The second-quarter report of $ Spotify.US was released before the US stock market on July 23. The market's main focus before the financial report was undoubtedly the company's profit improvement. This has been the core logic behind Spotify's stock price doubling since the first price increase in July last year.

Due to the implicit price increase in bundled packages in June, the market is not only paying attention to the price increase effect on gross profit margin in this second-quarter report, but also eagerly anticipating the management's feedback on user response after the promotion of new bundled packages, actual optimization of content costs, and long-term goals for subsequent gross profit margin improvement, hoping for more detailed descriptions and clear guidance.

Specifically, the core points of the financial report are as follows:

1. Meeting Expectations, Positive Guidance on Gross Profit Margin

This financial report in Q2 has responded to some market expectations regarding the most concerning profit issues: Q2 profits slightly exceeded expectations, while the guidance for Q3 significantly exceeded expectations.

Since operating expenses generally do not change much, Spotify's profit elasticity mainly comes from the gross profit margin, with the variable factors of the gross profit margin mainly coming from content costs.

By breaking down the cost items to estimate content costs, after the additional cost of audiobooks in Q2, the proportion of content costs to subscription revenue actually decreased slightly by 1pct. However, the second quarter has not yet fully implemented the "bundled package," indicating that even without the bundled package, Spotify has been quietly weakening the influence of the three major labels through algorithm bias and support for independent musicians.

The company's positive guidance for Q3 actually implies the management's high confidence in user feedback on bundled packages and cost optimization. More outlook descriptions can be heard from the management's related answers during the conference call.

2. Mediocre Customer Acquisition Performance? Partly Expected

Net increase in MAU in the second quarter was 11 million, lower than the original guidance of 16 million, and the outlook for the third quarter was also below expectations.

Unlike Netflix, Spotify has both paying users and free ad-supported users, so the overall traffic pool MAU is 626 million. Excluding the Chinese market, Spotify's overall market share is actually very high, with some platform fatigue in customer acquisition. Looking at different regions, more user growth potential comes from emerging markets, but this requires more investment in marketing and promotion costs to stimulate user demand.

However, since the second half of last year, Spotify's sales expenses have been declining year-on-year, which may have affected customer acquisition in emerging markets, leading to two consecutive quarters of MAU falling short of guidance.

However, third-party platforms have gradually disclosed MAU data over the past three months, so this bearish factor has already been somewhat reflected in the stock price.

3. Strong subscription growth, advertising drag

The mediocre customer acquisition directly impacts, especially in emerging regions, dragging down advertising revenue. In the second quarter, both advertising users and advertising revenue fell short of expectations, with a significant slowdown in growth.

On the other hand, the subscription user base mainly in Europe and the United States has been growing steadily, and with the effect of price increases, overall subscription revenue has basically met expectations.

4. Profit growth leads to cash flow improvement

Improvements in core profitability naturally lead to synchronized improvements in cash flow. In the second quarter, Spotify's free cash flow reached 490 million euros, hitting a historical high. The proportion of free cash flow to revenue also increased to 13%, up more than 6 points from the previous period.

5. Performance Overview

Dolphin Research Viewpoint

In two in-depth reports over a month ago, Dolphin mainly mentioned a logical point:

Due to the high market share and the industry environment with significant competitive threats (less exclusive content advantage), the key for Spotify to increase its valuation is to negotiate with copyright holders. When the long-standing unbreakable revenue sharing ratio permanently decreases, based on the current costs and future optimization expectations of Netflix and TME, Spotify's valuation still has considerable room for growth.

Similarly, if it cannot make a breakthrough in the short term, for example, if the final solution for bundled packages is for Spotify to revert to its original pricing system, then relying solely on the short-term performance and stock price boost from price increases, in a situation where competitors have not followed suit in raising prices, may face user backlash, which is not safe in terms of valuation.

However, with the copyright association lawsuit dragging on, Spotify has introduced an original Basic plan to address this (in fact, from the perspective of user habits and cost-effectiveness, we expect that more than half of users will probably continue to renew the original bundled plan by default). This storm may not have a conclusion in the short term. This may give Spotify a key window of opportunity to lower content sharing ratios, showcasing its platform's dominance in traffic.

Therefore, despite the flaws in user growth in this financial report, Spotify has basically met market expectations by exceeding current small expectations and significantly exceeding guidance in profit performance, addressing the core issues that the market is most concerned about. In the upcoming conference call, analysts will likely find ways to have the management share more feedback on bundled package users. If interested, you can pay attention to this.

In terms of valuation, Spotify's valuation compared to similar tech stocks is not low, although there has been some adjustment recently, it still remains higher than our previous conservative expectations, slightly lower than neutral expectations. However, due to the speed of profit improvement exceeding expectations this time, and the current critical turning point for Spotify's cost optimization logic to be realized, there is hope for the short-term stock price to remain relatively strong.

Below is a detailed analysis of the financial report

I. Average customer acquisition, possibly due to reduced promotion

In the second quarter, Spotify acquired 11 million customers, with an average monthly active user base reaching 626 million. The growth mainly came from Europe and other regions, with Indonesia and Colombia being significant contributors according to third-party data. This is related to Spotify's growth strategy over the past two years, focusing on user penetration in the Asian and South American markets.

Falling short of the acquisition target for two consecutive quarters, it may be due to reduced promotional spending over the past year. However, the surprise of margin improvement outweighs the concern of user growth. The market may assume that the music streaming market has reached a stable stage and is more concerned about Spotify's profitability.

On the contrary, the subscription situation is relatively stable. Looking at the subscriber base, Europe and the United States remain the main contributors. This is not only reflected in the growth of paid users due to high conversion rates but also in the overall support for subscription revenue growth due to the significantly high average revenue per user (ARPU).

Therefore, Spotify's growth narrative involves earning profits through the European and American markets, while attracting low-paying users from emerging developing countries through free advertising to build a user base of over 600 million, waiting for future subscription catalysts.

Out of the 626 million users as of Q2, 246 million are paid subscribers. The subscription rate has shown a downward trend over the past three years, currently standing at 39.3%. Although the difficulty of converting users from emerging markets added in the past two years is higher than that of European and American users, which has lowered the subscription rate, there is still potential for conversion in the future.

For the guidance in the third quarter, the company expects an increase of 130 million in MAU to reach 639 million, falling short of the market's net addition expectation of 190 million. However, the company's guidance for end-of-quarter subscription users at 251 million is in line with market expectations

The actual situation reflected here is that, despite the market tending to saturate (emerging markets requiring investment in user education), due to the early land grab, locking in a user traffic pool of 630 million, Spotify can also maintain the growth of subscription users from within to ensure stable performance.

II. Strong Subscription, Week Ad

In terms of revenue performance, the growth difference between free ad users and paid users has brought about different business growth trends. Coupled with the price increase, subscription revenue maintained a stable growth of 20.8% in the second quarter, while advertising revenue rapidly slowed to 13%.

As subscription revenue accounts for 88% of Spotify's revenue structure, the slowdown in advertising did not drag too much, and the overall revenue growth rate still follows the changes in subscription revenue.

Looking ahead to the third quarter, the company guides for revenue of 4 billion euros, implying a year-on-year growth rate of 19.2%, still mainly driven by price increases (following the UK, Australia, and the US in the second quarter), in line with market expectations, and basically around the short-to-medium-term guidance given by management to "strive to maintain a 20% revenue growth."

III. Gross Margin Exceeds Expectations, Cost Reduction in Addition to Price Increases

The most eye-catching aspect of the second-quarter report lies in the profitability side, which is essentially the performance of gross margin, which increased by 1.6 percentage points compared to Q1. Although operating expenses are also being compressed, compared to the cost accounting for nearly 70%, the impact on profit after optimization is not as significant.

In the cost structure, the nearly rigid revenue sharing ratio of copyright content costs is the most headache-inducing and also the largest proportion, while the amortization cost of proprietary content is very low. Therefore, whether there is room for compression here depends on the commercial negotiations between Spotify and upstream content providers.

In "Rising prices more expensive than Apple Music, where does Spotify's confidence come from?", Dolphin discussed the development of the music industry and the changing profit-sharing ratio in the industry chain. Historically, the revenue sharing ratio is not absolutely rigid, and Spotify has also lowered the revenue sharing ratio of the three major labels twice.

As Spotify's traffic continues to grow, the increase in excellent works from small and independent labels and musicians, as well as Spotify's ability as a platform to control traffic distribution through algorithms, the playback share of the three major labels on Spotify has gradually decreased in recent years. Therefore, when the balance of power in the industry chain tilts towards Spotify, the rigid revenue sharing ratio may no longer be rigid.

In fact, by breaking down the cost items for the second quarter, Dolphin estimated that the proportion of content copyright costs to total revenue has decreased by approximately 1.3 percentage points. After adding the cost of audiobooks, the cost ratio can still decrease, which can indicate a certain issue:

On the one hand, the effect of price increases, and on the other hand, the content costs are also under a low base, showing a further slowdown in growth, indirectly indicating a loosening of the revenue sharing ratio.

In addition to the natural optimization of content costs, Spotify's bundled packages launched in June also actively optimized the rhythm. For more details, you can review Dolphin's analysis in "Digging into Spotify: Worth several Tencent Music?", with the final conclusion:

Through bundled packages, the cost shared by the copyright holders decreased by 16%, and as a result, Spotify's gross profit margin is expected to increase by 1.5-3 percentage points (corresponding to a 50%-100% acceptance of the +$1 music and audiobook bundled package)

Finally, the improvement in core business profitability also brought about a simultaneous improvement in cash flow. In the second quarter, Spotify's free cash flow reached 490 million euros, hitting a historical high. The proportion of free cash flow to revenue also increased to 13%, up more than 6 percentage points compared to the previous period.