa. This is one of the few opportunities for someone in the streaming space to be able to offer something that is Netflix-like or HBO-like or Disney+ like, where you have to go there to get it.
Niu: Right. Because musical artists, they want their content everywhere, because that's how they make their money. And it's not like, there's not really a market for exclusive music, because it's not like companies are going to hire the musical artists in-house.
Lewis: Yeah. And what isn't clear to me is with this acquisition, you know there are a lot of very popular shows from The Ringer. Do those stay publicly available on all podcast platforms, or is this something that eventually gets phased behind a paywall, where you have to be a Spotify Premium member in order to access it? That will maybe hurt the popularity of some the podcasts. It might limit the listenership. But also, it could be a major draw for them in bringing in premium members.
Niu: Right. So they haven't given too much detail on some of the kind of detailed logistics and how this integration is going to work. And as you mention, they have a lot of other content, like written text articles. They have videos on the website. Those things don't really play into Spotify's audio platform strategy at all, so it's a little unclear how that's going to play out. If I was a writer at The Ringer, I'd be a little worried about job security, personally, right now. And on the call, he did -- so he didn't really answer those questions, Daniel Ek, the CEO, but he did kind of make a grandiose analogy that he thinks The Ringer will be the next ESPN. But I'm pretty sure that Disney's ESPN+ streaming service is going to be the next ESPN.
Lewis: [laughs] Yeah. I mean, that's the safer bet. You know, it's already ESPN. It can continue to be ESPN. This also fits into the big-picture plans for Spotify, because, listeners, you may remember, we talked about how at CES they announced their streaming ad insertion. And this is the technology that will allow them to dynamically insert ads. And it's pretty clear, when you look at all these different acquisitions, the focus on podcasts, the focus on exclusivity, they're getting beyond the content and they're looking a lot more at how that content is monetized. And if they can do a really good job with that, you go beyond just kind of the core economics of providing podcasts; you also get into some of the ad business economics, which are even better.
Niu: Right. And, I mean, it is worth noting that since they only really kind of made this big expansion with these splash acquisitions last year, it's still very much early days for podcasting for Spotify, but the early data is looking promising. So they've been up front in cautioning investors, "Hey, it's early, this data is pretty preliminary," but they have shared some meaningful data points that they have so far. So, for example, podcast hours streamed last quarter nearly tripled. Podcasts are helping drive really strong conversions from free users to premium subscribers, while also reducing churn, strengthening retention. I mean, podcasts and music are just so complimentary that it's creating this really virtuous cycle of engagement, because they said that podcast listeners are listening to more music and vice versa. So, again, it's early on, but it's so promising that management is committed to investing heavily in product improvements as well as podcasts throughout 2020.
Lewis: A lot of those things you just talked about, Evan, were kind of more usage data points. Are there any things to suggest that this is actually having an impact on the company's profitability?
Niu: So if you exclude some one-time items from a year ago, gross margin was essentially flat at just a little bit over 25%. That was at the high end of guidance, which Spotify attributed to improvements in non-royalty components -- things like payment fees and infrastructure delivery costs and some of the other things that they pay for as part of their cost of sales.
So podcasts still, I think, represent an opportunity to incrementally reduce their royalty costs in the long term to the extent that some of that engagement shifts away from music toward podcasts. Of course, all engagement is good, but as far as profitably goes, it's better for Spotify if people are listening more to podcasts compared to music. But all that being said, it's probably still going to take a while until we see any meaningful improvements to the cost structure, but I think they'll get there.
Lewis: All right, we are going to switch gears and talk about some reporting changes in big tech which we're really excited about. Before we get over that discussion, though, just a quick reminder to our listeners -- if you're looking for more stock ideas, recommendations, coverage on companies, you can go check out our Stock Advisor service. You get stock recommendations from David and Tom Gardner every single month, Best Buys Now, and a whole lot more. Just go over to if.fool.com. We've got a 50%-off discount for our listeners over at if.fool.com. We've got to drop the company plug in there every now and then, Evan, just to let people know, you know, that's what we really do. We have fun with our podcast as well, but you know, we're a company that talks stocks more often than not.
We are talking, in the second half of the show, about Alphabet in particular. We got some fourth-quarter results from them this week. The short answer on the report was, the market didn't necessarily love it. It was one of the few stocks that I own that was actually down there a couple of days this week. We're not going to spend too much time talking about the financials; what I really want to focus on is a major change that Google parent Alphabet is making with its reporting structure. I think it's something that a lot of people have wanted for a long time.
Niu: Yeah. So for the first time ever, they are officially disclosing revenue for both YouTube and Google Cloud, essentially breaking it out into search ads -- their core business -- YouTube and Google Cloud and kind of these other components, giving investors a lot more granular detail about where all this money coming from. And investors -- and, more importantly, the SEC -- have been pressuring Alphabet to share these numbers for years. So this is a major win for investors, in terms of transparency, to finally get really hard details into how this business is split up, how each segment is growing. So YouTube ad revenue in 2019 was just over $15 billion, which is up 35% for 2018 and now represents almost 10% of Google revenue. And Google Cloud revenue was almost $9 billion, which is up over 50%. So those businesses are putting up some nice growth.
Lewis: It seems like this is kind of a slow and steady march for Alphabet. We got them into the large umbrella holding structure a couple of years ago, and we got some insight into what was going on with the internet properties versus the other bets and a little bit of transparency there. Now we're getting a better sense of what's going on with some of the internet properties in those operations. We just want to know as much as we can about the businesses that we're trying to follow here, particularly as they get bigger and bigger. When you're in the two-digit billions, that's something that is pretty material to the business. Some people might argue otherwise, but I would say if something represents 15% of the total revenue for a segment, it's probably worth breaking out when it's the size of Google.
Niu: Right. So Google Cloud and YouTube combined are now about 15% of this business. So yeah, that's pretty meaningful. I think you should start sharing with investors.
Lewis: Now, why are we getting these disclosures now?
Niu: So it is absolutely because Alphabet promoted Sundar Pichai to CEO of Alphabet. So listeners might remember that he was named Google CEO back in 2015, as part of the Alphabet restructuring that you just mentioned. He was promoted to Alphabet CEO in December.
And I was reading this article -- I'm not going to take credit for it, but MarketWatch made a really good call a little while ago and pointed out that as part of changing revenue recognition rules that were implemented a couple of years ago, the SEC essentially required companies to provide financial information to investors in a similar way that is presented to the chief decision maker, which is to say the CEO. Alphabet's response -- and this is going to sound kind of silly, because it is -- was that then-CEO Larry Page himself didn't even see YouTube results. So they were like, well, if Larry Page didn't see it, then investors don't need it. Which is kind of a really silly rationale, because Larry Page has long been criticized as something of an absentee CEO, like, he doesn't make public appearances, he doesn't -- I mean part of that's health-related, but he doesn't participate in conference call. You know, he's just not around. And it's kind of like a silly reason to withhold this information.
Now, in contrast, Pichai had worked his way up as a Google executive over all these years, and he obviously knew all these numbers. So when they named him CEO, and kind of through that reasoning, out the door. So I think that's a big part of why we're seeing this reporting change.
Lewis: Yeah, I think it's a little bit laughable to look at something that's a multibillion-dollar business and not think that it's something investors should know. I think, for the most part, if a business is that size, we want to know; we want to be able to dissect it and see how it stacks up to the competition. And I understand that there are different reasons why a company may or may not disclose something. You know, in the case of Apple and services -- you know this is something they're touting because they want to create a growth story for their business beyond just their iPhone segment, similar to what we saw with Amazon and AWS a couple of years ago, where we think of Amazon as this e-commerce platform, and then, oh, yeah, we have this wildly profitable cloud segment as well. They decided to disclose that. Some businesses will look and say, "You know, we don't want people to be able to stack up the size of our business to competitors; we want them to have to approximate based on third-party revenue." I have to say, after years and years and years of getting AWS breakouts, it's nice to be able to know the size of Google Cloud.
Niu: Right. And I think you're right. A lot of it is competitive reasons. When they disclose things to public investors, they are also disclosing things to all their competitors. And for example, in the case of Apple, same reason they've never disclosed things like Apple Watch numbers or details around wearables in kind of a hard, concrete way. I mean, it's definitely a nice change of pace. I mean the whole, like, "Larry Page doesn't even know the stuff" is kind of a stupid argument. [laughs]
Lewis: [laughs] Yeah, it's laughable, right. It's totally laughable.
Niu: "Our CEO has no idea how big this huge business is." [laughs]
Lewis: [laughs] Especially when it's a major growth driver and something that is only being used more and more. YouTube is just so public-facing and such a large part of how people consume content and interact with Google, period, that I think you just have to talk about it at some point. I'm glad they're finally doing it.
Niu: Right. I mean, it is nice that they're giving us revenue, but one thing they're not giving us is cloud operating expenses. So, for example, when Amazon first started breaking out AWS revenue, back in 2015, it also provided information around expenses, you can get kind of a sense of operating income and operating profitability. In fact, kind of interestingly, we were just talking about AWS on earnings last week, but their AWS is actually about to get even more profitable, since they are making an accounting change where they're extending the useful life of their servers from three years to four years. And what that does is that reduces the depreciation expense that they recognize. So, in effect, it's going to improve operating margins even more.
So we don't know how that looks like for Google Cloud because they're not giving us the cost data, but we do know that they're investing very heavily in the cloud business, because they're trying to catch up with AWS and Microsoft Azure as well. So I wouldn't be surprised if their operating margins are a bit lower.
Lewis: Yeah, you know, thinking about it and the rationale for why they may or may not be disclosing this. In the case of Amazon, by disclosing their operating margins for AWS, they were able to point to what is a very high-margin business compared to its e-commerce segment, especially its international segment, which is losing money. In the case of Google, they actually might have a higher-margin business with its ads business, and they might be having their margins come down because of stuff that they're doing in the cloud. It's hard to say.
Niu: Right. And to your point earlier about how companies use reporting to kind of shape the narratives, like, when it comes to Apple, the same thing with Amazon, as soon as they start breaking this out, everyone's like, "Whoa! AWS is so profitable." And it really kind of changed the narrative of like, "Oh! Amazon's e-commerce is single-digit low-margin stuff." But it really kind of changed the investor perception once they saw how profitable that segment was.
Lewis: If anyone is talking about the big hitters in cloud computing, they're talking about Amazon's AWS Google Cloud and they're talking about Microsoft Azure. We know two of those three. We still don't have any information on Microsoft Azure.
Niu: Right. So Microsoft discloses intelligent cloud revenue, which was almost $12 billion last quarter. That includes Azure, but it also includes a bunch of other stuff. So they are still guilty of kind of obfuscating some of this information that investors are calling for. They disclose Azure revenue growth, but not the dollar amount, so that disclosure kind of falls flat, because you have no context to what base they're coming off of. And they've never really given a good justification for why they don't share this information. Of course, like we just talked about, some of this is just competitive sensitivity and things like that.
But it's worth noting that they cannot use Alphabet's reasoning, because CEO Satya Nadella was previously the executive that was in charge of running Azure and the cloud business before he was named CEO. So he clearly knows what's going on there. But they're still just not breaking it out. Hard to say if or when they will, but I think that with Google making this change, it definitely adds some pressure to them to do so, especially since Microsoft has been so focused on cloud computing and cloud services under Nadella. So, hopefully, it will be soon, but hard to say.
Lewis: I would think so. I mean, it is becoming a large part of the narrative. You look at the year-over-year gains -- they're posting really impressive growth in the cloud infrastructure market and they're becoming a very relevant player there. I think the estimates I saw were that they were in second place and posting something like 60% year-over-year growth. And so, there's some pretty gaudy growth going on there. I have to imagine that they want that to become part of the story for the stock at some point.
Niu: Yeah, exactly. And they are the No. 2 player behind Amazon, and Google is No. 3. And I mean, we have these high-profile wins like the government JEDI contract, the Defense Department thing that they're fighting over now. I mean, yeah, they are huge players, so they really should start to share this more with investors.
Lewis: Maybe that'll happen in 2020. Maybe we'll finally get our wish by the end of the year, Evan.
All right. We're going to wrap our stock conversation there. Regular listeners know that if anyone leaves us a five-star review on iTunes, I read it on the show and I'll answer any questions or point they might make. Got two new ones over the past week, one from Hey Bull Dog! Hey Bull Dog! left us a five-star review and said: "This is one of my favorite all-time podcasts, which gives me a variety of industries to focus on for my investing strategies" -- industries to focus on, on Industry Focus; I see what Hey Bull Dog! did there -- "but I do miss the weekly podcast on healthcare. It's such an important part of the economy that Wild Card Wednesday leaves me wanting. Other than that, I love it."
And I hope that Hey Bull Dog! caught this Wild Card Wednesday, where Jason Moser and Shannon Jones were talking earnings and coronavirus, and talking about some healthcare businesses over there. We hear you on that, and we're trying to work healthcare regularly into the routine for Wild Card Wednesday. I've given this explanation once or twice, but really, we're just trying to make sure that we're putting people in a position where they can cover stuff that they're comfortable talking about and give listeners great information. And so we're going to alter our lineup and our schedule accordingly. If we have someone emerge as a really awesome healthcare host, who has the time, we're going to be, you know, looking to do that in the future. But we hear you and we've been really, really amazed with the outcry of people wanting more healthcare content. Clearly, Shannon Jones' presence has been missed on the show. I certainly miss hanging out with her; she's doing all this work on a different floor, so I don't get to see her too much.
We also had Scott write in to the show. "Love the podcast. A couple of things to make it easier to listen to. One, the moderator speaks much louder than the guests, that I have to keep adjusting the volume. And two, the up-talking is grating, makes it a little difficult to take people seriously. Before you say, 'It's not me,' ask a friend. Thanks for a great and relevant show!"
And I will say, I'm definitely guilty of that, Scott. Fair criticism there. I think this is one thing where, because we do some remote taping -- you know, Evan and I are not the same room. There are times where I'll intentionally raise my voice a little bit, just to give him a sense that I'm putting the question over to him. We're trying to signal to each other a little bit that, "Hey, it's your turn to talk." Because we can't really pick up on each other's nonverbal cues. Evan, does that help you out?
Niu: Yeah. [laughs]
Lewis: [laughs] And I just did it right there.
But, you know, this is a little bit of the behind-the-glass kind of experience for what's going on. So I will take those pieces of feedback into consideration. Always trying to be better, always trying to improve. Fair point there, Scott. Thanks for leaving your review and thanks writing in to the show.
And, listeners, of course, if you want to leave us a review, we would be happy to have one. And if you want to write in to the show, IndustryFocus@fool.com, where you can get us, or you can tweet us @MFIndustryFocus.
Evan, I think we're going to put this one to bed. Thanks for hopping on today's show.
Niu: Thanks for having me!
Lewis: All right. And if you want any more of our stuff -- I got caught up midway through the wrap and I didn't say goodbye to Evan -- you can go over to iTunes or wherever podcast and catch us there.
As always, people on the program may own companies discussed on the show. The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear.
Thanks to Austin Morgan for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!