Spotify (SPOT -4.62%), known for popularizing music streaming, launched its podcast feature in 2015 and has quickly gained market share ever since. In fact, according to a recent survey, 25% of U.S. podcast listeners use Spotify for their primary app versus only 20% for Apple (AAPL -1.22%). This divide will only increase over the next few years. Spotify has set itself up to lead the podcast market by investing in exclusive content, empowering show creators, and creating a dynamic ad market that will help it capture the majority of dollars flowing through the industry.

Spotify's music streaming service, displayed on desktop, tablet, and phone screens.

The music streaming service is branching out with a big bet on podcasts. Image source: Spotify.

An industry overview

The podcast market is on fire. Some 75% of people in the U.S. now understand what a podcast is, up from only 49% in 2015. Apple started out as the leader in the space, allowing users to download shows as early as 2005. It has captured the majority of listenership by pre-loading its podcast app on new devices, making it free for its 1 billion-plus users to download and stream shows.

However, after 15 years, there is finally real competition coming to take Apple's throne. Enter Spotify.

Exclusive content

Owning podcast content will be crucial for Spotify to convince listeners to switch platforms. In 2019 and early 2020, it acquired podcast producers Ringer, Parcast, and Gimlet for more than $400 million total. Only some of the acquired shows have gone exclusive so far, but it is a long race and investors should expect more and more podcasts to only be available on the Spotify app over time.

The biggest investment, and the deal that shocked the industry, was Spotify signing The Joe Rogan Experience, or JRE for short, for over $100 million. The deal states that the JRE video and audio shows will only be available on Spotify by the end of 2020, bringing the entire back catalog and new shows to the platform. The JRE is probably the most listened-to podcast in the world, with over 200 million monthly downloads (compared to The Daily, the second most popular show, at around 60 million), and will likely convince millions of listeners to switch to Spotify. 

Other important exclusive deals include The Michelle Obama Podcast and a Kim Kardashian-produced show about criminal justice. These may not carry the weight of a JRE, but they'll still add to Spotify's value proposition.

Owning the creation tools

If signing the JRE, Kim Kardashian, and Michelle Obama is the "Netflix" strategy for Spotify, then its acquisition of Anchor is the equivalent "YouTube" one.

Anchor is the most popular place for independent creators to distribute and monetize a podcast (estimates suggest that 70% of new shows on Spotify use the platform), and Spotify bought the company for $150 million in 2019. The website allows podcast creators of any size to easily distribute their shows to all the popular platforms for free, and monetizes its users by giving them advertisements to read and then taking a 30% cut of revenue.

This is similar to how YouTube works with independent video creators. Everyone wants to be on YouTube because it is free, easy to use, instantly available to a billion users, and easily monetizable. Anchor's key differences are its audio-only status (for now) and the way it distributes to multiple platforms instead of just one.

Dynamic advertising network

Spotify wants to give podcast ads the same online, automated advantages that display and video ads currently enjoy. It is bringing what it calls "streaming ad insertions" to podcasts, which will insert preset ads into participating shows. This could help better measure the effectiveness of ads, and more effectively match shows with sponsors, which in turn could help creators get paid at higher rates. 

While Spotify may have been the first to invest in podcast supply, its competitors have countered quickly. Apple has been rumored to be investing in original content for its app, while Amazon has started releasing originals on its Audible platform. Both these companies are highly capitalized, but I wouldn't be concerned as a Spotify shareholder. It has been competing against the tech giants in music for years, and it's leading because music streaming has been Spotify's top priority, while its competitors treat it as a side project. I see no reason why podcasts will be any different. 

It is important for Spotify to take a slice of as many audio advertising dollars as it can as spending transitions from radio to podcasting over the next decade. Revenue is projected to hit as much as $60 billion by 2027, and even if the industry is only half that size by then, the investments being made by Spotify now are laying the groundwork to capture a sizable cut of the future dollars flowing through the industry.

Currently, Spotify has gross margins of 25%, bolstered by its revenue-sharing deals with the music labels. But that figure could expand as the company's exclusive podcasts and ad network continue to grow. One number I look at every quarter is the percentage of Spotify users who engage with podcast content. Last quarter it was 21%, up two percentage points from the prior quarter, which indicates that podcast listening continues to flow over to Spotify. 

If this trend continues, and the majority of the company's users start listening to podcasts on the platform, these sizable up-front investments could positively affect gross margins, which in turn could make the stock's price-to-sales ratio of 6.4 a lot more reasonable to investors. Margin improvement is important, because Spotify is not yet profitable (although it is cash flow-positive), which is what really matters to investors over the long term.