Spotify: The definite Netflix of the music industry

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$Spotify(SPOT.US) The quarterly report will be released on February 4th before the US stock market opens. Despite a solid profit, the stock price has been rising steadily. However, with the logic of cost reduction and internal efficiency improvement through traffic distribution rights, as well as the pricing dividend from leading companies, Dolphin Jun originally had an optimistic outlook based on imagination, but soon saw signs of gradual realization and fulfillment.

Specifically, here are the key points from the financial report:

1. Profitability remains the main area of exceeding expectations

On the profit side, the only apparent exceedance seems to be the company's guidance for Q1 2025. In fact, Q4 2024 also performed well due to cost reduction and efficiency improvement, but due to the increase in market capitalization, the equity incentives related to market value and associated taxes (Social charge) were also significantly raised, thus affecting the operating profit performance under GAAP.

However, if we exclude this non-recurring expense and look at Non-GAAP operating profit or directly at free cash flow, we can find that Q4 still implemented the "cost reduction and efficiency improvement" policy.

In terms of specific operations:

(1) Gross margin steadily improves

The steady improvement in gross margin mainly comes from the optimization of copyright costs, which has always been the main logical support for Dolphin Jun's optimistic outlook on Spotify. Dolphin Jun estimates that the copyright cost/subscription revenue of paid content has continued to decline by 1-2 percentage points quarter-on-quarter.

Due to its importance and the changes over the past two quarters, let's elaborate a bit on the optimization of copyright costs:

Copyright costs mainly consist of the copyright costs paid to songwriters and the recording rights costs paid to label companies.

The revenue-sharing ratio for copyrights is predetermined by industry associations. The direction of adjustments generally does not decrease but only increases, thus protecting the interests of songwriters. However, platforms can reduce the overall revenue-sharing ratio through other means, such as Spotify's bundled packages.

The revenue-sharing ratio for recording rights is relatively flexible now and in the future. In short, to push down costs, one must weaken the bargaining power of top labels in the industry chain. As a platform that serves as a traffic distribution center, more decision-making power and influence are held in its own hands. The platform can weaken the competitiveness of top labels by providing more recommended traffic to long-tail old songs or new songs created by independent musicians, podcasts, audiobooks, etc., thus negotiating a more cost-effective revenue-sharing ratio.

In the past two years, Spotify has been continuously strengthening this point, such as building a creator monetization platform and ensuring good traffic distribution, creating a healthy economic ecosystem for independent musicians or podcast and audiobook creators.

(2) Strict control of operating expenses

On the expense side, although there was a significant increase in Social charge and many activities and market expansions were conducted, Spotify's three expense items still saw a double-digit year-on-year decline The adjusted operating profit margin is 12.5%, unchanged from Q3.

2. Steady Growth in Subscription Users

In Q4, the number of MAUs and paid subscribers exceeded expectations, but the growth of advertising users showed some improvement yet fell short of expectations. In Q4, the Wrapped 10th Anniversary event accelerated user penetration in 184 regions worldwide. Additionally, in certain specific areas, video podcast content was introduced to enrich the service experience of membership benefits.

For Q1 2025 guidance, the company's expectations for monthly active users are in line with the market, but the subscription number expectations are higher than market assumptions, which also implies that advertising users may again perform flat with no surprises in Q1.

To some extent, the faster new MAUs convert into loyal paid subscribers, the more beneficial it is for the company's profit-generating flywheel to turn quickly. This can be driven to some extent by enriching the service content of membership benefits.

In the past, we were concerned that users in developing countries might struggle to afford Spotify's not-so-low membership fees. On the other hand, if Spotify's product experience is excellent enough and its competitive advantages are clear, as seen from Netflix's experience, users with real demand may have a willingness to pay for mental content that is not inferior to physical goods.

3. Brand Advertising Demand Shows Significant Recovery

In Q4, advertising growth continued to lag, primarily reflecting weak demand in the brand advertising market. The number of advertising-supported users reached 425 million, with a net increase of 230,000 quarter-on-quarter. Although there was some improvement compared to the net increase in the first three quarters, market expectations were also not low.

From the management's revenue guidance for Q4, it is expected that there will still be some minor pressure on the advertising side. Future growth in advertising revenue will rely on podcasts; although there are many users of music advertising packages, the advertising effectiveness is generally low due to the limitations of music listening scenarios, resulting in a very low per capita ARPU, far less than the monetization efficiency of paid subscriptions.

4. Cash Flow Continues to Reach New Heights

The improvement in core business profitability naturally leads to a simultaneous improvement in cash flow. Spotify's prepaid business model itself is also more advantageous. 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 Q4, Spotify's free cash flow further reached a new high of €880 million, doubling year-on-year, accounting for 20% of revenue, higher than the adjusted operating profit margin during the same period.

5. Performance Overview

Dolphin Investment Research Perspective

Overall, the quarterly report continues to reflect the price increase dividends of the leading companies observed in the previous quarter, as well as the company's own cost reduction and efficiency improvement further enhancing profitability.

**In the short term, the impressive performance of subscription revenue compensates for the advertising revenue pressure during the brand advertising downturn. Based on the current user growth and payment rate momentum, there is hope to continue achieving user penetration in global regions through more membership benefits and promotional activities in the future At the same time, the overall willingness to pay among users may not be significantly lowered by users in developing countries.

In the last quarter's conference call, the company mentioned that it is testing a high-tier subscription package aimed at fan users, which can provide additional benefits such as early access to music, effectively achieving a "price increase." Therefore, in the short term, the steady growth of subscription revenue (with both volume and price rising) is unlikely to be interrupted.

From a medium to long-term perspective, the profit margin improvement brought about by copyright cost optimization still has considerable potential. Since this involves changes in the entire industry chain's structure, it cannot be quickly adjusted in the short term. However, at the very least, Spotify has already leveraged its platform's traffic distribution advantage to reduce overall copyright costs.

As with last quarter's view, although the market value has been continuously growing, under the strong fundamentals in the short term, a pre-market valuation of 120 billion corresponding to a 35-40x 2026 EV/EBITDA valuation is clearly not a bubble, especially when compared to the growth rates and valuations of peers.

This valuation is basically aligned with the current Netflix, whose high valuation is primarily supported by its competitive advantages. Therefore, if Spotify can continue to maintain its leading position and accelerate revenue-sharing negotiations with upstream suppliers through large traffic, even if its business model is slightly inferior to Netflix, it still has the opportunity to become the Netflix of the music industry.

The following is a detailed commentary on the financial report.

  1. User Growth is Impressive

In the fourth quarter, Spotify gained 35 million monthly active users (MAU), significantly exceeding the performance of the previous three quarters. By the end of the year, the average monthly active users reached 675 million, with the incremental growth mainly coming from Latin America and other regions.

However, management's guidance for the next quarter, Q1 2025, can only be described as meeting expectations, with an anticipated growth of 3 million to 678 million, but this quarter-on-quarter net increase is less than the market's original expectation of 13 million.

However, the payment situation continues to show steady growth. The newly added users mainly come from regions outside North America, such as Latin America, Europe, and other remaining areas. The U.S. region may still be somewhat affected by price increases.

As of Q4, among the 680 million users, there are 260 million paying users, and the overall payment rate remains stable. Although the newly added users in emerging markets over the past two years have faced higher conversion difficulties compared to users in Europe and the U.S., which has lowered the payment rate, it is still possible for the payment rate to increase in the future.

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II. Subscription remains stable, advertising has not fully recovered

In terms of revenue performance, the growth difference 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 17% in the fourth quarter, showing a natural slowdown due to a high base. The growth rate of advertising revenue in the fourth quarter was 7.2%, which is not impressive given the advantage of a low base, indicating that it is still affected by weak brand advertising demand.

However, subscription revenue still accounts for 87%, so the slowdown in advertising has not significantly hindered total revenue, and overall revenue growth still follows the changes in subscription revenue.

Looking ahead to the first quarter of 2025, the company guides revenue of €4.2 billion, implying a year-on-year growth rate of 15.5%, which is basically in line with market expectations. From the short-term trend of the two main businesses, it is clear that subscription revenue will still need to shoulder the growth burden. The subscription business will rely on (indirect) price increases (though this may be offset by the price increase effect in low unit price developing countries) and user growth as a dual driving force, maintaining the long-term guidance set by management—fluctuating around a 20% growth rate.

III. Continuing the operational rhythm of "cost reduction and efficiency enhancement"

The fourth quarter report mainly exceeded expectations on the profit side, with an operating profit margin maintained at 11.2%, primarily due to the impact of rising market value and the simultaneous expansion of equity incentives and related social charge taxes, while actual operating expenses were strictly controlled with a double-digit decline trend.

In the fourth quarter, the social charge reached €9.6 million (about 2% of revenue), which put some pressure on current profits. Since the current market value remains high, the company expects this part of the welfare expenses to also be nearly €8 million in the next quarter.

The gross profit margin in the fourth quarter increased by another 1-2 percentage points compared to the third quarter. Although operating expenses are also being compressed, compared to the nearly 70% cost ratio, the optimized impact on profits is not as significant.

! In terms of costs, the share of copyright content sharing costs is high and has remained relatively rigid, while the amortization cost of self-owned content is very low. Therefore, whether there is room for compression here depends on the business negotiations between Spotify and upstream content providers.

Through cost breakdown, Dolphin estimated that the proportion of copyright costs for paid content in the fourth quarter continued to decline by 1.4 percentage points quarter-on-quarter. Copyright costs are mainly composed of the copyright costs paid to songwriters and the recording rights costs paid to label companies.

Finally, the improvement in core business profitability also brings a simultaneous improvement in cash flow. In the fourth quarter, Spotify's free cash flow reached €880 million, continuing to hit a new high and significantly exceeding market expectations. The proportion of free cash flow to revenue also increased to 20%, up 3 percentage points quarter-on-quarter.

Dolphin's articles on "Spotify":

1. Financial Report

November 13, 2024, 3Q24 earnings call summary: Spotify: Partnering with TTD, gradually shifting from brand advertising to performance advertising (3Q24 conference call summary)

November 13, 2024, 3Q24 financial report commentary: Spotify: The positive feedback from the price increase of the leader has arrived

July 23, 2024, 2Q24 financial report commentary: Spotify: Did it explode again? The music small giant provides a standard answer

2. Depth

June 25, 2024 " A Deep Dive into Spotify: How Much is it Worth Compared to Tencent Music? "

June 13, 2024 " Where Does Spotify's Confidence Come From, Even with Price Increases Higher than Apple Music? "

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