Spotify: The positive feedback from the leading company's price increase has arrived

$Spotify(SPOT.US) The Q3 report was released after the US stock market closed on November 12, and the 6% surge in stock price already indicates the market's attitude towards this financial report. So what exactly is good about it?

Looking at the core points of the financial report:

1. Current Performance: Profits Exceed Expectations

In the Q3 financial report, the profit indicator (operating profit) is the main area that exceeded expectations. Not only did Q3 significantly beat expectations, but the guidance for operating profit in Q4 also surpassed market expectations.

Since the proportion of operating expenses is not high, Spotify's profit elasticity mainly comes from gross margin, and the variable factors of gross margin mainly come from content costs. However, the three operating expenses in Q3 continued to compress, primarily reflecting actions such as layoffs. The employee stock incentive expenses in Q3 decreased by 26% year-on-year, indicating a significant optimization of overall employee costs.

The steady increase in gross margin mainly stems from the optimization of copyright costs. Last quarter, we also discussed in detail the optimization logic and space of Spotify's bundled packages on its overall content costs, which directly led to a continuous and steady increase in gross margin.

By breaking down costs, we calculated that the proportion of copyright costs for paid content continued to decline by 1-2 percentage points quarter-on-quarter (estimated). Copyright costs are mainly composed of the copyright costs paid to songwriters and the recording rights costs paid to label companies.

Last quarter, Spotify bundled audiobooks into its packages, which invisibly weakened the proportion of copyright sharing. However, due to the ongoing disputes over the profit-sharing issues behind the bundled packages and the fact that it has just been implemented for less than a quarter, user adjustments to renewals may not be significant. Therefore, the decline in the proportion of copyright costs to revenue in Q3 may also be related to the optimization of recording rights costs from Labels.

The optimization of recording rights costs can actually be driven from two aspects. One is the decrease in the proportion of non-top label music, with the share of smaller labels and independent musicians increasing, which naturally promotes cost rate optimization. The other is to directly negotiate with top labels to lower the sharing ratio during contract renewals.

However, during the current contract period, directly changing the sharing ratio on the contract may be quite difficult and is generally discussed during contract renewals. Therefore, in the short term, the optimization of recording costs in Q3 mainly relies on the first factor mentioned above, which is to divert traffic to non-top copyright music, blogs, and audiobooks to weaken the sharing ratio of the three major Labels in overall revenue.

2. Guidance: Profits and User Numbers Exceed Expectations

The guidance for Q4 mainly reflects that user metrics (MAU, subscription numbers) and operating profit exceed market expectations. The operating profit exceeding expectations is essentially a continuation of the trend from Q3. The user numbers exceeding expectations indicate that the growth trends of MAU and subscription numbers are basically stable, which alleviates market concerns about the short-term impact on user retention and new customer acquisition after the price increase

3. New traffic is generally average, and advertising performance is poor

Q3 advertising continued to drag down overall revenue, resulting in total revenue falling short of market expectations, which may be related to the average growth of advertising users in Q3. The number of ad-supported users reached 400 million in the third quarter, with a net increase of 9 million quarter-on-quarter, still at a low level compared to previous years and below market expectations.

From the management's revenue guidance for Q4, it is expected that there will still be some pressure on the advertising side. Future growth in advertising revenue will rely on podcasts. Although the number of music advertising package users is also considerable (reaching 400 million in Q3), the advertising effectiveness is average, possibly due to the usage scenarios of listening to music, with a very low per capita ARPU, far less than the monetization efficiency of paid subscriptions.

4. Cash flow continues to improve significantly

The improvement in core business profitability naturally brings about a simultaneous improvement in cash flow. Spotify's prepaid business model also has inherent advantages. Especially when the industry position is stable and there is no need for heavy investment in software, hardware, or content, cash flow will show a more significant expansion.

In Q3, Spotify's free cash flow reached a new high of €710 million, a year-on-year increase of 229%, accounting for 18% of revenue, higher than the operating profit margin for the same period, and up 5 percentage points quarter-on-quarter.

5. Performance Overview

Dolphin Investment Research Perspective

Regarding this financial report, the market continues to focus on profitability (which is also the core support for this round of high valuation), and this time will also pay new attention to a user metric to observe user feedback after the price increase this year, such as whether the subscription growth rate has slowed and retention rates.

Clearly, Spotify has provided a relatively satisfactory answer. Especially regarding the latter, the Q4 guidance indicates a net increase of 25 million subscription users quarter-on-quarter, showing a clear acceleration trend, and has not declined or slowed down due to the price increase, which may be a positive feedback from the leading price increase. Coupled with the price increase, this provides a strong guarantee for subscription revenue growth in the next 1-2 quarters.

However, the management's total revenue guidance for Q4 did not significantly exceed expectations, indicating that the advertising revenue, which accounts for about 10-15%, will still be under pressure. Advertising revenue relies on music advertising packages on one hand and podcasts on the other. Currently, the company's strategic focus appears to be on developing audiobooks, but in reality, it is on "raising prices." By bundling audiobook content, the price increase this year is being rationalized. After all, among the 250 million paid users, how many are accepting the price increase for the bundled package because of audiobooks?

In addition, the bundled package also weakens the share of upstream costs, which, although criticized by the industry, ultimately temporarily ends Spotify's tug-of-war with the royalty association by retaining the original paid package (without audiobook content). However, a bundled package that is only $1 higher may lead users to happily accept the "price increase," as they can enjoy all audiobook content services upon renewal, likely making this the majorityThis point can indeed be a good reference for Tencent Music. Currently, Tencent Music's SVIP benefits mainly revolve around fan economy and bundling with Tencent Video. Looking ahead, there is potential to bundle with more audio, audiobooks, podcast content, etc., thereby increasing the average transaction value.

Due to the short-term price increase and the dividend from the profit inflection point, as well as the long-term logic of optimizing copyright costs, Dolphin 君 is not surprised by Spotify's strong stock price in the short term. However, as of yesterday, Spotify's valuation has approached the optimistic expectations set by Dolphin 君 six months ago when coverage began. After the release of the Q3 financial report, the stock rose by 6 points in after-hours trading, exceeding Dolphin 君's optimistic value.

However, the performance over two consecutive quarters has indeed shown us some results from Spotify that exceeded our initial expectations. After simply raising the subsequent performance expectations, Spotify's market capitalization of nearly $90 billion in after-hours trading implies a Forward P/FCF of 25x and an EV/EBITDA of 35x. Clearly, the valuation is not low, but considering the strong fundamentals in the short term, Dolphin 君 believes that compared to other peers, Spotify's valuation is not considered to be in a bubble.

The following is a detailed commentary on the financial report

1. Customer acquisition is average, but guidance shows a clear upward trend

In Q3, Spotify acquired 14 million new users, with an average monthly active user count reaching 640 million, with growth mainly coming from Latin America and other regions.

The customer acquisition in Q3 basically met expectations, but management's guidance for the next quarter, Q4, is 665 million, with a net increase of 25 million, showing a clear trend of recovery.

On the contrary, the payment situation is relatively stable. From the perspective of the paid subscription user base, North America remains the mainstay, not only reflected in the growth of paid users due to high conversion rates but also supported by the absolute high per capita payment amount (ARPU), which effectively supports the overall growth of subscription revenue.

As of Q3, among the 640 million users, there are 250 million paid users, and the payment rate has seen a slight downward trend over the past three years (from a peak of 45% down to the level of 39%-40%), but the payment rate is currently stable. Although the newly added users in emerging markets over the past two years have a higher difficulty in conversion compared to users in Europe and the United States, which has lowered the payment rate, it is not impossible for the payment rate to increase in the future.

II. Subscription and Advertising: A Tale of Two Extremes

In terms of revenue performance, the growth disparity between free advertising users and paid users has led to different business growth trends. Coupled with the impact of price increases, subscription revenue maintained a stable growth of 21% in the third quarter, while advertising revenue slowed down to only 5.6% this quarter after a slowdown in the previous quarter.

Fortunately, with subscription revenue accounting for 88%, the slowdown in advertising did not drag down overall performance too much, and the overall revenue growth still followed the fluctuations of subscription revenue.

Looking ahead to the fourth quarter, the company guides revenue of €4.1 billion, implying a year-on-year growth rate of 11.7%, which is below market expectations. From the short-term trend of the two main businesses, it is clear that advertising will continue to face pressure. The subscription business, on the other hand, is still driven by price increases and user growth, maintaining the long-term guidance set by management—fluctuating around a growth rate of 20%.

III. How Did Profits Exceed Expectations?

The third quarter report mainly exceeded expectations on the profit side, with the operating profit margin having risen to 11.4%.

However, the key driver behind the operating profit is actually the performance of the gross profit margin, which has increased by another 2 percentage points compared to the second quarter. Although operating expenses have also been compressed, their impact on profit is not as significant when compared to the nearly 70% cost ratio.

In terms of costs, the share of copyright content distribution costs is high and relatively rigid, with very little amortization cost for proprietary content. Therefore, whether there is room for compression here depends on the commercial negotiations between Spotify and upstream content providers.

In the article "A Deep Dive into Spotify: How Does It Compare to Tencent Music?" and the commentary on the last quarter's financial report, the author focused on two sub-costs within copyright costs, potential optimization directions for the future, and the space for optimization

Through cost breakdown, Dolphin has calculated that the proportion of copyright costs for paid content in the third quarter continued to decline by 1-2 percentage points quarter-on-quarter (estimated). Copyright costs are mainly composed of the copyright costs paid to songwriters and the recording rights costs paid to label companies.

Last quarter, Spotify subtly weakened the copyright revenue share ratio through bundled audiobook packages. Previously, we estimated that Spotify's gross margin could improve by 1.5-3 percentage points by taking this opportunity (corresponding to a 50%-100% acceptance of a $1 music and audiobook bundle).

However, due to the ongoing disputes over the profit-sharing issues behind the bundled packages, and the fact that it has just been promoted for less than a quarter, user adjustments to renewals may not be significant. Therefore, the decline in the proportion of copyright costs to revenue in Q3 may also be related to the optimization of recording rights costs from Labels.

The optimization of recording copyright costs can actually be driven from two aspects. One is the decrease in the proportion of non-top-tier label music, with the share of smaller labels and independent musicians increasing, which naturally promotes cost rate optimization. The other is to directly negotiate with top-tier labels to lower the revenue share ratio during contract renewals.

However, during the current contract period, directly changing the revenue share ratio in the contract may be quite difficult, and it is generally discussed during contract renewals. Therefore, in the short term, the optimization of recording costs in Q3 mainly relies on the first factor mentioned above, which is to divert traffic to non-top-tier copyright music, blogs, and audiobooks to weaken the revenue share ratio of the three major Labels in overall income.

Finally, the improvement in core business profitability also brings about a simultaneous improvement in cash flow. In the third quarter, Spotify's free cash flow reached €710 million, continuing to set a new high. The proportion of free cash flow to revenue also increased to 17%, up 5 percentage points quarter-on-quarter.