Spotify (NYSE:SPOT) counted 141 million ad-supported listeners as of the end of the third quarter. And while free listeners outnumber premium subscribers by a considerable margin, Spotify's advertising revenue was less than 11% of its total revenue in Q3. Not only that, the gross margin on that ad revenue is about 10 percentage points lower than subscription revenue -- 16% versus 26.5%.

Many investors may see Spotify's ad business as a way to offer an on-ramp to the premium subscription service. Indeed, a lot of the tech company's subscribers started off as free listeners.

But Spotify's advertising business offers a lot of value beyond making it easier for consumers to try the music-streaming app before committing to a subscription. And management expects that value to grow faster than its subscription business over the long term.

The Spotify app displayed on a tablet, smartphone, and desktop.

Image source: Spotify.

Strong margins in developed markets

Spotify has been able to grow its ad pricing to the point where a free listener can be as profitable as a paid listener in some markets. At a recent investor conference, Spotify's incoming CFO, Paul Vogel, noted that ad-supported listeners produce similar (and sometimes better) gross margin in developed markets like the United States.

While there are certainly some additional operating expenses involved with selling and serving advertisements, there's a clear path to profitability as ad prices climb. As more and more ad dollars shift to digital formats, Spotify could see ad-supported gross margin in more markets exceed its gross margin on premium subscriptions.

Importantly, Spotify doesn't need ad prices in less-developed markets to grow to levels it currently sees in markets like the U.S. today. The company's content costs in a market like India, for example, are considerably lower than in developed markets. That's why it's able to charge less for a premium subscription in those markets, and it should be able to reach margin parity in those regions over time.

Doubling advertising's revenue contribution

Outgoing CFO Barry McCarthy shared Spotify's aspiration to double the percentage of total revenue from advertising from about 10% today to 20% long-term. He said there are two ways for Spotify to accomplish that goal.

First, the company's investing in ad technology. It's pushing to move ad sales to an automated and programmatic platform. That should enable Spotify to attract more advertisers and offer better ad targeting over time as it improves. Ultimately, more bidders for higher-value ad impressions should result in higher average ad prices.

Second, Spotify is investing in advertising for podcasts. The unique thing about podcasts is both free and paid listeners will get ads. It's accepted practice for the medium. Spotify has an opportunity to develop ad technology for podcasters that allows them to serve unique ad breaks for each listener instead of embedding ad breaks into the audio recording.

More valuable ad breaks have the potential to attract more podcasters to the platform. They may be able to generate greater revenue from Spotify's technology with less effort despite Spotify taking a cut of the ad sales. Ultimately, more podcast content creates a virtuous cycle for listening hours and advertising revenue.

Spotify is still in the early stages of its strategy with podcasting. It's already invested hundreds of millions in content and technology, but it says the investments are paying off extremely well. As the company invests more in general ad technology, it should see ad revenue per user continue climbing. And if it can improve ad prices in less-developed markets to levels comparable with the United States and other big advertising markets, it should see gross margin come more in line with the paid subscription business.

Spotify is still most profitable when it converts free listeners into paid listeners. But the free ad-supported tier shouldn't be written off as merely a customer acquisition vehicle.