Spotify Technology SA (SPOT) Q3 2022 Earnings Call Transcript

Spotify Technology SA (NYSE:SPOT) Q3 2022 Earnings Call dated Oct. 25, 2022.

Corporate Participants:

Bryan Goldberg — Head, Investor Relations

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Paul Vogel — Chief Financial Officer

Presentation:

Operator

My name is Regina [Phonetic] and I will be your conference operator today. At this time, I would like to welcome everyone to the Spotify Third Quarter 2022 earnings call. I would now like to turn the conference over to Bryan Goldberg. Please go ahead.

Bryan Goldberg — Head, Investor Relations

Thanks, operator, and welcome to Spotify’s Third Quarter 2022 Earnings Conference call. Joining us today will be Daniel Ek, our CEO; and Paul Vogel, our CFO.

We’ll start with opening comments from Daniel and Paul, and afterwards, we’ll be happy to answer your questions. Questions can be submitted by going to Slido.com, S-L-I-D-O.com and using the code #SpotifyEarningsQ322. Analysts can ask questions directly into Slido and all participants can then vote on the questions they find the most relevant. We ask that you try to limit yourself to one to two questions, and to the extent you’ve got follow-ups, we’ll will be happy to address them time permitting. If for some reason you don’t have access to Slido, you can email Investor Relations at IR@Spotify.com and we’ll add in your question.

Before we begin, let me quickly cover the Safe Harbor. During this call, we’ll be making certain forward-looking statements, including projections or estimates about the future performance of the company. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed on today’s call, in our letter to shareholders, and in filings with the Securities and Exchange Commission. During this call, we’ll also refer to certain non-IFRS financial measures. Reconciliations between our IFRS and non-IFRS financial measures can be found in our letter to shareholders in the Financial section of our Investor Relations website and also furnished today on Form 6-K.

And with that, let’s turn it over to Daniel.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Alright. Hey, everyone, and thank you for joining us. I hope you had the time to review our results, and as you can see it was another solid quarter. User growth and subscriber growth keeps humming along very steadily. I’ve said it before but it can’t be understated, top-line growth in the platform is the leading indicator for future success on all other financial metrics. But I want to start by addressing the macro-environment which I know is top-of-mind for all of you. There’s a lot of global uncertainty, but for Spotify, our business continues to perform very nicely around the world. And outside ads, we aren’t seeing much impact at all. And the ads business is still growing and will be important but it remains a relatively small portion of our overall revenue to date.

So, if you recall, at our Investor Day in June, I said that I suspect many of you think Spotify is a great product, yet at the same time, you may also think that we’re a bad business or at least business with bad margins for the foreseeable future. And our Q3 results clearly show that our investments in the product and experience have resulted in strong user growth, retention, and increased engagement. But they’ve also been a drag on near-term margins.

Just to remind everyone, this is all consistent with the strategic decisions we communicated in early 2021, and again, at Investor Day. So, as we’ve said, we expect this drag on margins to start to reverse in 2023. As I also shared at Investor Day, LTV, the lifetime value of a user, is the primary tool we use to inform our business decisions and judge whether our strategy and investments are working and achieving better outcomes. And the beauty of LTV is that it factors in the longevity, quality, and value of the relationship we have with a user. It is a critical metric to all teams at Spotify. And we’re constantly experimenting with what leads our users to stay longer, engaged more deeply, and ultimately, convert to our paid offerings. And what we’ve seen time and time again is how sticky our users are because of the product and experience that we’ve created. And I believe we have the lowest churn across our competitive set because of the many ways we keep listeners and happy, and therefore, retained. And because of the strength of this relationship, we know that spending to acquire new users is a worthwhile investment that over time will have a meaningful return.

So here’s how we think about it. This tradeoff is worth making if our actions result in an increase in lifetime value of a user and we also maintain a healthy customer acquisition cost to LTV ratio. But I also want to reiterate that we are keenly aware that this is an uncertain time and the cost of capital has increased, so inevitably, you should expect our hurdle rate for new investments to be higher, and consequently, you should also take this to mean that we will be more selective with our overall spending moving forward. We will make new investments with two criteria in mind. First, it must be accretive to margin of the investment period given this new hurdle rate, and second, over the long term, that investment must strengthen our value proposition to users and creators alike. This said, new opportunities will likely emerge in downturns. As an example, we may find that our customer acquisition cost goes down as the cost of advertising typically declines in a softer market. This would then offer us a clear opportunity to grow our market share even in a challenging economy, because we can acquire users at lower costs relative to LTV. We saw this dynamic play out in the beginning of the pandemic and we benefited from it, and we expect we would do so this time around should the opportunity present itself as well.

And this philosophy is not new for those that have followed us for a while. But I realize that this may frustrate some of you who would prefer we managed to the quarter. Some companies do just that and, I guess, that’s what some investors look for, especially now, in this show-me-market. But simply put, I don’t think that’s a winning strategy long term, nor is it the right one for Spotify. We’ve been transparent that 2022 was going to be an investment year which would result in a drag on our gross margin in the short term. This quarter is case in point. But it shouldn’t come as a surprise that nothing really has changed with our fundamentals. Our business is strong, we are heading into 2023 with more cost certainty, stronger product, and a better user proposition.

So, this is all playing out largely as we expected despite the macro environment. Our confidence in our ability to meet our long-term goals and the ambitions we laid out at Investor Day remains unchanged. And based on the strong demand for our platform amongst consumers and creators this quarter, I believe we will deliver.

With that, I’ll hand it over to Paul to go deeper into the numbers, and then, Bryan will open it up for the Q&A. Thank you.

Paul Vogel — Chief Financial Officer

Great. Thanks, Daniel, and thanks, everyone, for joining us. I’d like to add a bit more color on our operating performance and highlight what we’re seeing with respect to the macro-environment and then touch upon our outlook.

Starting with our strong user performance, total monthly active users grew to 456 million in Q3. This was the largest Q3 net additions in our history, and excluding our exit from Russia, our year-to-date net additions are at a record high, and we expect this to sustain throughout year-end.

Moving to Premium, we finished the quarter with 195 million subscribers, 1 million ahead of guidance thanks to broad-based strength across regions, particularly LATAM. Our revenue grew 21% year-over-year to just over EUR3 billion in the quarter. This was slightly ahead of guidance, driven mostly by foreign exchange. Our advertising business grew 19% year-on year-on-year and was led by strong double-digit gains in our podcasting business. While this overall result was a bit below expectations, we continue to see encouraging signs that our ad strategy is working despite some of the near-term macro headwinds, and particularly, the continued strength and interest in SPAN.

Turning to gross margin. Gross margin of 24.7% was below guidance by 50 basis points. There are three factors that contributed to the results and in order of significance. First, the expected renewal of a large publishing contract outside the US resulted in accrual adjustment this quarter. The adjustment reflected revised estimate spend in the previous nine quarters, and while the amounts were immaterial in any single quarter, taken together, they added up to a material impact in Q3. And second, like many, we did experience some impact to the top-line advertising growth from the macro slowdown, and this shortfall had a modest impact on margin. And third, currency fluctuations, mainly the continued strength in the US dollar, had a small impact on cost of revenue. Historically, currency has had a big impact on operating expense and is somewhat minimal impact on cost of revenue. However, given the significant strength of the dollar, it has started to impact gross margin as well.

Taking a step back, we don’t see anything in the results to change our view of the margin potential we laid out at Investor Day. Importantly, we view the publishing renewal in this quarter along with the recent proposed settlement related to the US CRB on Phonorecords IV rates as very positive developments. They offer greater cost visibility, and taken together, these two deals are consistent with the profitability targets we communicated to you at our Investor Day.

Looking at operating expense. Growth in the quarter was slightly lower than forecast on a currency-neutral basis, however, currency fluctuations proved greater than planned. When combined with our modest variance in gross profit, our operating loss was slightly below guidance. Currency continues to be a big impact, adding EUR85 million to operating expenses or just over 14 percentage points of year-over-year growth.

And touching on free cash flow, we generated our 10th straight quarter of positive free cash flow. We cont — we continue to generate roughly EUR200 million in free cash flow on a trailing 12-month basis. and given the timing within quarters, we may see free cash flow turn negative in Q4, but we still expect to be free cash flow positive for the year and moving forward.

Turning to our outlook. Looking at Q4 and beyond, as Daniel said, we continue to monitor the global macro-environment and to date, we’ve seen no material impact outside of our ads business. When we get — when we began 2022, we stated that we expected to see MAU and subscriber net addition growth at roughly similar levels to 2021. As we enter the fourth quarter, we now expect MAU net additions to finish materially higher by year-end and we see subscriber growth roughly in line with those expectations, excluding the impact of Russia.

With respect to Q4 ARPU, we expect it to be up mid-single-digits on an as-reported basis. On the advertising front, we are seeing some modest improvement from where we were a month or two ago but the macro-environment still has a reasonable amount of uncertainty. As such, we expect another quarter of decelerating growth in Q4, we continue to remain confident in the long-term potential of the business.

Our gross margin outlook for Q4 is 24.5%. We recognize this is likely a bit below what many of you have been expecting based on the commentary exiting our Q1 results for a gross margin of around 25% for the balance of the year. The variability in these figures is primarily result of three factors: one, including the softening macro-environment over the course of the year which is reflected in the current advertising slowdown. We also see another quarter of negative currency exposure. And last, Q4 includes a restructuring charge at our podcasting business, which should lead to improved productivity at select studios on a go-forward basis. All in, we anticipate approximately 70 basis points of impact from these three items, with the impact spread roughly evenly across each.

And in closing, despite a uncertain macroeconomic environment, we continue to be highly encouraged by the overall trends we’ve seen year-to-date. We laid out a vision for our business model expansion at our Investor Day which we still firmly believe we will execute against. This year has been one of investment, hitting both gross margin and operating expense. And while it’s too early to provide any guidance with respect to 2023, we do expect our profitability rates to improve relative to 2022 as we grow revenue, lap certain investments, and deploy capital more efficiently.

And with that, I’ll hand things back to Bryan for Q&A.

Questions and Answers:

Bryan Goldberg — Head, Investor Relations

All right. Thanks, Paul. [Operator Instructions]

And our first question today is going to come from Matt Thornton on pricing. Can you update us on your thoughts around pricing given the recent increases at Apple Music and YouTube Family?

And then, secondarily, is there any update on HiFi as either a feature or a separate Premium plan?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah. So, this is Daniel. So, maybe just by way of context, so in the last two years, we’ve actually done more than 46 price increases in markets around the world. And I mentioned this on earnings calls before but the results from these have been conclusively the same, which is: it’s been as good as we would have hoped for if not better in many of these places. So, take that to believe that we believe we have significant pricing power on this, and that, we’re offering an amazing consumer value proposition. And that just keeps improving with our improvements in the service.

So, I think when our competitors are increasing their prices, that’s really good for us. Because again, with our deep engagement that we have and the lowest churn of any competitor, we would likely fare better. So, we’re set up super well for the coming years. And again, in specific, mostly to the US-based price increases, it is one of the things that we’d like to do and this is a conversation we’ll have in light of these recent developments with our label partners. And I feel really good about sort of this upcoming year and what that means in pricing in relation to our service.

Bryan Goldberg — Head, Investor Relations

All right. Next question is going to come from Doug Anmuth on gross margins. How confident are you in 2022 representing a near-term trough on gross margins with inflection in 2023 as laid out at the Investor Day? What are the key drivers and is there anything that could derail that trajectory?

Paul Vogel — Chief Financial Officer

Yeah, so I’d say at a high level, we still remain very confident with the margin profile and margin guidance we gave at the Investor Day. We’ve said a number of times, 2022 is going to be an investment year. You’ve seen it sharpen both gross margin and on the operating expense line. And we expect to see improvements as we move into 2023.

We’ve talked about particularly things like Podcast, that has been a drag and that should turn into a less of a drag, then eventually, a benefit moving forward. And nothing has changed at all in terms of our expectations there. Obviously, there’s some macro uncertainty, so the speed of that turnaround could always be impacted by a quarter or two or at least the slope of that turnaround. But when you look at sort of the guidance we gave in terms of when we think we can break even and the impact of something like Podcast over the long term, nothing has changed at all in terms of our expectations.

So, we still feel really good about it. Obviously, the macro could impact a little bit the overall speed of that trajectory, but we don’t see anything impacting kind of where we’re headed at all.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah. And maybe, my additions to that too. If you really separate it out from the business standpoint, you can really think about it as two major parts of the business at the present moment with more being developed with Audiobooks, etc. So, the two major parts is, obviously, our music business side and then it’s our podcasting business side. And as Paul said, on the structural side on podcasting, we believe that to, long term, be a much higher gross margin business than the one we’re currently in the music, simply because the way to mimic that would be to look at platform type of businesses that usually end up having a higher gross margin than normal services.

And then on the music side — in the prior question came a question about pricing, so any pricing we would do would be accretive to that business too. And as mentioned, we’ve been selective in doing it during the pandemic in macro environments, and we’ll do so, opportunistically, too, but if you think in light of our competitors raising prices, that obviously gives us more confidence going into it too.

So, we’re very bullish long term that we’ll get to these numbers that we outlined during Investor Day.

Bryan Goldberg — Head, Investor Relations

Okay. Next question from Mario Lu. You recently launched your own site to sell tickets to live events, how is it performing versus internal projections? And does this move the needle for the roughly EUR200 million of Marketplace revenue expected in 2022 and healthy double-digit growth in 2023 given at the Investor Day, or was it already embedded?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah. I’ll start with this one and maybe Paul can add to it. So, first, I actually think are kind of conflating two parts. Marketplace does not include the Live business, just to set the record straight there. So, we feel really good about the Marketplace business and how that’s developing and we feel really good separately to that of the Live business, although it’s very early days. So, lots of experimentation of just enabling more ticketing to be available across Spotify. That ticketing, in turn, had drove better results, so more people are seeing more tickets, and therefore, as they’re seeing more tickets, conversion rates, and overall ticket sales has improved too. So it’s early days. I can’t disclose any numbers just yet, but we feel encouraged by that part.

And then, in regards to the numbers that we gave around Marketplace, that’s completely separate from that, but we feel really good about where we are with Marketplace business.

Paul Vogel — Chief Financial Officer

Yeah, nothing else there other than the Marketplace has sort of been trending in line with expectations throughout the year.

Bryan Goldberg — Head, Investor Relations

Okay. Next question from Rich Greenfield. Daniel, you appear increasingly frustrated with Apple. What would you like to see them do that they are not allowing today? Can you give us a couple of examples of issues that are problematic for Spotify? And also, can you update us on the Google Play partnership from earlier this year?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, sure, Rich. So really, at the core of this is the same argument I’ve been saying now for about four years, which is our view is that this is the next great battle from net neutrality and to what I call the platform neutrality wars. And the key part that we want to do as Spotify is we want to have the ability to communicate with our customers the way we choose to do that and the way our customers are accepting to have that line of communication. We do not want a gatekeeper or a monopoly in the way to dictate how we communicate with our customers.

The second part of that is we think that there ought to be a payment method of choice by this. So really, allow us to use whatever payment method we think is the optimal one and that the customer wants to use. And that’s important.

And the last part is, having the same axis: if you are a platform that offers a competing service, on that platform we, want to have access to the same level of APIs that you would offer your own service.

Those are the three big things. And case in point actually, there is a New York Times article that I would just highly recommend all a view on the call today to read. I think it just highlights again what’s happening there, but the short gist of it, it’s a pretty lengthy article, but the short gist of it is Apple keeps putting up roadblocks of just stopping us more and more and more. I think the app was rejected three times or four times at present moment, really despite us having lawyers in the room to make sure we were compliant with this. So, they keep moving goalposts which is exactly what we’ve said all along. And if you contrast that to trying the same experience now on an Android device, and on Google, it is a beautiful experience.

So, this just showcases that we can build an amazing audiobook experience. However, on iOS, the purchasing flow is inherently broken because Apple decidedly wanted it to be broken. And I just think it’s absurd, frankly, that they’re allowed to keep doing this.

So yes, I’m probably more vocal about it because it’s insane that it’s been taking four years to us to get the resolution for something that’s just absurd and holding everyone back. It holds developers back, it holds creators back, and it’s bad for consumers.

Bryan Goldberg — Head, Investor Relations

Okay. We’ve got another one from Doug Anmuth. Can you detail the drivers of software gross margin for 3Q and in your 4Q outlook? And what changes in 2023?

Paul Vogel — Chief Financial Officer

Yes, sure. I’ll kind of recap of maybe some detail what I said on my prepared comments. But — so, in 3Q — in the third quarter, there was a couple of things that impacted the business. And I’ll say them in the order of importance. So, the first was the reversal of an accrual. As many of you know, and oftentimes, we have relationships with our royalty partners, and some of the times, those contracts expire. And as we are negotiating new contracts, we estimate as best we can what we think the expenses we need to incur during that period of time. Normally and in most cases, we’re always very conservative, in most cases it resulted in us actually getting a slight benefit when we actually settled the contract. In this case it was a very modest impact. The reason it mattered in this quarter is because the contract had been expired for over two years, and so, it was nine quarters worth of small little adjustments over nine quarters that we had to take in this quarter. So, that was the biggest one.

The second one, as I talked about, was some of the ad softness. Again, it wasn’t too material, but the ad softness did have a small modest impact on gross margin. And the same thing with currency also. Again, not something we normally call out as part of gross margin, but in this quarter, the currency moves were significant enough to impact it.

Just going back to the first point real quick, I would say that we feel really good as I said in my comments, Phonorecords IV as well as this International agreement, a lot more cost certainty as we head into 2023. And that’s cost certainty and the cost of that cost certainty, it’s consistent with the model and the outlook we gave to you at the Investor Day. So, we feel really good about all of that.

And then, in — with respect to the fourth quarter, there’s a couple of things in there. Again, these are probably all in equal amounts but the ad softness again relative to some of the investments we made, we’ll have a little bit of an impact there. Currency, again in 4Q, and then as I said, there was a one-time restructuring charge for some of the changes we made in our podcasting business in — a month or so, a couple of weeks ago. And that charge will hit Q4 which runs through the cost of revenue.

Bryan Goldberg — Head, Investor Relations

All right. We’ve got a question from Jason Bazinet. Can you please describe the two or three primary levers you believe will allow you to expand gross profit margins 300 basis points to 500 basis points over the next few years?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, Jason. It’s really just a reiteration probably from much of what I’ve said during the Investor Day. So, I would just highly recommend you to take a look at that. But in essence, when you look at it, our Music business has continuously improved its gross margin. However, we had — have invested in non-music content quite substantially over the past few years, which meant that we were kind of at a level where it looked like our top-line gross margin hadn’t moved much at all in that process. And so, the belief is that we can keep expanding our margin on the Music side, and as we’ve said before, this heavy investment that we’ve done on the podcasting side is going to reverse in 2023 as it starts moderating.

And then last point I would just add is to say that structurally as the revenue mix shifts to more and more non-music content, so both podcasting, but also, Audiobooks, etc., those gross margins in those categories is going to be significantly higher than the ones we’ve had in the music business too. So, that’s going to be a net positive as more and more of the revenue starts shifting to those categories. And that adds up to the gross margin improvements that you’re talking about, and then some, when you look at the sort of long-term improvement.

Bryan Goldberg — Head, Investor Relations

All right. Another one from Rich Greenfield. This time on competition. The elephant in the room question is: TikTok expanding Resto [Phonetic] to more markets as they hire music industry executives. Curious how you think about the threat given TikTok’s importance in A&R and Music Discovery? And how Spotify is positioned?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, so first off, like many other technology founders, I’m very impressed with how TikTok has been executing in. And obviously, it’s been formidable to watch their growth and how well they’ve been executing throughout the year, so we take it very seriously when we look at that.

Now that said, we have been in markets with Resto for quite some time and we’ve seen considerable growth in those markets. So, I feel really good about our competitive position as it relates to that. So, I feel good about, yes we know that they’re investing in it. When they’ve taken share or they haven’t taken share from us, it’s been from others. We keep watching it, however. And the key again is the only real competitive advantage I think in tech is to move faster than everyone else. So, this is also part of the reason how you should look at our backdrop of investing so much as we have done in this past year is because we want to move faster.

So, I mentioned this in the last earnings call but the number of experiments that we do, the number of product improvements that we do each quarter is a metric that I look at. And as a — probably the most important leading indicator for long-term success. So, that makes me feel good because we’ve really kind of improved our product velocity over this year. And I think, you’re starting to see it already in the product but you will certainly start seeing a lot more of it coming into 2023.

Bryan Goldberg — Head, Investor Relations

All right. Next question from Doug Anmuth. What does the Spotify Machine look like in five-plus years? And what gives you confidence that Spotify can have as much success with Audiobooks books and other products as it has with Podcasts.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, sure. So, first and foremost, just as a reminder for people, what the Spotify Machine is, it’s really a framework of how to think about Spotify, where the three dominant ways to think about it is that it’s one-user experience shared across many verticals of content. And what that enables us to do is to leverage all the key technology, so all the pillars that we’ve built Spotify throughout the year, so Freemium, personalization, ubiquity, all of those facets. And in addition to that, obviously, it enables us to go and take the scale of the existing audience base and cross-sell to new verticals to gain ground faster.

So, when you look at that from Music to podcasting, the reason why we’ve been so successful is because we’ve been able to upsell people who’ve never listened to a Podcast before to start listening it on Spotify and that is what got us to the number one position in podcasting. And so, our belief when you look at the Audiobooks market is that while books is a pretty big industry, Audiobooks is still a niche offering, only enjoyed by tens of millions of consumers around the world.

And if you think about that from first principles, it’s pretty clear that Audiobooks should be something that should be enjoyed by hundreds of millions of people if not billion so people around the world. So, to grow that market is absolutely key for us.

And so, the way to think about the Spotify Machine is: we are investing in better Freemium experience, better personalization, better ubiquity experience, that then benefits more and more of these verticals. And in addition to that, you should expect us to add more and more of these verticals. So that’s — we can get to sort of double whammy. And in a way, I actually think about that, if you want an analogy, there’s probably healthy ones on the B2B business sites where the hard thing was to get distribution and get the customers in the door, but then a sales force or someone else then kept adding more and more the products to leverage that existing distribution channel that they’ve built. So, you can think about the Spotify Machine as our ability to do that to where we’re going deeper and deeper into each vertical with more and more of the business offering but leveraging the distribution we have to consumers.

So, there’s plenty of opportunities to expand in the coming years.

Bryan Goldberg — Head, Investor Relations

All right. Next question from Batya Levi on podcasting. Can you provide more color on Podcast engagement and your expectations to reach profitability in this part of the business?

Paul Vogel — Chief Financial Officer

Yes, so engagement in Podcast has been strong. We’ve seen Podcast MAU as the percentage of our total MAU continued to increase, it was up again in Q3. And then Podcast consumption per Podcast MAU is also up year-on-year. So, we’ve seen really strong trends in general across all of podcasting. And as we continue to build out the tools and services to monetize, continue to expand the audience, continue to grow reach, we feel like we’re right on track with our ability to generate the profitability that we mentioned earlier on the call, and also at the Investor Day.

Bryan Goldberg — Head, Investor Relations

All right. Next question from Deepak. Your fourth-quarter guidance implies Premium subscriber net adds of 22 million for 2022 versus 25 million in 2021 and 31 million in 2020. What’s the right way to think about annual net sub-adds for 2023 and beyond?

Paul Vogel — Chief Financial Officer

Yeah, so let’s first look at 2022. Keep in mind that that number in 2022 includes Russia and the impact of us exiting Russia. And so, when you look at it more on an organic year-over-year basis, 2021 and 2022 were very similar in terms of net additions. You just have to back out the impact of our withdrawal from Russia which was impactful. So, that’s number one, so you’re looking at comparisons.

And then, second, we haven’t given any guidance on 2023. Yeah, we’ll do that in our next quarter call, so we feel really good about the subscriber growth we’ve had this year. And like I said, if you back out Russia, it’s right in line to even slightly better than our expectations.

Bryan Goldberg — Head, Investor Relations

All right. Deepak’s got a follow-up on gross margins. Can you unpack the gross margin expectations between Premium versus Ads in the fourth quarter guide? And more importantly, how should we think about the Premium gross margin expansion in 2023?

Paul Vogel — Chief Financial Officer

So, when you look at what we’ve reported — obviously, any — we talked about overall gross margins, but any of the overall weakness or softness in Q3 on the Ad — the revenue side is going to impact the Ads business from a gross margin perspective. And if wanted [Phonetic] the Premium side. And most of the other impacts on consolidated gross margin are going to kind of be evenly distributed across both.

And again, as we look into 2023, I’ll just sort of reiterate what I said, 2022 has been an investment year. We’ve had a couple of things in Q3 and Q4 which I have identified [Phonetic], which are — which have been an impact on the Q3 and Q4 gross margin. But we look at 2023 as a year where you’ll start to see the dynamic of revenue and cost growth start to reverse. As Daniel mentioned, we’re continuing to look at and be thoughtful about how we greenlight and deploy our capital. And we still feel really good about the long-term model and the profile we gave to you at the Investor Day.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

My only addition is: I kind of said this comment already, but I think you should expect the music margin as it has been to keep ticking up, but the real sort of negative drag on margin had been the podcasting side. And that is also a lot more within our control in terms of how we allocate the expenses on that part of the business as well. And we’ve been investing quite heavily.

Bryan Goldberg — Head, Investor Relations

All right. Net question from Eric Sheridan on the Ad market. Can you talk about the current state of trends that you’re seeing with respect to audio, digital advertising, especially any nuances by type of advertiser, geographic impacts?

Also, anything on exit velocity to the Ad business in September that you can share?

Paul Vogel — Chief Financial Officer

Yeah, so from a geographic perspective, we saw the softness really mostly in EMEA. A little bit in North America, but we saw in EMEA. Obviously, the war, [Phonetic] the economies are getting back to those businesses, if even in places like the UK, we actually had some positive advertising for a week around the Queen’s passing which also impacted our business. And so, we definitely sold the most there from a geographic perspective.

In terms of exit velocity — when you look at October, it’s a little bit of a nuanced answer, we obviously, had seen some of the trends kind of moderate throughout Q3. If you would have — kind of look at where we were a month ago to where we are now, the October numbers look a little bit better than where we thought they’d be a month ago. But there’s still uncertainty in those in those numbers.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Hey, Paul, you should probably mention what you told me before too, about sort of the uptake from advertisers.

Paul Vogel — Chief Financial Officer

Yep. Yeah, also, it’s a great point. So, one of the things that we look at to monitor the health of the advertising business and kind of discern between what’s macro and what is structural is when you look at SPAN and you look at the number of advertisers that are participating in SPAN, that continues to move up. And so, even though, the macro may impact how much they’re spending in any one period of time which is obviously macro-nated — macro-related, when you look at it from a pure structural standpoint, we feel really good about what we’re offering and the number of advertisers that are participating in that ecosystem.

And so, the fact that we’re seeing that up year-on-year and continue to grow, shows us that we believe that the overall structural health of our — of/or [Phonetic] the Ads business that we are building at Spotify is very healthy.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, and my only two additions as a piece of context for everyone on the call is, on the one hand, I think as Paul said, the important thing is to decide whether this is a cyclical or a structural thing. And it’s our firm view that this is more cyclical than structural. So, the long-term growth of digital advertising is still going to be healthy, we believe. And there’s more offline dollars that’s going to move to digital dollars.

But in regards of audio advertising as well, I think we are in a great position because relative to the competitive marketplace, there’s a lot of services and platforms out there that offer video advertising and display advertising, but that is in competition to each other. And if you think about Spotify now in relation to all of that, if you want to advertise via audio, and in this case you want to reach customers in the car or as they’re commuting, that’s just one example or on-the-go on mobile devices, Spotify is the place to advertise for them.

So, I think we sit in a very different bucket than an advertiser thinking about — if they were going to spend a video dollar, there’s plenty of places to think about where to do that, where there’s much fewer on the audio side, and there’s really one leader which is Spotify.

And then, in addition, I do want to highlight perhaps something that’s obvious, but Ads is just a very small part of our business at current state. So, any headwinds in the advertising business for us is just a lot smaller than it is for platforms that solely rely on ads. So when you think about our product roadmap, I would suspect that when you compare that to some of the other platform companies, they probably have to realign and re-do quite a lot of their product roadmaps based on the headwinds that they’re seeing because it’s just pretty material for them, whereas for us, this is a much smaller part of our business. And it’s important in long term, but in the short term, it impacts us a lot less when there are headwinds.

Bryan Goldberg — Head, Investor Relations

All right. We’ve got a question from Steven Cahall on pricing. When you think about price increases, how the label terms impact your thinking? Is there scope to align interests by agreeing that incremental pricing will pay a lower share of royalties so you and the labels share in the upside?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, I mean, I can’t comment on the specifics on any of the label terms. But again, any price increases that we choose to do should be a net-net, a win-win for both parties. So, that’s definitely part of any conversations when we’re talking about pricing with our label partners. As you could imagine, even in the past, and in the context of the 46 price increases, we’ve already made.

Bryan Goldberg — Head, Investor Relations

All right. Next question is coming from Benjamin Black. Could you talk about the launch of Audiobooks? What the early takeaways have been or any feedback you can share? And how do you envision evolving the product from here?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, again, it’s super early days. So, I think the really healthy metrics for me is to look at engagement and retention among the Audiobooks purchasers that we’re having. And that looks just very solid. So, it’s early but good engagement overall. We see it being additive to all the other engagement that’s happening on the platform which was our hope, ambition, so it’s nice to see that being played out.

Now that said, and as I said earlier in the call, the purchasing experience in particular on iOS has been below expectation on our side. That’s obviously without our control and it’s something that we’re working on trying to improve. And I feel good about where we will end up in — despite of all of that in 2023. And that will allow us to scale.

We kind of knew this was one of the possible scenarios and we’d been planning for that, but I’m disappointed, obviously, in all the Apple back-and-forth.

Bryan Goldberg — Head, Investor Relations

All right. The next question is going to come from Brett Schaefer. [Phonetic] What needs to happen for Discovery Mode and the two-sided Marketplace to take its next step and continue to expand Premium margins?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah. Overall, it’s really two parts of this — two-sided. Part one is demand and the other one is, obviously, supply. So, if you think about it in very simplistic terms, more artists, more releases participating helps on the one side of it, and then, more inventory, high demand from consumers, and seeing that marketplace-type products helps with that. And so, it’s a constant sort of pulling levers on both sides for us to try to expand that. And that’s what we’re doing and it’s kind of more of the same really rather than any major innovation.

Paul Vogel — Chief Financial Officer

The other thing I would add is, within the questions that are implying that the Marketplace isn’t helping margins, it’s actually helping margins a lot. We’ve just chosen to take some of the benefit from the Marketplace growth and reinvested in our business which is why you haven’t seen the consolidated gross margin expand. But we feel really good about the benefit we’ve seen from Marketplace and its ability to drive margins in the future.

And again, right now, that’s just being masked by some of the investment we’ve chosen to make, again, not to sound like a broken record but — kind of what we’ve talked about throughout the 2022.

Bryan Goldberg — Head, Investor Relations

All right. Next question is going to come from Justin Patterson. Can you discuss how you’re thinking about the pace of headcount investment in this environment? Are there opportunities to slow opex growth and focus more on productivity?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, well, as I said in my opening remarks, this is definitely — we are keenly aware that this is a very different macro-environment than the one we previously had been in before. And I know some investors may not think that I care because I’m focused on the long term, but I do. So, for me, what that really means is that cost of capital has increased, and when cost of capital increases that means that the hurdle rate that we’re doing for any new investments needs to increase.

In addition to that, we had already planned to probably slow down some of our opex increases for 2023. but obviously, in light of even more uncertainty, it’s even more prudent to take a big look at those numbers, and obviously, manage the — that opex side much better than we have. And Paul can probably share more context on that but I just wanted to say that from my side.

Paul Vogel — Chief Financial Officer

Yeah, I mean, we’d — obviously, we’ll give sort of more guidance and clarity on 2023 on our next earnings call. But as I’ve said a couple of times, I think you can expect that dynamic of revenue growth and expense growth to flip from where it’s been over the past couple of years, and start to see that focus shift in sort of how we manage the business. And we invested a lot in this year to set ourselves up for the future in terms of people and product and being able to build what we needed to have. And then the hope is to start to leverage some of that investment over the next year or two.

Bryan Goldberg — Head, Investor Relations

All right. We’ve got time just for a couple more questions here. The next one’s going to come from Rich Greenfield. Are there ways to be more innovative on price and functionality on your service besides an all-you-can-eat product for a fixed price?

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah. So, I think the higher-level way of thinking about it is Spotify is predominantly up until now been a subscription, as you say, all-you-can-eat service. All that said, a few years ago, we started investing in advertising being the other way. So, you can think about raising ARPUs as a combination of either being on subscription or either on Ads, and it’s kind of interesting to see how people are blending the two together, now, on the video side. So that might be an opportunity where consumers may not see that the price point is increasing, but effectively, the ARPU is increasing. So, that’s one.

And then, the second part is, a la carte to the mix, too. So, as you can see the other way to raise ARPU, and you’ve seen us do that now a few times, so you have Audiobooks which is bought a la carte; you also have Live concert tickets, that’s also now bought a la carte.

So, it’s really the three modalities of revenue playing together rather than thinking about us as predominantly a subscription service even though, obviously, that’s where the majority of the revenues come from today. So, I think that gives us a lot more flexibility. And then, we’re already innovating quite a lot on the all-you-can-eat model, in particular, in Southeast Asia. So, you should take a look at what we’re doing there if you want to see some sort of early indicators of things that we might scale if it makes sense to other parts of the world there, too.

So, lots of innovation on — on — I took it to mean sort of ARPU increase rather than price increase over the coming year, so a lot more to come there.

Bryan Goldberg — Head, Investor Relations

Right. We’ve got time for one more question, that’s going to come from Deepak on podcasting. Can you discuss your return expectations on Podcast content investments for 2023? And is the rising cost of capital environment causing you to revisit the planned levels of investment in Podcasts?

Paul Vogel — Chief Financial Officer

Yeah. I would — I would probably answer this question a couple of different ways. One is: we look at all of our content investment through the lens of returns and the impact on LTV across all of Spotify. So, we’re going to continue to lean into looking at every investment we make and is that increasing or decreasing and having a positive impact on LTV, so that’s number one.

Number two is: I think as Daniel mentioned, right, the cost of capital has gone up, and so, any investments we make, any continued growth we make, the hurdle rate is definitely going to be higher moving forward. And so, we’ll continue to be thoughtful and careful about how we commit our capital.

And then, third, not surprisingly, we are constantly looking at and modeling out the impact of both our content invest — investment, as well as the advertising that goes on top of it as well as any benefits we get to engagement and user growth. And looking at the three of those combined to make decisions on how much we want to invest going forward. And now, nothing will change in that sense.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

Yeah, and my only addition to that, as we said at Investor Day, we were expecting margins to improve in 2023, and that’s, obviously, a function of us growing revenue faster than we’re growing content cost. So, that’s been our plan all along for 2023. And being consistent with what we’ve been communicating before.

Bryan Goldberg — Head, Investor Relations

All right. Thank you, Deepak, and thanks, everyone, for the questions. That concludes our Q&A session. And I’ll turn the call back over to Daniel for some closing remarks.

Daniel Ek — Founder, Chief Executive Officer & Chairman Board of Directors

All right. Well, thank you, Bryan, and thank you, everyone, for listening to today’s earnings call. So, I’ll really close by saying that with one quarter left in a year that’s seen war, a lingering pandemic, inflation, supply chain disruption, and threats of a global recession, I’m just really proud of all that we’ve accomplished. And that despite all of this, we’re precisely where we thought we’d be.

And while there may be roadblock — more roadblocks than they were in the past, we remain incredibly confident in the course we’ve charted and in the destination we mapped out for ourselves. And we will be more nimble and more prudent as the times’ demand.

So, for more details and more context, please check out For the Record podcast that we’ll be dropping later this evening. Thank you, everyone, for tuning in.

Bryan Goldberg — Head, Investor Relations

All right. And that concludes today’s call. A replay will be available on our website and also on the Spotify app under Spotify Earnings call replays. Thanks, everyone, for joining.