Spotify's (NYSE:SPOT) gross margin potential is controversial in the investment community because most of the content streamed by Spotify users is licensed to the company by the major music labels -- Universal Music Group, Sony Music Entertainment, and Warner Music Group, as well as by the Music and Entertainment Rights Licensing Independent Network, known as "Merlin," which represents the digital rights of independent labels. That content was 85% of the content streamed on Spotify last year, and Spotify is reportedly required to pay the labels 52% of the revenue that music generates plus additional royalties to the publishers and other rights holders. As a result, Spotify makes relatively low margins on label-controlled music. Despite that, Spotify has significant potential to expand its gross margin in at least three other ways.

Podcasting should have much higher margins than music

Spotify has made major inroads into podcasting lately. In February, the company announced its plans to acquire Gimlet Media, an independent producer of podcasting content, for 172 million euros; and Anchor, a leading player in podcasting creation, publishing, and monetization, for 136 million euors. In March, Spotify announced plans to acquire Parcast, a storytelling podcast studio, for 49 million euros. 

A woman wearing red headphones and looking at her smartphone

Image source: Getty Images.

Podcasting is a rapidly growing business, and Spotify is already the clear No. 2  player behind Apple in terms of users after being in the business for only two years. Spotify founder and CEO Daniel Ek thinks that non-music audio, notably podcasting, can represent more than 20% of listening on Spotify in the long run. 

Importantly, Spotify's profitability with podcasting should be meaningfully better than its profitability with label-controlled music. Third-party podcasters upload their content for free and receive no royalties since they benefit from free exposure and potential ad revenue. Podcasts should bring in more listeners who will pay for a premium subscription or listen to ad-supported music.

Where Spotify will make money directly from podcasting is via original content. For example, last year Spotify signed comedian Amy Schumer to an exclusive podcasting deal. Spotify keeps all the ad revenue generated by this content, and ad revenue has much higher margins than label-controlled music.

Increasing engagement with owned podcast content should help drive ad-supported revenue higher. It is still early, but if non-music content makes up 25% of listening in five to 10 years and has a 40% gross margin, all else equal, that alone would drive Spotify's reported gross margin from around 26% today to almost 30%.

Spotify's sponsored listings could have "software-type margins"

Spotify is a "one-sided marketplace" that serves its users, but it has a big opportunity to also serve labels and artists. This will make it the "two-sided marketplace" that management has been talking about since the company came public early last year. The company intends to serve labels and artists by allowing them to advertise on the platform. One of the first examples of this is known as "sponsored listings," which allow labels and artists to promote new music to targeted Spotify users who the company expects will enjoy it. The key with sponsored listings is to make sure that users find it helpful and not intrusive, but I don't expect this to be a problem given the company is well-known for its personalization and discovery expertise.

On the third-quarter conference call, Ek said sponsored listings could have "software-type margins," which I interpret to mean 90%+. After all, the platform is already up and running, and the company is simply inserting particular songs into Spotify's playlists, which costs the company almost nothing incremental. It is too early to tell how big this could be, and management has not given specific guidance, but it should be large enough to noticeably drive gross margins higher given its extremely high margins.

Some costs should not grow as fast as revenue

Finally, Spotify's revenue should continue to grow rapidly for a long time, but some of its costs are more fixed and should grow at a slower pace, and this will boost margins. These costs include the technical costs of streaming, customer service, and certain payment fees. This should contribute to gross margin expansion over time. 

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.