Spotify (NYSE:SPOT) has a long-term goal of 35% gross margin. In the second quarter, it showed meaningful progress toward that goal, reaching a gross margin of 25.8%. Some of the biggest contributors toward that improvement are the new deals it forged with record labels last year.

Spotify will once again find itself at the negotiating table next year. It keeps these contracts short purposefully with the intent to use its scale as leverage for better rates. Indeed, Spotify has grown by 42 million listeners over the last 12 months. Most analysts believe Spotify will be able to get the labels to concede better royalty fees next year in exchange for access to its massive and rapidly growing audience.

But the improved royalty rates alone won't likely be enough to push Spotify much closer to its long-term goal, according to MKM Partners analyst Rob Sanderson. He thinks Spotify may be able to use its scale to attract more of the record labels' marketing dollars instead, boosting the margin on its ad-supported business. Over the long term, that could have a much bigger impact on Spotify's gross margin than the renewed rates.

Screenshots of Spotify on mobile.

Image source: Spotify.

Where Spotify currently stands

Unlike most of its competitors, Spotify operates on the freemium model. It offers a free ad-supported version of its product with the option to get rid of ads and get a few extra features for a monthly subscription.

The premium service has significantly higher margin than the free service. Premium gross margin was 26.9% in the second quarter compared to a gross margin of 16.3% for the free service. Granted, there will always be a gap between the free service and the premium service, giving Spotify an incentive to upgrade users to its premium plan. But there's a lot of room to close the gap as it currently stands.

Sanderson points out that record labels spend about 15% to 20% of their revenue on marketing. Spotify's goal in its negotiations next year, then, should be to guarantee a larger share of that marketing spend for its platform. As one of the largest ad-supported music streaming platforms in the world, Spotify presents the unique opportunity for labels to get a direct measurement of how well their advertising efforts work.

In Spotify's second-quarter letter to shareholders, management says, "The path to success involves building services and tools for labels and artists focused on promotion, marketing, and career management." Creating more marketing products to get listeners to click on that new album or buy a concert ticket is essential to Spotify's growth and a big part of its two-sided marketplace strategy.

It's starting with its Spotify for Artists platform, which has over 200,000 artists on board, representing the vast majority of listening on the platform. The real opportunity, however, may be in the 2.8 million or so artists that currently represent the long tail of listening on Spotify, and exposing those artists to a broader audience.

Will advertising really make that big of a difference?

Investors might look at Spotify's income statement and notice that 90% of revenue comes from its premium service. That implies a premium listener is worth more than 10 times in revenue what a free listener is. It also implies the fastest way to increase its overall gross margin is to increase its premium gross margin.

While that may be true, increasing the margin of the free service shouldn't be overlooked, as it's relatively low-hanging fruit. Moreover, the only way to increase the profit margin on its free service is to increase the top line. As a result, free listeners ought to be worth more relative to paid listeners over time, thus increasing the importance of the company's gross profit margin on those users.

Adding revenue from the record labels' marketing departments could help boost that top line, as will Spotify's continued efforts to attract more direct advertisers with its self-serve ad platform. Spotify also noted in its second-quarter earnings report that its gross margin on the free service in emerging markets (where ad prices are relatively low) is still well behind its margin in developed markets. It ought to benefit from the secular growth in those economies, too.

As it stands, increasing the margin on Spotify's premium service is the fastest way to improve its overall margin. But in order to do so, it requires a massive concession from the record labels, something the company is unlikely to achieve in next year's negotiations. Consistent improvements in its ability to monetize free users with advertisements is the long-term path to Spotify's 35% gross margin goal. And additional marketing on the platform from record labels can certainly help it get there.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.