Spotify's new round of price increases kicks off, optimistic about Spotify and its strategic shift to profitability

Brief Introduction

Spotify $Spotify Technology(SPOT.US)$ is the world's largest music streaming service platform, with a market share of about 32% as of 1Q24. Spotify's revenue comes from paid subscriptions, and 11% from advertising. Considering the multiple new features and monetization strategies that may be launched in the foreseeable future, I expect Spotify's market position and profitability to improve in the coming quarters.

Thesis: I expect various forms of price increases to increase Spotify's ARPU, expand its gross margin, and process its stock price performance in 2024. I like Spotify's recent shift in business focus to profitability and its defensive attributes in the Internet software sector.

Market Overview

Over the past 10 years, the global music streaming market has grown at a CAGR of about 33%. It has mainly gained market share from traditional music downloads and music purchases. In the next few years, the market is expected to grow at a CAGR of about 10% (lower left chart). The main driving force will come from a) the continuous improvement of the global music streaming market penetration rate; b) by integrating related functions to gain more share from the traditional podcast and video fields (which account for about 50% of the music consumption market).

Benying Research | Spotify's new round of price increases kicked off, optimistic about Spotify and its strategic focus shift to profitability

Spotify kicks off a new round of price increases, optimistic about Spotify and its strategic shift to profitability

Driver #1: Multiple catalysts to stimulate ARPU and conversion rate growth

I expect Spotify's ARPU to continue to increase in the second half of 2024, mainly driven by its rich pricing tools, such as subscription price increases, paywalls, new features and new subscription methods. At the same time, management has recently shown great confidence in increasing ARPU in the next few quarters. I expect the number of paying users to achieve a modest 2-4% quarter-on-quarter growth in the next three quarters, which takes into account the slight increase in user churn caused by price increases.

Shifting focus to profitability: Spotify's ARPU and GPM trends reversed in 3Q23, thanks to its first-ever subscription price increase on 7/24/2023 (lower left chart), which is also an important signal that Spotify is shifting its focus to profitability. In the three quarters after the price increase, Spotify's number of subscribers still maintained double-digit year-on-year growth and a small month-on-month growth, which not only reflects the strong resilience of paying users, but also justifies the potential for more price adjustment space.

Benying Research | Spotify's new round of price increases has kicked off, optimistic about Spotify and its strategic focus shifting to profitability

Adjustment of price increase strategy: Since 2Q24, Spotify seems to have adjusted its price increase strategy. Compared with the previous round of price increases that were more concentrated in the early stage, this round of price increases seems to be more dispersed and will depend on specific functions (see figure below). I expect the implementation of this round of price increases to be more flexible, resulting in lower customer churn, and more sustainable improvement of Spotify's profitability and support for its stock price performance. The most recent price increase was implemented in the United States on June 3, covering all packages except the student package. This price increase may be one of the price increase plans in the five regions in the near future, which also means that more potential stock price catalysts may come in the near future.

Benying Research | Spotify's new round of price increases kicks off, optimistic about Spotify and its strategic shift to profitability

A rich toolbox: As management shifts its focus to ARPU and profitability in the coming quarters, I expect to see the following catalysts that may increase Spotify's ARPU in 2024:

• More package tiers: This will bring greater flexibility to subscriptions, such as music-only packages, audiobook-only packages, etc. Spotify can also expand the range of daily/weekly packages it implements in some regions.

----- Premium package tiers: May be called Spotify Lossless. Higher-resolution music will be provided, which will be used to meet the needs of hardcore music fans and cost-insensitive users for higher listening quality.

----- Daily/weekly packages: Spotify can expand this type of package from some countries in Southeast Asia to other regions with low penetration and price sensitivity, such as the African market.

• More paywalls: Used to restrict non-paying users from using individual distinctive features, such as AI playlists, interactions with favorite artists, purchase of artist merchandise, or viewing exclusive short films/music by artists, etc.

• AI playlists: Currently still in beta and limited to certain regions. AI playlists can be created by simply entering a prompt in a text box (e.g., I want to listen to music that will make me feel energetic when I go to work on Monday). Management said in the Q1 earnings conference that more AI features are coming. I expect similar AI features to become an important catalyst for Spotify's ARPU, conversion rate, and stock price.

• Early Bird: Pay to listen to new singles/albums earlier, watch new MVs, or get the qualification to purchase concert tickets in advance.

Expected conversion rate improvement: I think Spotify is currently in a stage where it needs to balance its user growth and profitability, so I do not expect its MAU to be the main driver of subscriber growth and profitability in 2024. This also takes into account the potential for more price increases in the near term and the company's continued cost optimization. However, I expect MAU to continue to grow slightly, especially considering that management has realized the excessive marketing cost cuts in 2023 (lower left figure) and proposed a moderate recovery of marketing spending in 2024, which can also help to buffer the impact of subsequent price increases. Spotify's conversion rate from non-paying users to paying users has been weak over the past three years and is significantly lower than the growth of MAU (lower right chart). I expect improving conversion rates to be one of management's top priorities in the near term, as high conversion rates will indicate a stronger market position and healthier unit economics and LTV/CAC levels. I believe that improving conversion rates will be one of the main drivers of Spotify's profitability and stock performance in 2024.

Driver #2: More operational efficiency improvements and monetization channels

I expect Spotify's margin expansion to continue in the second half of 2024, mainly due to cost control measures including personnel optimization and further growth in Marketplace business revenue.

Layoffs: With the rapid expansion of Spotify's business and accompanied by 10 acquisitions since 2019, its employee headcount has doubled to 9,123 (as of 12/31/2023) compared to 5 years ago. Substantial layoffs will only begin in 2023, and the most recent layoff of up to 14% of the total number of employees in December last year brought a significant boost to Spotify's 1Q24 results. Spotify may still have more room to improve its operating efficiency, especially considering that its per-employee contribution to revenue has not increased significantly since 2019, and the increase in user scale is not the primary focus of the business in the near term. Management expects more smaller layoffs in 2024-25, and I expect Spotify to implement more layoffs of >300 people (>3.3% of total employees) to have a meaningful positive impact on its profitability and stock price.

Marketplace: Marketplace is a platform that helps creators on the Spotify platform to gain more exposure, build more private domain traffic, and diversify their revenue sources. Financially, Marketplace has begun to have a positive impact on gross margin since 2021, which is due to Spotify starting to charge creators for certain services. As can be seen from the roadmap, Spotify still has many other options for charging. In addition, Marketplace gives music distributors (labels) and other music copyright owners the opportunity to promote related services and products to music creators, which can be returned to Spotify in the form of copyright fee discounts. Copyright fees account for about 70% of Spotify's total revenue costs.

Valuation

I think Spotify has a wealth of tools to support growth in user scale, subscribers, market position, and investor sentiment. Spotify's clear path to profitability in 2024, strong financials, and future AI capabilities make it an attractive bullish option. Spotify is currently trading at 3.2x EV/Sales, which is not too high compared to the industry. The industry median valuation level implies a ~20% upside in the stock price. Valuation is for reference only and does not constitute investment advice.

LTV/SAC: Another factor driving Spotify's valuation is its steadily increasing LTV/CAC (Lifetime Value of Customers/Unit Acquisition Cost) since 3Q22. The current level of 3.3x shows that Spotify has a fairly good balance between user scale growth and customer acquisition costs.

Catalysts

• More price increases in more regions; more substantial layoffs under the condition of stable MAU trend