Share prices of Spotify (SPOT 1.73%) dropped as much as 10.9% in early trading on Wednesday after the company announced first-quarter earnings. Wall Street analysts apparently were disappointed by a mere 24% monthly active user growth to 356 million users, and that was enough to send shares lower despite otherwise impressive results. 

It's no surprise that Wall Street is focused on hitting analyst estimates short-term, but that approach can miss the long-term story for the company. And what I see in Spotify's results is a company executing well on its long-term vision to be a growth stock for the next decade or more. 

Person listening to headphones with a blue background.

Image source: Getty Images.

Creators and listeners come first

It's important to understand how Spotify plans to grow its business long term. There are really two sides of the market the company is building right now: creators and listeners. In both areas, we're seeing signs of growth.

I'll focus primarily on the podcast business below because I see it as the biggest growth opportunity, and the one Spotify is investing most heavily in. But some concepts like the growth in advertising dollars translate to the music business as well. 

Creators come first...

First and foremost, Spotify is trying to build a platform that is the top choice of creators. That involves both building tools to attract new podcasters and paying creators for exclusive content, like The Joe Rogan Experience, which draws in more listeners to find other creators. Interestingly, Spotify has done this with a fairly open platform rather than locking creators into the Spotify platform. Podcasts created using Spotify's free-to-use platform Anchor, for example, can be listed to on other podcast players and podcasters can even create subscription business models elsewhere and use Spotify as a player. This is intended to build the number of creators on Spotify. 

To that end, management said the number of podcasts on the platform increased from 2.2 million at the end of the fourth quarter to 2.6 million at the end of Q1 2021. Creator growth? Check. 

These investments in creators come at a cost, though. Management said that "non-music costs continue to grow at a slightly faster rate, which is a modest drag on our gross margin." I'll get to that gross margin number below. 

...But listeners matter too

A great slate of creators would be nothing without listeners, but here too Spotify is growing. Monthly active users were up 24% from a year ago to 356 million users, and premium subscribers increased 21% to 158 million users. 

Spotify doesn't break out the hours its users listen to podcasts, but it did indicate that listenership is up, saying this in the earnings release: "From a consumption standpoint, we saw a strong increase in Q1 podcast consumption hours vs. Q4, with March activity driving an all-time high in terms of podcast share of overall platform consumption hours." 

The number of listeners is growing and the number of hours listening to podcasts is growing. That's key to the company's network effect in podcasting. 

The platform of choice

Spotify is betting on a more open and flexible podcast platform than that of a company like Apple (AAPL -2.88%) because it is betting it can win on the merits. In other words, Spotify thinks creators will want to host podcasts on its platform because they can find more listeners there and monetize better than on any other platform. Here are the steps to look for in the strategy: 

  1. Open up the platform to more creators and listeners. 
  2. Attract a large number of creators and listeners. 
  3. Build the tools to match listeners and creators effectively. 
  4. Build a monetization platform to make podcasts profitable for creators than on other podcast platforms, whether they choose subscriptions or ad-supported content. 

After recent changes to the podcast app, Spotify is actually becoming more open for creators, so No. 1 is happening. For No. 2, listener numbers and podcasts are growing. And Spotify is building tools like podcast topic search and navigation upgrades that should match creators and listeners more seamlessly (No. 3).

If these three things continue to happen, Spotify is setting itself up to be the creation and listening platform of choice, and that will help drive the effectiveness of ad-supported monetization, or No. 4. Now that Apple is offering subscriptions through its podcast app, it's this monetization side that Spotify needs to prove itself in. 

Advertising is the key to unlocking Spotify's growth

The long-term thesis for Spotify is that it will create a marketplace of creators and listeners that will be extremely attractive to advertisers, who will ultimately finance the podcast creator economy. Think of it like the strategy Alphabet's (GOOG -5.03%) (GOOGL -5.04%) Google used when growing search.

Google wasn't the only search engine out 10-15 years ago, but it bet that it was so much more effective at matching users with information (and advertisers) that its main goal was just growing internet usage. Free or cheap computers went to schools, email was made free, fiber was built around the U.S., anything Google could do to get more people online was going to be good for the bottom line long term, even if users weren't locked into a Google platform. 

An Asian man listens to podcasts on his smartphone while sitting at a desk with a laptop atop it.

Image source: Getty Images.

As the internet grew, Google became the search engine of choice. It was also the most effective advertising tool for businesses trying to reach customers, which grew advertising revenue. Being in an open platform makes the opportunity bigger, and if Spotify wins on the merits it can lock in creators as the best podcasters make it their platform of choice. 

Spotify has the creators and listeners, as already noted. What can be challenging is building out the advertising ecosystem and getting momentum going with advertisers. But there appears to be some progress. In particular, I noticed this quote in the earnings announcement: "Ad-Supported Gross Margin was 4.4% in Q1, up 1,100 bps Y/Y. As a reminder, all content costs related to podcast investment are included in the Ad-Supported business for the current and historical periods."

A gross margin of 4.4% seems ridiculously low, but notice that all podcast investments are included in this number. The implication is that the investments made in software or exclusive content are relatively fixed while the incremental growth in advertising revenue should be high margin. That's why we see the 1,100 basis point improvement in the ad-supported business gross margin on revenue growth of 46% versus a year ago. 

If advertising revenue continues to grow at a pace like this, we could see Spotify's margins increase rapidly, and that would be very welcome news for investors. 

Optionality for future growth

If Spotify succeeds at bringing in the best podcast creators in the world, it has a lot of options for how to grow the medium. Anchor is adding tools like text-to-audio in a partnership with WordPress. Video podcasts continue to grow, and creators are just starting to learn how to use that medium. Those are just two of the growth opportunities that Spotify can leverage as it builds more tools for creators. 

Notice the theme here: Spotify is innovating tools for its creators. And if it succeeds in doing that, it'll attract listeners and ultimately advertisers, growing revenue and margins along the way. 

Spotify may have missed Wall Street's user guess in the quarter, but the company is executing on its long-term strategy to make podcasts a huge business. And as long as we're seeing the number of podcasts available going up, hours listened going up, and ad-supported revenue and margins going up, the company is on the right track. That's why I'm not panicked about the drop in Spotify's stock on Wednesday.