Earnings Call Transcript - SPOT Q3 2023

Operator, Operator

Good morning and welcome to Spotify's Third Quarter 2023 Earnings Call and Webcast. All participants are in a listen-only mode. As a reminder, this conference call is being recorded. I would now like to turn the call over to Bryan Goldberg, Head of Investor Relations. Thank you. Please go ahead.

Bryan Goldberg, Head of Investor Relations

Thanks, operator, and welcome to Spotify's Third Quarter 2023 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, using the code #SpotifyEarnings Q323. Analysts can ask questions directly into Slido, and all participants can then vote on the questions they find the most relevant. If for some reason, you don't have access to Slido, you can e-mail 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 shareholder deck, 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 shareholder deck in the financial section of our Investor Relations website and also furnished today on Form 6-K. And with that I'll turn it over to Daniel.

Daniel Ek, CEO

All right. Hey, everyone, and thank you so much for joining us. I hope you've had the opportunity to review our shareholder deck. Bottom line, it's a really exciting time at Spotify, and I'm very pleased with how the business is performing. It was a truly stellar quarter and one that clearly illustrates that we're making great progress against the goals that we laid out for you at our 2022 Investor Day. Q3 was our second largest quarter ever for MAU net addition. As we look ahead to the end of the year, we're forecasting to hit another big milestone, reaching more than 600 million monthly active users at the end of the year, and this puts us well on our way to reaching more than 1 billion global users by 2030. To put that number into context, 15 years ago this month, Spotify went live in France, Finland, Norway, Spain, Sweden, and the UK. It's been a wild ride. Next, let's turn to the strength of our subscriber growth. We walked into 2023 thinking we would do just over 20 million in net subscriber adds for the full year, but we're actually on track to deliver 30 million, which is a significant beat from where we thought we would be. In fact, this will be the second biggest full year gain in net subscriber additions since going public. This momentum is especially significant when you put it in the context of the price increases that went into effect in Q3. As we previously shared, because of our confidence in our product and our ever-expanding content offering, we felt the timing was right to raise prices across more than 50 markets. I know some of you wondered how we’d weather these increases, so I'm really pleased to report that this went as well as we hoped, even modestly exceeding our expectations. All of this sustained growth is a testament to the exceptional value Spotify continues to deliver globally. With our new focus on operational efficiencies, we managed to achieve this with reduced marketing costs. The essence of our business model is to deliver unparalleled value to our user base through an ever-improving consumer and creator experience. This is coupled with every now and then expanding our ecosystem through new verticals to deliver even more value. This nicely segues into the groundbreaking audiobooks offering for premium subscribers that we announced a few weeks ago. Not only will our expansion into this category supercharge the growth of the audiobooks format, but it will also drive engagement and reduce churn, which further enhances our value proposition. This gives us more flexibility for our business. While it's still too early to see the impact in our numbers, initial signs from subscribers in the UK and Australia are incredibly positive as we bring them more content to discover. In the first two weeks since launch, premium subscribers in these two markets are loving the breadth of titles and have already listened to over 28% of the catalog. They are flocking to fiction, memoirs, sci-fi, and fantasy. I can't wait to see what US subscribers gravitate towards when we launch there soon. In terms of how all of this flows down to the underlying fundamentals of the business, including, of course, revenue and gross margin, I'll turn it over to Paul to provide more detail, and then Bryan will open it up for Q&A.

Paul Vogel, CFO

Great. Thanks, Daniel, and thanks, everyone, for joining us. I'd like to add a bit more color on the quarter and then touch upon the broader performance of the business and our outlook. Q3 was a very strong quarter. MAU grew by 23 million to 574 million, and we added 6 million net subscribers, finishing at 226 million. Both MAU and subscriber growth continued to be well above our historical trend and outperformed forecasts. On the revenue front, we grew 11% year-on-year to EUR3.4 billion during the quarter. Importantly, our FX-neutral growth was 17% and accelerated 300 basis points versus the prior quarter's result, reflecting the early effects of the new pricing and accelerated advertising results. Turning to gross margin, gross margin of 26.4% was above guidance by 40 basis points due primarily to favorability in our music business. Moving to operating expenses. Growth in the quarter was lower than forecast, mainly due to lower-than-expected personnel and related costs as well as marketing spend. When combined with our better gross profit, we achieved an operating profit of EUR32 million in the quarter. We believe this is an important inflection point for the business as we start to see the benefits of our focus on speed and efficiency and progress towards delivering on the profitability targets we laid out to you at our Investor Day last summer. Finally, free cash flow was positive EUR216 million in Q3. Looking ahead to the fourth quarter, we are forecasting 601 million MAU, an increase of 27 million from Q3 and 235 million subscribers, an increase of 9 million over Q3. This gives us about 112 million MAU for all of 2023, which is nearly 60% above our four-year historical trend, adding 30 million subscribers for the year, which is 12% above the historical trend. 2023 should finish with the highest net additions for MAUs and the second largest for subscribers in company history, but actually the largest if you exclude the impact of Russia. We are also forecasting EUR3.7 billion in total revenue, a gross margin of 26.6%, and an operating profit of approximately EUR37 million. Turning to revenue, we are forecasting a 300 basis point headwind to growth, given the strengthening of the euro relative to the dollar. Excluding this effect, our constant currency revenue will be closer to EUR3.8 billion, reflecting our expectation for accelerating currency-neutral growth to 20% year-on-year versus the 17% growth we delivered in Q3. This acceleration is aided by a full quarter benefit of the price increases we announced in Q3. In sum, we are very pleased with how we're tracking into year-end. While it's too early to give guidance on 2024, I do want to point out that we are confident in our path and expect another year of meaningful progress towards delivering on our profitability goals for the business.

Bryan Goldberg, Head of Investor Relations

Thanks, Paul. Again, if you've got questions, please go to slido.com, #SpotifyEarningsQ323. We're going to be reading the questions in the order they appear in the queue, with respect to how people vote up their preference for questions. Our first question today is going to come from Matt Thornton on efficiency. Daniel and Paul, you've been successful in wringing out cost efficiencies across marketing, personnel, and podcasts. Do you feel the business is at steady state now on the cost side, or do you see more opportunity?

Daniel Ek, CEO

Yes. I'll start, and maybe Paul can fill in. Yes, we feel, as we walked into the year, just to level set and remind everyone, we talked about having a great product, but also needing to become a great business and to prove that out to investors. That's been very much the focus for Paul and myself and the rest of the management team throughout this year. I think you're really starting to see this nicely being proved out with the delivery of this quarter's results. But it really is two parts here. One is the thing that I said in my opening remarks, which is we are focused, as always, on providing a great consumer experience and creator experience. That is what allows that top line growth to then translate into that business side. The new part of the Spotify modus operandi is our focus on efficiencies. We're starting to see some leverage here coming into play, but this is the state going forward. Paul and myself and the rest of the management team are constantly looking at how we can make improvements. We're constantly finding new ways to bring more efficiencies out of the business. So I'm pleased with the progress so far. We've seen some improvements, but you should expect us to continue to look for more improvements going forward because that's just our modus operandi.

Paul Vogel, CFO

Yes. I would just add, we're obviously very pleased to see some of the initial success with an operating profit in Q3 and guidance for operating profit in Q4 as well. Our expectations are now that we will consistently be in the black moving forward. Obviously, you never know what can happen in any one quarter, but we feel good that we're on a different trajectory, and we've hit an inflection point with respect to profitability of the business.

Bryan Goldberg, Head of Investor Relations

Great. Next question is going to come from Justin Patterson, a related question on efficiency. Daniel, you began the year restructuring business units with the goal of greater efficiency and product velocity. As we head towards 2024, where do you see the next areas to be more efficient while driving innovation? And Paul, how should we think about expense puts and takes of audiobooks scaling?

Daniel Ek, CEO

Yes. As I mentioned in my last response, it's very much a focus across the base. Just to highlight one example. As the product and technology teams are working on this focus of efficiency, everyone at the company is tasked with it, and everyone has their own deliverables. We constantly find ways where, for instance, we are on the compute side of our infrastructure, finding from engineers that there are better utilization patterns. They're able to save expenses as we're doing that. This is just one example where it’s not that we're looking for top-down initiatives as much as we're seeing a lot of bottom-up initiatives that are adding up to the numbers. You saw it very clearly in our marketing spend. We delivered better top line numbers with less spend because we're now focused on this efficiency goal. I think that's the power of the Spotify team and the work that everyone is doing. That also gives Paul and me great comfort that there are great opportunities out there as long as we get the teams focused on it.

Paul Vogel, CFO

Yes. With respect to the audiobook side of the question, let me take a step back for a second. If you look at 2023, we said from the start of the year that we expected to see gross margins sequentially improve every quarter this year. We knew what we were planning to do throughout the year. We expected to see these initiatives come into play, both price increases and the launch of audiobooks. We're glad that we were able to realize and expect to continue to realize that sequential growth. As you look into 2024, we expect to see a continued improvement in our gross margin trends and a continued improvement in our operating income trends as well. Obviously, there's some investment for the audiobooks business, but nothing about the launch will derail our progress on the gross margin side or our progress on the operating income side. This is probably just as important, our progress on the free cash flow side. We did EUR200 million of positive free cash flow in Q3, and we feel good about that trajectory.

Bryan Goldberg, Head of Investor Relations

All right. Next question from Rich Greenfield on our subscribers. Is this your first-ever North American subscriber loss? Is that due to churn from the price hike? And how does this inform future price hikes? Did premium churn subs shift to the free ad-supported tier?

Paul Vogel, CFO

Yes. To answer the first part, we actually did not lose subscribers in North America. I think what's going on here is the math you are coming up with is a number based on three rounded numbers. You've got a prior quarter number, a current quarter number that are both rounded as well as a percentage number that's rounded. We actually grew subscribers in North America in line with expectations. All of our regions performed well from a subscriber perspective and relative to expectations. Therefore, we did not lose any subscribers in North America. It was actually a good quarter there. So I think it's just rounding. If that's unclear for anyone, please reach out to the IR team after, and we can walk through how that works. Regarding the price increase, as Daniel mentioned in his opening, we feel really good about how that went down. When you think about a price increase, you're focused on two components: one is anything that elevates churn, and two, anything that impacts the gross intake in any way. The churn was right in line with expectations. We've talked about in the past when we've raised prices that churn had never been material, and it was similar this time around. Even more importantly, we outperformed on the gross intake side, which is one of the reasons why we outperformed on overall subscribers. Therefore, churn from the price increase is right in line with expectations and gross intake even better than expected, which led to the outperformance.

Bryan Goldberg, Head of Investor Relations

All right. Another question from Justin Patterson on AI. Daniel, Spotify has made a lot of progress with AI through DJ and the AI voice translation pilot. Could you talk about how you view these products affecting listener engagement and creating opportunities for creators? In turn, what type of monetization opportunities does this create for Spotify?

Daniel Ek, CEO

Yes. I think the primary way we look at AI is that, especially through the tools you're mentioning, is about increasing engagement with the service by creating even more compelling value. We think about that primarily leveraging AI to create or augment already amazing content. A great example would be through AI DJ, which mimics some of the behavior on radio, providing context around the music you're hearing. It's doing an excellent job in providing cultural context, all of the things that you love radio for, but now through a personalized DJ. This nicely scales what AI can do. It personalizes things, contextualizes things, provides this at a scale that would be impossible to do by humans. Regarding the AI voice translation part, it's meaningful because if you fundamentally think about Spotify, the more content we have on the service, the generally better engagement we start seeing. The more likely it is that we can serve up something that consumers love. The AI voice translation tool is fantastic for creators and consumers. For consumers in non-English language content, they generally have much less to consume. This capability enables creators to reach more geographies that they currently aren't able to penetrate at all. You've heard me say before that the win-win is what we look for at Spotify—something that's great for creators and consumers. This usually leads to great results for Spotify. The primary way to think about these initiatives is that it does create greater engagement, leading to reduced churn. Greater engagement also means more value for consumers, which allows us to raise prices as we did with great success last quarter. We're constantly focused on improving that ratio by adding more value for consumers. This can be reflected in our top line growth with MAUs growing nicely, segueing itself into better subscriber growth, and this leads to better revenue growth. It's a trifecta, but it starts with improving the consumer and creator value proposition, which is a primary focus for us.

Bryan Goldberg, Head of Investor Relations

All right. Another question from Matt Thornton on growth drivers. What are the key incremental drivers of growth as we look into 2024? For example, can marketplace grow faster than the core business? Do you expect audiobooks to move the needle in 2024? Is ticketing and merch at all material yet? What about a full global rollout of a new UI, AI DJ, or anything else?

Daniel Ek, CEO

Yes. I'll start, and then Paul can chime in. For 2024, to set the expectation, it is about delivering on the core. Hopefully, investors can see the core has plenty left to offer when it comes to growth. We feel good about the growth we’ve had in 2023, and we see that transitioning into 2024. That's, of course, delivering against all of the initiatives we already have. Our advertising business, on one hand, is seeing more scale, which will drive more efficiencies. You mentioned marketplace; we're heading very nicely there on the business side, offering more products to people and seeing better results relative to marketing spend that label teams and artists encounter, which is a testament to how more artists will keep investing with us. Regarding the product side, you're right about the new UI; it's being fully rolled out, and we're seeing great results with that. AI DJ has been rolled out to more countries, predominantly for the English language, but you should expect local versions of AI DJ to allow for better engagement. That engagement allows for greater flexibility for the business. This leads either to more top line growth through a better proposition at a low price or the ability to raise prices if we produce a great value. There will be plenty of opportunities in 2024 for the core business to produce. We are making great progress on ticketing and merch and other fronts, but they are not yet material drivers. I don't want any investor to have that expectation, but long-term, they will be and we’re excited about them. For 2024, it's about delivering on the core, which has plenty more to give.

Paul Vogel, CFO

Yes. I would just add quickly to Daniel's point. We'll have almost three to four quarters of the price increase from a growth perspective impacting 2024. Additionally, as Daniel mentioned, the advertising business has improved throughout 2023, so we hope that advertising can continue to be a driver in 2024 as well.

Daniel Ek, CEO

I forgot to mention, by the way, regarding audiobooks, which you asked about, yes, we do think audiobooks will help the 2024 results as well, but it’s still early days. It’s in early product development and launch. The primary focus is to bring it out in more markets.

Bryan Goldberg, Head of Investor Relations

Great. Another question from Justin Patterson. This one is on subscription pricing. Spotify is now delivering a lot more value through product innovation and the inclusion of audiobooks. It also seems like churn was minimal from recent price increases. Given these dynamics, how is your approach towards pricing as a lever changing versus what we've observed in the past?

Daniel Ek, CEO

There are two paths to mention; one was before this prior quarter and one is going forward. We talked about this when we raised prices that we were adding a leg to the stool. To provide context, we had plenty of growth drivers. We can grow in a market by keeping the price relatively low and grow top line that grows the market and revenue. We can, of course, grow engagement further and have more advertising. That's another way to grow our business. We hadn’t, until that point, used the lever of price increases extensively, but we did. I feel good about what we learned there. Therefore, it’s definitely part of the arsenal of tools we can deploy to continue business growth. Expect to use that when we see appropriate dynamics. The primary reason you're seeing the top line growth is that we're providing amazing value to consumers. This is our primary focus to continue delivering amazing value. When we achieve that, we have greater flexibility to raise prices to maintain a good value-to-price ratio. We have a lot more opportunities moving forward, and we feel confident based on what we've learned from this price increase.

Bryan Goldberg, Head of Investor Relations

All right. Next question is going to come from Benjamin Black on gross margin. You've guided to sequentially improving gross margins for all of 2023. When we look forward to 2024, given the price increases and improving profitability at podcasts, should a similar gross margin progression hold true?

Paul Vogel, CFO

Yes. First on the podcasting side, we've seen improvements, and we expect it to soon reach breakeven and then be something that’s actually additive to gross profit. We are on track on the podcasting side there, and that should continue to be helpful into 2024. Same with the music side in terms of incremental gross margins there. When we think about audiobooks, there's obviously some investment anytime you launch a new product. But as I said earlier, we feel great about the continued progression in gross margins into 2024. We'll provide more specific guidance on the next earnings call. When thinking about sequential growth, we tend to see some seasonality in Q1 versus Q4, which varies from year to year. Advertising tends to be slower in Q1, but we expect improvement in gross margins going into 2024, and we feel good about reaching all the targets we talked about at the Investor Day and the significant progress we've already made.

Bryan Goldberg, Head of Investor Relations

All right. Next question is from Doug Anmuth on audiobooks. Can you talk about the cost structure and the economics of audiobooks? How should we think about the impact on gross margin in the fourth quarter and into 2024? What gives you confidence in adoption by subscribers?

Paul Vogel, CFO

Yes. I’ll just reiterate, while there's some initial costs with a new product launch, you'll see that the gross margins improve from Q3 to Q4. As I said several times now, we continue to expect gross margins to improve again in 2024. Our confidence in adoption comes from the initial weeks of positive activity in the markets we've launched in. We believe audiobooks will be a great product that opens opportunities for more authors and consumers. The podcasting business became much larger globally because Spotify entered that market; we anticipate having the same benefit with audiobooks, which will benefit authors and consumers.

Daniel Ek, CEO

Yes. We feel great about the adoption in the UK and Australia. Just as a reminder to investors, we're planning to launch in the U.S. this coming winter. With this initial launch, the signs are positive, and the consumers trying the experience are loving it. They're finding it a natural part of the Spotify experience and a great value add. It reflects our earlier point about consistently improving the experience by adding more offerings for creators and consumers alike. Then, every now and then, we add verticals that significantly enhance the value proposition.

Bryan Goldberg, Head of Investor Relations

Okay. Next question from Rich Greenfield on marketing efficiency. You accelerated user and revenue growth while cutting marketing spend. Can you help us understand what's enabled this dynamic and whether you believe it's sustainable into 2024?

Daniel Ek, CEO

Yes, Rich. I would make this a testament to the focus on efficiency, as we discussed. Again, it became marvelous when the team focuses on something at Spotify; we tend to achieve it. When Paul and I set that objective, we started seeing the teams focus much more on the performance marketing mix, and they pulled back from other areas while doubling down on effective ones. We've seen this trend play out over a few quarters. Initially, I was kind of skeptical whether we could keep this going, but with recent learnings, it seems very possible, and we are increasing our rate of learning at a great pace across the marketing team. This is a positive sign going into 2024.

Bryan Goldberg, Head of Investor Relations

All right. Another one from Rich Greenfield on advertising. Advertising growth in constant currency accelerated to 24% from low to mid-teens in previous quarters. What's driving that acceleration? How are you feeling about the timeline to drive advertising towards 20% of overall revenues compared to 13% today?

Paul Vogel, CFO

Yes. The quarter just saw a nice acceleration both on the music side and the podcasting side on constant currency. We've improved our selling and our tools, and we're doing a great job across both music and podcasting. Having both in the ecosystem is really helpful, which we've discussed before. While I don't have an update regarding reaching 20%, what we've stated in the past is we believe over time that advertising can grow to 20% or more. But we feel good about the acceleration on the advertising side in Q3 and how those trends have improved throughout the year.

Bryan Goldberg, Head of Investor Relations

Okay. Benjamin Black on audiobooks. Audiobooks monetization is via overage charges. But how do you think about medium-term monetization of this offering? Will there be additional tiers with discrete payments for access? At your Investor Day, you highlighted 40% plus gross margins for audiobooks. What's the bridge from this offering to hitting those targets?

Daniel Ek, CEO

Yes. I'll start, and maybe Paul can chime in. First and foremost, it's very early days on the audiobook side, but we're encouraged by what we're seeing. You're correct; this offering is included in the premium offering. It is a benefit our members get and provides more flexibility as a business. The offering is for 15 hours a month. For consumers hitting that base of 15 hours per month, they can top up. We already see consumers upgrading heavily, engaging in ways we wouldn't have imagined, but the base is small. Therefore, it's hard to predict long-term trends. The capability exists, and it will be part of our business. We also believe being part of the subscription is where the real value lies, expanding the market of audiobooks. This format is one that consumers love and creates more value, allowing for added flexibility for our business. Paul, do you want to talk about the bridge to the 40% gross margins?

Paul Vogel, CFO

Yes. We're not providing specifics on how monetization will work right now. However, we don’t believe the initial investment from launching a new product will materially impact our trajectory for gross margins in 2024. We expect to see progress in gross margin and operating profit as early as 2024. It's important to focus on driving a great product for Spotify, continuing to raise usage and engagement. We know that when users engage with multiple parts of Spotify, they retain better and are more engaged, leading to improved financials, a pattern we've seen before in podcasting.

Bryan Goldberg, Head of Investor Relations

All right. Next question from Doug Anmuth on podcasting. How should we think about the timing for achieving podcast gross margin profitability? What are the biggest opportunities to improve the podcast cost structure going forward?

Paul Vogel, CFO

Let me take the second part first. On the podcasting side, we're continuously looking at how to be the most efficient we can as a business. That means investing where it makes sense and being strategic in spending decisions. You've seen us this year right-size parts of the business where it made sense. Moving forward, we’ll keep investing, but we anticipate continued efficiencies through being smarter about our podcasting budget and growing advertising on top of it. We’re feeling optimistic about the trajectory of podcasting, having transitioned from a significant drag a year ago to a minimal drag, now heading to profitability in the short term.

Daniel Ek, CEO

Yes, unlike the music business, which has more of a variable cost structure, podcasting has more of a fixed cost basis. The biggest issue right now is how to reduce the fixed cost base efficiently while increasing revenues through advertising. We're working on both, and we expect to see improvements in gross margins.

Bryan Goldberg, Head of Investor Relations

Okay. Next question from Benjamin Black on operating expenses. You made some hard decisions on headcount reductions this year. Looking towards the fourth quarter and 2024, how should we think about the pace of operating expense and headcount growth? Is there more room to tighten up expenses?

Paul Vogel, CFO

I'm not going to give any 2024 guidance yet. We'll do that next quarter. I'll reiterate what we've said already, as a company, we want to be as efficient as we can. The changes made in 2023 are not one-time. This is the way we are running the business, consistently focusing on how we can operate efficiently and effectively. Our expectation is that this approach will translate into hitting the margin targets we laid out at the Investor Day.

Bryan Goldberg, Head of Investor Relations

Okay. It looks like Ben has another question on music economics. Without getting into the details of your negotiations with the labels, I'm curious how the win-win played out? Is it related to better economics on the ad-supported side, marketplace commitments, more flexibility to introduce new tier options by bundling services like audiobooks, or anything else?

Daniel Ek, CEO

As you know, Ben, we don’t comment on specifics around our negotiations with rights holders. What I can say is this negotiation process is ongoing every year, akin to a trade agreement. There are lots of components where labels want things from Spotify, and Spotify wants things from labels, like resolving small elements like lyrics, payment terms, market entries, and more. It’s a complex arrangement. The goal is to ensure both sides benefit. The history of Spotify shows both sides win when the business grows, which helps the labels and publishers as well. In doing so, we both achieve better economics with more scale. That's what we expect to continue into the future. Our gross margin improvement comes from providing more services for the industry, as we discussed earlier. Our marketplace helps reduce the marketing expenses labels face, leading to improved margins. This win-win dynamic is crucial for the rights holders and us.

Bryan Goldberg, Head of Investor Relations

Okay. Next question comes from Mike Morris on subscription ARPU. Your constant currency premium ARPU growth trend improved from negative 3% last quarter to negative 1% this quarter. Can you share more detail on the drivers? What do you think is a normal amount of drag from product or market mix? How much price-related positive impact was there in the third quarter, and how much is implied in your fourth quarter revenue guidance?

Paul Vogel, CFO

When looking at the ARPU trends, taking a look at the product mix, we’ve had a slight increase in family plans over the quarters. That has slightly dragged the numbers down. It’s been a modest impact, but that’s been the main reason behind the recent ARPU numbers. It's hard to predict if this will continue or level out, but that's the core reason behind the modest variation in ARPU. There was a small impact from the price increase in Q3, which we expect to grow more significantly in Q4. With the price rise impacting approximately 75% of our revenue base, we anticipate that Q4 will see a mid-single-digit ARPU benefit.

Bryan Goldberg, Head of Investor Relations

Okay. Another question from Doug Anmuth on the marketplace. How should we think about current marketplace growth relative to the approximate 40% year-on-year growth you realized in 2022?

Paul Vogel, CFO

Marketplace is one component among many that contribute to our total growth. It has grown nicely. We haven’t shared specific numbers but expect growth to keep driving our margins. Adding more value to the ecosystem is essential, as our marketplace only works for labels if they see the benefits.

Bryan Goldberg, Head of Investor Relations

Okay. Another one for Mike Morris on audiobooks. How much impact do audiobooks have on the fourth quarter gross margin guidance, and what are the factors that drive audiobooks gross margin impact over time? What type of usage is required for the product to be accretive to gross margin?

Paul Vogel, CFO

Yes. There’s a minor impact in Q4. As I mentioned, any new product launch comes with some costs. However, we continue to expect gross margins to improve from Q3 to Q4 and again nicely into 2024. It’s hard to pinpoint specific drivers because our monetization model is still evolving. We want to focus on how to make this a valuable product for Spotify that drives usage and engagement. Our past experiences tell us that users engaging with more than one part of Spotify leads to better retention, higher engagement, and lower churn. We expect the same with audiobooks.

Bryan Goldberg, Head of Investor Relations

Okay. We have a question from Zach Morrissey on other cost of revenue. Can you share more color on what's driving the improvement in other cost of revenue? Is there an opportunity for further improvement in 2024?

Paul Vogel, CFO

There are various efficiencies we've achieved through improved scale as we focus on cost discipline. Other cost of revenue includes cloud cost, streaming delivery costs, customer service, and payment fees. Many of these areas improve with scale as well. We're always seeking ways to be more efficient, focusing on improving our gross margins. While royalties to rights holders are our larger cost, other revenues are substantial, and we aim to enhance this area consistently.

Bryan Goldberg, Head of Investor Relations

All right. And we have time for one more question, which comes from Maria Ripps on AI. It seems like across the industry, generative AI-powered tools are improving advertiser creative and leading to better KPI performance. Is Spotify investing in generative AI to improve its products for advertisers? If so, are you seeing any tangible improvements in ad performance?

Daniel Ek, CEO

Yes. We’re actively investing in AI and machine learning to enhance our advertising products, from improving targeting to optimizing campaign performance. Specifically, regarding generative AI, the biggest opportunity lies in enabling marketers to create compelling audio advertisements. Producing high-quality audio advertising has historically been expensive for marketers. But generative AI can lower that cost dramatically while allowing for broad creative scalability. We can translate creative into multiple languages, utilize the same voice actor across different ads, and produce numerous ads tailored to each user. This significantly reduces entry barriers for marketers. We’re excited about these developments, though I caution that it’s still early days. There’s much to discover and develop across this space. Generative audio ads can become a catalyst for our advertising business moving forward, contributing prominently in 2024 and beyond.

Bryan Goldberg, Head of Investor Relations

Great. Thanks, Maria. That will conclude our Q&A session for today's call. I’ll hand it back over to Daniel for some closing remarks.

Daniel Ek, CEO

In closing, as you can see, we feel very good about the progress and results. Many of the actions we've taken over the last 12 months are really bearing fruit. I'm confident that we are well on our way of being both a great product and a great business. Thank you again for joining us. Please feel free to check out our For The Record podcast dropping later today.

Bryan Goldberg, Head of Investor Relations

Okay. 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.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.