Spotify (NYSE:SPOT) is spending $500 million on podcasting technology and content this year. It's acquired various media and tech companies as well as signed several celebrities to create exclusive podcasts for the platform, including Amy Schumer, Joe Budden, and the Obamas' Higher Ground production company.
In the short term, investors will see a negative impact on the company's gross margin. Management forecasts margin contraction in the second half of 2019 as it increases its investment in podcasts.
Meanwhile, the biggest advantage management holds up for growing podcasts is improved engagement on the platform. But since Spotify doesn't disclose average time spent per user on its platform, investors may be left guessing how the company is doing. So, what's the best indication of whether or not the podcast investments are paying off?
"We'll keep spending more money."
Speaking at a recent investors conference, Paul Vogel, head of investor relations at Spotify, said, "How will you know if it's being successful? Well, because we'll keep spending more money."
There are metrics management will monitor internally to help guide its decision. Those include some numbers it provides to investors every quarter, including subscriber and user growth. It'll also include numbers like engagement growth and subscriber churn.
"The most important thing for us is still growing top of the funnel ... It's growing users and subs," Vogel noted. Podcasts are a way for Spotify to attract new users to the platform, and provide another layer of differentiation from its competitors that all offer the same 50 million songs. Exclusive podcasts may help lower Spotify's customer acquisition cost over the long run.
But it's hard for investors to differentiate what's growing those subscriber and user numbers. They'll have to trust that management -- which has deeper insight into the big drivers for user growth -- is investing appropriately. And if more of its investments are going toward podcasting, that's a good sign it's working.
The company has made multiple big podcasting investments recently. From production deals to technology acquisitions to new product features, it's building out podcasts to become a much bigger part of its service this year.
Fixed-cost economics are good for the long term
When Spotify signs an exclusive production deal with the Obamas, it pays upfront for a certain amount of content. Unlike its deals with music labels, which require Spotify to pay out licensing fees on a continuous basis based on overall revenue and listenership, Spotify has an opportunity to improve its margin on its podcasting spend if it achieves appropriate scale.
It's the same model Netflix (NASDAQ:NFLX) uses with its original productions compared to content licensed from other media companies. Netflix relies on its growing subscriber base to improve its profit margins, but it requires a huge amount of cash invested up front.
And just as Netflix has continued to increase its investments in original content as it grows subscribers and revenue, Spotify is likely to do the same. Additionally, Netflix differentiates its service through originals, and Spotify hopes podcasts will have a similar impact on how consumers view its service in a market where it's even harder to create differentiation.
While watching for management to announce and discuss new big investments in podcasts isn't an exact metric for investors to watch, it's probably the best way to judge whether earlier investments are paying off as expected. While the ultimate goal is improved gross margin, it will lag greatly behind Spotify's investments. What's more, the more Spotify invests now, the longer it'll be putting off gross margin expansion. So, if you wait until the company starts showing margin improvement, it's too late.