Spotify Technology (SPOT 1.78%) continues to grow its music and podcast business, monetizing both premium and ad-supported listeners at a higher rate. But the company's growth has not been as quick as some investors hoped for.

Shares dropped 5.7% on Wednesday after second-quarter earnings were released, falling by double digits at one point during trading. But investors will want to keep an eye on the long-term story of this company, which I think is one of the best growth stocks today. 

Person listening to music on headphones.

Image source: Getty Images

Where to look for growth

Spotify is trying to grow in a few areas at once, and that makes the company's earnings results a little difficult to decipher. From a content perspective, it is offering music and podcasts, which are very different markets. Most music is controlled by the large music labels, while podcasts are produced by a variety of small companies and independent producers, including some owned by Spotify or under exclusive deals with it. 

To monetize content, Spotify offers premium subscriptions or ad-supported content. It does break out premium and ad-supported revenue sources, but does not currently break out detailed information about whether premium or ad-supported listeners are consuming music or podcasts. What we know is that second-quarter fiscal 2021 revenue from premium subscribers was up 17% from a year ago (6% sequentially) to $2.44 billion, and ad-supported revenue jumped 110% (28% sequentially) to $326 million. 

The music business is growing steadily, with industry revenue up 7.4% to $21.6 billion in 2020, according to Statista.  Spotify can grow with the industry and work to monetize music, particularly with more-effective ads. But music is not where I would look for double-digit growth to come from. Podcasts are where investors should look, and in that content segment, it's the ad business that I see as most important. Pricewaterhouse Coopers estimates that ad spending on podcasts will grow from $800 million in 2020 to $1.7 billion by 2024, achieving an annual growth rate of about 20%. Let's dive into how ads are performing on Spotify.

Ad-supported podcasts are the future for Spotify

Spotify hasn't been shy about podcasts being its future. The company has acquired companies like The Ringer, Gimlet, and Anchor and signed exclusive deals with The Joe Rogan Experience, Armchair Expert, and Call Her Daddy that are approaching $1 billion in cost

Based on the spending on content and the fact that podcasts are where Spotify is targeting its ad investment, it's the ad segment that I'm keeping the closest eye on. Here are some highlights from the second quarter. 

  • As mentioned, ad-supported revenue was up 110% (126% on a constant currency basis) versus a year ago to $326 million.
  • Ad-supported gross margin was 11.3%, an improvement from 4.4% in Q1 2021 and a negative 12.9% gross margin a year ago. The ad-supported gross margin includes "all content costs related to podcast investment," the company says, so this is a big margin considering the outlays Spotify is making for content. 
  • Fill rates of ad inventory for the Spotify Audience Network saw a "meaningful increase" in advertisers and a double-digit increase in CPM (cost per thousand impressions). 

Spotify doesn't break out how many ads are being served to music listeners and how many are going to podcasts. But if the podcast business is going to work in the long term, it's going to need an advertising business to get there. 

What's crucial for Spotify to go the distance is that it increases its CPM to advertisers as well as listening, or inventory for ads. So far, it looks like the strategy is working, even if it isn't as fast as investors would like. 

What to look for from Spotify

The trends are pointing in the right direction for Spotify; we just don't know how quickly podcast listening or advertising are going to grow. What I'll point out is that the ad network is relatively new, and it takes years for companies to learn how to use new digital ad tools and build them into their budgets. As a result, there could be a multi-year wait until we see real fruit from these investments. 

For now, Spotify's investments in podcasts and the ad network that goes into them are looking strong. We should watch to see if revenue growth continues to be strong because with a few years of high double-digit growth, the ad business could be even bigger than premium subscriber sales for Spotify. And that's when I would see this being a truly disruptive company in the audio business.