Spotify (SPOT -0.16%) subscribers are listening to more and more podcasts as the company invests hundreds of millions into content and technology. While listening has increased, the content investments have been a drag on Spotify's gross margin. So far, Spotify hasn't been turning a profit on its massive podcast investments.
But podcast spending will reach more of a steady state going forward, and podcast listening growth doesn't appear to be slowing down. As such, CFO Paul Vogel thinks the inflection point on podcasts isn't too far away, and it'll be accretive to Spotify's overall gross margin in the near future.
The impact of podcasts on profits is clear
Spotify changed its accounting slightly in 2020 to show investors the impact of its podcast content costs on the business. Those costs are now included in its calculation of ad-supported gross margin. The idea is that podcasts are another way to drive paid subscriber growth, just like the free ad-supported music streaming service.
The impact is quite clear. The ad-supported gross margin fell from 16% in 2018 to 12% in 2019 and then 1% in 2020. 2020 was also impacted by the start of the COVID-19 pandemic, which created a lot of uncertainty in the advertising market.
Last year, the podcast business started to swing the other way. The ad-supported gross margin climbed to 10%. That said, it saw an 84 basis-point contraction in the metric during the fourth quarter -- possibly due to supply-chain impacts on ad spending.
Investors should expect podcasting investments to continue weighing on gross margin in 2022. Vogel told analysts at a recent investors conference that he's not optimizing for margin right now; he's optimizing for margin three to five years from now. To that end, the company has long-term goals of reaching 1 billion users (it's at 400 million now), 20%-plus revenue growth per year, and a total gross margin of between 30% and 40%.
The inflection point is near
While podcasting and its associated investments have been a drag on gross margin for the last few years, it's starting to move closer toward the consolidated gross margin of the business. It will continue to drag gross margin in 2022, but "the inflection point is not too far away," Vogel said.
But podcasting isn't just another revenue source for Spotify. "The steady state gross margins on the podcasting business should be really nice and will definitely be additive to where we are on a consolidated basis right now," Vogel explained.
In other words, revenue from podcasts will generate much higher gross margins than the rest of the business. That's because Spotify can actually produce leverage from its podcast assets, whereas it's limited with its leverage in the music streaming business. Where it pays a certain percentage of revenue to music labels, along with certain guarantees, it pays for podcast content up front. What's more, its podcast advertising technology can produce even greater gross margins as it's merely a platform business for other creators to sell ads.
The decision to keep investing is fueled by the success it's seen so far. "If we weren't investing as aggressive as we are behind all this good stuff would we have higher gross margins? Yes we would," Vogel said. Investing today will ensure Spotify is a more profitable business five years from now. And that's a sign of a good growth stock.