Spotify (NYSE:SPOT) has been on a podcast shopping spree since 2019, spending hundreds of millions of dollars on exclusive content deals and software to help people create and host new podcasts. Most recently, it made a deal to acquire Megaphone for $235 million.

The move will accelerate Spotify's path toward monetizing podcast listening on its platform, making Megaphone its most important acquisition in the space to date.

A man standing at a reception desk with the Spotify logo on the wall.

Image source: Spotify.

Bringing podcast advertising into the digital age

With the Megaphone acquisition, Spotify will make its Streaming Ad Insertion (SAI) technology available to third-party publishers hosting their content on Megaphone's platform.

Spotify introduced SAI technology at the start of 2020. Unlike other dynamic advertising technology for podcasting, SAI is able to insert ads in real time and target specific users. Other dynamic ad platforms merely swap out ads ahead of listens with limited targeting abilities for marketers.

Spotify has a big advantage in podcast advertising. Unlike other podcast players, its listeners have to log into an account. Spotify is able to gather a lot of demographic information about its users, including their home address. It also knows all the devices they use and can get information from payment cards on file. All of that data can help marketers find the right audience for their ads using Spotify's ad tech.

Up to this point, SAI was reserved for Spotify's own podcasts. Once it integrates the technology into Megaphone's ad platform, it'll be very simple for creators to monetize their podcasts more efficiently. Importantly, that'll give Spotify a chance to partake in the broader market for podcast advertising.

Spotify sees a big opportunity

Spotify's massive spending on podcasts suggests it expects to take a sizable portion of the $1 billion podcast advertising market and expand the addressable market while it's at it.

Earlier this year, the company changed how it reports its podcast content spending. It attributes all of the podcast content costs to its ad-supported business. That suggests management sees the majority of the value of its podcast content costs coming from advertising over the long term. Previously, management noted how engagement with podcasts led to increased subscriber conversion and retention.

But the massive investment in podcasting may take some time to see a direct return on investment in terms of ad revenue. While Spotify has a lot of advantages in selling programmatic podcast ads thanks to its established sales team and ad technology from its music business, the market is still relatively small.

The bigger opportunity for the podcast business goes beyond its original and exclusive podcasts. Spotify is making it as simple to start and monetize a podcast as it is to start and monetize a website -- perhaps simpler. Doing so will greatly expand the market for podcast advertising and put the company in the pole position when it comes to connecting creators, marketers, and listeners. What's more, that network effect should strengthen over time as it adds more creators to its platform, attracting more advertisers and listeners.

The Megaphone acquisition is a big step toward unlocking that opportunity. As Spotify moves to monetize podcast content from individuals and other media companies, investors should look for ad-supported gross margin to start trending back up again. The cut Spotify takes from SAI should produce a very high gross margin on a net basis. While the ad opportunity is still relatively small, Spotify's content costs for third-party podcasts are minuscule.

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.