One of the keys to Spotify's (SPOT 13.98%) long-term success will be raising its average revenue per user (ARPU). While management long resisted price increases, it started enacting them around the world at the end of 2020 and through the first half of 2021. As a result, the company saw ARPU increase 6% year over year in the first quarter, contributing toward its total revenue growth of 24%.
Spotify says investors shouldn't expect the same level of ARPU growth in the last three quarters of the year as it laps its price increases. Nonetheless, investors should expect ARPU to have bottomed in 2021 with incremental improvements moving forward. Here's how that should impact Spotify's financials.
Image source: Spotify.
Spotify reached minimum ARPU
Spotify -- based in Stockholm, Sweden -- saw its ARPU decline from 5.49 euros per month in the fourth quarter of 2017 to 4.12 euros in the first quarter of 2021. Several factors were at play in the 25% decline, but the biggest was the shift in subscribers to multi-person plans.
In late 2020, Spotify started implementing price increases for plans around the world. While mostly focusing on family plans and its two-person duo plan, it also raised prices for individual subscribers in some markets. Importantly, management saw minimal impact on subscriber churn or gross additions from the price changes.
But there are a couple things that could drive ARPU higher over the next few years without explicit price increases.
First of all, Spotify is running fewer promotions to convert listeners to paid subscribers. It historically ran seasonal promotions, offering steep discounts on the premium service with the expectation that many would stick around to pay full fare after the promotion ended.
Second, subscribers coming off their student plans will have to start paying the full rate for premium. Students can only renew their status for up to four years, and Spotify only expanded the student plan to many countries in 2017.
Combined with occasional price hikes, Spotify should see slow and steady improvements in ARPU over the long term.
Growing ad revenue across the board
Spotify's ad business isn't confined to its ad-supported listeners any more. It generates ad revenue from premium subscribers through podcasts. It also generates revenue from its two-sided marketplace through products for artists like Marquee, which is responsible for prompting users to listen to new releases or buy tickets to upcoming concerts in their area.
Spotify's ad revenue is growing as a percentage of total revenue, reaching 11% in the first quarter. Ad revenue growth of 24% was supported by double-digit percentage growth in ad pricing.
A couple of factors should allow Spotify's ad business to grow as a percentage of total revenue. First is improved ad technology, including podcast ad measurement. Second, there is greater engagement with ad units, including owned and operated podcasts, third-party podcasts, and Marquee.
If Spotify is able to generate more revenue from ad-supported listeners, it won't feel the need to convert as many to premium subscribers. That will reduce promotional pricing events and support steady price increases over time.
What it means for investors
Growing ARPU will ultimately lead to an expansion in gross margin and steady operating profits. Gross margin has slowly increased over time, even as ARPU declines. The next few years of steady to increasing ARPU should lead to strong expansion toward management's long-term outlook of 30% to 35% gross margins. For reference, gross margin reached 25.2% in the first quarter.
Improvements in ARPU should also lead to better operating leverage, enabling Spotify to generate meaningful operating profits in the future. Ultimately, investors need to see profits from the music streaming company. Improving ARPU is the path toward those profits, and it would make Spotify's current share price a steep bargain if management can execute.
