Spotify (NYSE:SPOT) is the clear leader in the music streaming industry, with 320 million total monthly active users and more than double the paid subscribers of Apple Music, but its ambitions extend well beyond music. Over the last two years, Spotify has spent almost $900 million on several podcast-related acquisitions -- including two in particular that should help Spotify win the podcast market.

Anchor

Anchor is the introductory operating system for podcasting. Launching a podcast can overwhelm new creators, but Anchor provides first-time podcasters with everything they could possibly need. With its easy-to-use platform and creator tools, podcasters can upload and edit their show, distribute it to the world, and instantly connect with sponsors at no cost. For first-time podcasters, this makes Anchor the most compelling place to start, and the data backs it up. According to Spotify, approximately 75% of new podcast releases on the Spotify platform are powered by Anchor.

On Anchor, advertisers approach podcasts on an individual basis with a script and a proposed price they're willing to pay per listen. The podcasts can then accept or reject the contract, but advertisers have the ability to terminate the sponsorship at any time. This leaves the podcasts in a dangerous position, since there are no guarantees they'll be able to monetize each show, but at least the podcasts don't have to pay to be on the platform. 

Spotify for desktop and mobile

Image source: Getty Images

It's reported that Spotify paid $150 million in cash to acquire Anchor back in 2019. While Anchor's financials aren't publicly disclosed, the acquisition looks appealing. Going after the podcast distributors instead of any specific content creators is a safer bet for Spotify. By purchasing the rights to exclusive podcasts like The Joe Rogan Experience, Spotify receives a guaranteed audience -- with the caveat that it's risking money on a single individual. If Joe Rogan or any exclusive podcaster were to fall out of favor with his or her audience, the investment can lose its value.

Unlike exclusive content, owning the distribution is a bet on the market as a whole, not any one particular player. As long as advertisers shift away from radio and to podcasts, Anchor should be in good shape. Advertisers go where the ears are, and in this case, those ears are on Spotify. In its most recent quarter, Spotify had 70.4 million users who listened to podcasts -- 103% more than a year ago. 

Megaphone 

In November 2020, Spotify spent $235 million in cash to acquire the podcast advertising and publishing company Megaphone, essentially the next step up for podcasts after Anchor. The Megaphone Targeted Marketplace aggregates advertisers from all over and allows them to bid on the ad spots of different podcasts. Once a podcast is downloaded, the advertisement is instantly inserted into an ad slot at a mutual price based on listener data points such as age, gender, interests, or purchasing habits. This is called Dynamic Ad Insertion, and it means not every listener is hearing the same ad on any given show. With Megaphone, thousands of advertisers like Starbucks, Microsoft, Target, and plenty more can target a specific audience to optimize their marketing campaigns. 

Unlike Anchor, Megaphone isn't free. It costs participating podcasts $99 a month, plus a 50% cut of advertising revenue from its ad marketplace. While this sounds like quite the cost, podcasts that have established a consistent audience may still benefit by transitioning to Megaphone for one big reason -- the podcasts control their own ad inventory. Podcasters can insert ad slots in various places throughout each show and adjust the price for advertisers to bid on. So despite not always getting the price they want, they are pretty much guaranteed an advertiser at a low enough price. 

How do these acquisitions impact Spotify?

As I mentioned earlier, the financials for both companies aren't publicly disclosed, so it's hard to give any concrete numbers. However, it's safe to assume that both these companies have higher gross profit margins than Spotify's core business. Anchor and Megaphone are just ad marketplaces, much like Facebook. Users generate the content, advertisers bring the money, and the marketplace brings the two together. This type of business model requires a lot of up-front costs to develop a product and attract customers, but requires very few additional costs for each new customer.

On the music streaming side of Spotify's business, it's responsible for paying out most of its revenue in royalties to the artists, ultimately limiting margins. Yet by owning the "supply chain" of podcasts, Spotify is strategically purchasing a share of all the advertising dollars spent on podcasting, not just the money spent on its own platform.  

Advertising spending across podcasts is expected to rise to over $1 billion in 2021. As advertisers continue to see the value of well-targeted audio marketing it should result in higher spending volumes across both Megaphone and Anchor. Despite likely still being years away before these investments have any huge material impact on the business, this higher-margin advertising revenue should slowly begin to make up more and more of Spotify's overall revenue, making Spotify a more profitable business in the long run.

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.