After a fairly underwhelming stock performance so far this year, the world's largest audio streaming company, Spotify Technology (SPOT -7.28%), just crushed investors' expectations during its third-quarter report. Investors love to see companies seemingly turn things around in a quarter.
Following the news, the stock has since jumped by more than 10%, and quite deservedly so. Here are three big takeaways that should have investors excited.
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Hitting the core metrics
Before getting to some of the more attractive developments going on under the hood, it's hard not to mention Spotify's impressive headline numbers. After missing on its user growth in the previous quarter due to lower-than-expected marketing spend in its emerging markets and a temporary hiccup in the company's sign-up process, Spotify quickly retraced its steps in this most recent report. Led by strong growth in India, the company grew its total monthly active users (MAUs) by 19% to reach 381 million MAUs, which came in at the high end of its guidance range.
To help attract many of these new users, Spotify typically offers discounts or free trials for new sign-ups. While this tends to help acquire new customers, it often creates a decline in Spotify's average revenue per premium user (ARPU). But this quarter, it didn't. Thanks to some price increases in its more-mature markets, Spotify was able to offset its discounted new-user growth and increase its ARPU by 4% versus the prior year. Even with these price increases, the company saw its total customer churn actually decrease both quarter over quarter and year over year, a testament to the platform's stickiness.
This combination of user growth and higher ARPU helped Spotify generate $2.9 billion in revenue for the quarter, which is a 27% increase from the same period a year ago. Thanks to these positive results, the company also increased the bottom range of both its gross margin and revenue outlook for the fourth quarter.
Growth of the ad business
Throughout Spotify's history, the subscription business has always accounted for the lion's share of the company's revenue, and although it still does, that share is beginning to shrink.
In the third quarter, Spotify's revenue from advertising increased 75% year over year to $375 million and made up 13% of its overall revenue. This was a sizable increase from a year ago and amounting to $945 million for the first nine months of the year. Management also stated that it expects to reach at least $1.2 billion in ad revenue for 2021, which would mark the first time in the company's history that it crossed the $1 billion threshold. While there are certainly a few factors aiding in that growth, a leading contributor is the company's surging revenue from podcasts, which delivered yet another quarter of triple-digit growth.
As the number of podcasts on Spotify's platform continues to grow and the company continues building out its suite of advertising tools, investors should expect the advertising portion of the business to make up a greater percentage of Spotify's overall revenue. CEO Daniel Ek made this abundantly clear during the company's conference call when he said that it could eventually account for 30% or even 40% of overall revenue.
Improving profitability
It wasn't just the sheer growth that had investors buzzing after the quarterly report. Spotify's gross margins came in well above its own expectations at 26.7% and were 2 percentage points higher compared to the same time last year.
Historically, Spotify has been almost notorious for having low gross margins for a tech company since it's required to pay out a big chunk of its revenue to music rights owners. But it appears this quarter is marking the beginning of a gradual improvement. Thanks to the company's size, many artists are willing to sacrifice a higher take rate in exchange for increased exposure through Spotify's curated playlists. This, in turn, reduces the company's cost of revenue on music streaming and helps boost the gross margin for the category.
Despite Spotify's management team being quite secretive about the actual financials of its podcast business, it's certainly more profitable than the core music offering. Spotify's CFO Paul Vogel even hinted at its stronger economics without giving the explicit numbers by stating "obviously, the podcasting margin is helpful over time."
Between the growth of the music advertising business and the higher-margin nature of podcasting revenue, Spotify's gross margin should continue to trend upward. All in all, this quarter appears to have given investors a glimpse at the durability of Spotify's growth and the impressive operating leverage that the company can unlock.
