Spotify (SPOT -2.19%) has been slowly pivoting its business from just music to a broad audio delivery platform. That transition has largely meant building and acquiring the technology and talent to be a dominant player in podcasts.
What may not be as appreciated is how Spotify is planning to make money on podcasts long term. The company is likely to rely on advertising, serving up relevant ads on-demand to targeted customers. And this small segment of the business is showing tremendous potential for the company.
Spotify's core remains strong
Spotify doesn't entirely break out its music and podcast businesses, but we can get a feel for the general trends of each segment based on where revenue and users are coming from. In the third quarter, monthly active users were up 19% year over year to 381 million with both premium and ad-supported users up 19%. Growth was broad-based from a listener perspective.
On the revenue side, premium subscriber revenue rose 22% year over year and 6% sequentially to 2.18 billion euros. Management said gross margin for premium revenue was 29.1%, compared to 26.7% for the company overall.
While premium services -- and music specifically -- are currently the core money makers at Spotify, that's not where I believe the company's future lies.
Advertising is the future
What I'm watching most closely is the advertising business, which is still being built and rolled out across the company's creator network and geographies, but so far, so good.
In the third quarter, ad revenue jumped 75% to 323 million euros. Gross margin also continues to expand, hitting 10.5% in the quarter, up 9.9 percentage points from a year ago. Spotify assigns all of the expenses from its podcast content, including the tens of millions of dollars being paid to industry giants like Joe Rogan, Dax Shepard, Alex Cooper, and others, to its ad-supported segment, so this gross margin figure should improve as the podcast advertising business grows overall.
Building this advertising network will ultimately allow the company to dominate the audio medium. The option to monetize content will attract music and podcast creators, who will be able to make more money through Spotify's platform than they could alone.
Why Spotify's ad business is growing as others slow
Spotify isn't likely to be the hyper-targeted advertising platform that Google and Facebook are, and that's okay. The company can build a massive business on the back of brand advertisers trying to increase awareness around their products. Podcasts can fill this niche nicely.
Another great thing about brand advertising is that it doesn't require the same level of data depth as direct-marketing campaigns, which need to track the path of an advertising target and have been negatively impacted at companies like Snap and Facebook by changes to Apple's iOS 14.
Showcasing its strength, Spotify's 75% ad-supported revenue growth outperformed Snap's 57% and Facebook's 33%, although both social media platforms are building on larger revenue bases.
Given the strength in monthly user growth and podcast engagement along with the improvement in its ad business, Spotify could still be one of the most disruptive companies of the next decade. It's changing what we listen to and how advertisers are reaching customers, which is a long-term shift that favors this leading streaming business.