Spotify (NYSE:SPOT) added more subscribers than expected in the third quarter, and management says its investment in podcasts is one of the big reasons why.

"For music listeners who do engage in podcasts, we are seeing increased engagement and increased conversion from Ad-Supported to Premium. Some of the increases are extraordinary, almost too good to be true," management wrote in its letter to shareholders.

And engagement is growing. Spotify says podcast hours increased 39% quarter over quarter, and 14% of all monthly active users listen to podcasts on the streaming service. 

Podcasts are essential to Spotify's future growth and profitability. Outgoing CFO (and former Netflix (NASDAQ:NFLX) CFO) Barry McCarthy even went so far as to say, "Streaming was to Netflix as podcasting is to Spotify," during the company's third-quarter earnings call.

Spotify CEO Daniel Ek giving a presentation.

Spotify CEO Daniel Ek. Image source: Spotify.

"Onto something special"

So far, Spotify can't quite prove podcasts are driving increased engagement and conversion to paid subscribers. "We're working to clean up the data to prove causality, not just correlation," management wrote. "Still, our intuition is the data is more right than wrong, and that we're onto something special."

Management's cautious optimism should be welcomed by investors. It's already pouring between $400 million and $500 million into podcasting this year, which represents over 5% of its full-year 2019 revenue outlook and creates a considerable drag on its gross margin. Ensuring the strategy is actually working as expected -- or even better than expected -- is critical.

If Spotify can show strong causality that podcast listening leads to better subscriber metrics, investors should expect it to invest a lot more in the medium. Not only would the investment theoretically lead to greater paid subscriber growth and retention, but podcasts also offer several long-term opportunities to generate additional revenue from both free and paid listeners. For example, the company could completely revamp how podcasters sell advertisements by incorporating its ad tech into podcast streaming.

Short-term pain for long-term gain

While podcasts seem to be having a very positive impact on Spotify's top line and user metrics, the investments in technology and content are a near-term drag on its cost of revenue. Indeed, the company's gross margin has remained stable this year despite a mix shift in listeners to higher-margin paid subscribers. 

McCarthy's Netflix analogy isn't too far off. The DVD-by-mail-turned-video-streaming company invested a significant amount in streaming content and technology last decade, and it put a big drag on its financial results. And once streaming got off the ground, it started investing in its own original content, completely eating up its cash flow and pushing it to take on debt. But the results are hard to argue with. Netflix's revenue and subscriber base continues to grow over 10 years later, and it's been one of the best growth stocks of the 2010's.

Exclusive original podcasts may also be a new differentiating factor in fending off the competition. Netflix's originals are currently getting put to the test as major media companies move into the direct-to-consumer space. So far, Spotify is showing much better subscriber growth and retention compared to its newer competitors, which practically all offer the same 50 million songs for streaming on demand.

If Spotify's podcast investments can produce stronger subscriber growth today, the company will see improved profit margins long-term as more of its streaming hours move from licensed content to fixed-cost podcasts. Management expects its long-term gross margin opportunity is about 35%. That's 10 percentage points above the company's full-year 2019 forecast. So it's likely going to be a long time before management is ready to ease off the gas with podcasts.