The optimistic case for Spotify Technology (SPOT -3.31%) has always been that it would create an advertising network like Facebook, except for your ears and not your eyes. The company can connect listeners and creators of music, podcasts, and audiobooks with highly targeted ads from advertisers around the world, generating revenue that can be shared with suppliers. Spotify might not have Facebook's upside in terms of scale, but the potential for a very profitable, sticky business is there.
Over the past year, Spotify's business has taken big steps to make that advertising network a reality. The foundation -- the music business -- has its own limits, but it could be a cash cow that funds the true growth engine in advertising.
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A huge foundation of active users
Music is still the foundation for Spotify, and the company is in a better position in music than it's been in in its history. Not only does Spotify have 433 million monthly active users, up 19% from a year ago, it also has a more sustainable business model.
In the past, music labels could squeeze most of the margin out of Spotify's business, leading to far lower margins than most tech companies, like Meta Platforms and Alphabet.
SPOT Gross Profit Margin (Quarterly) data by YCharts
But this is changing because Spotify is monetizing more effectively. The gross margin for premium subscribers was 28.8%, up from 26.9% in the same quarter in 2018. That increase is mainly attributable to the marketplace Spotify has built to charge labels and artists for promotion. This may seem like a small change, but it can lead to sustainably higher margins long-term, which funds the rest of the business.
Advertising and podcasts
If Spotify is going to be a great investment, it's going to have to grow the podcast and audiobook businesses -- and also have an advertising business to match listeners to advertisers. This could be a high-margin business like Meta or Alphabet have, and also allow creators to monetize their content through Spotify's ad platform.
This does already exist, but it's small so far. In the second quarter, ad-supported revenue was up 31% to $360 million, and the gross margin was just 1.1%. The low margin is due to the cost of exclusive podcast content that is included on the ad side of the business. Spotify has spent hundreds of millions of dollars to lock up The Ringer, The Joe Rogan Experience, Armchair Expert, and more.
The idea is to sacrifice margin now to capture market share, hoping that the business performs far better in the future. The strategy is working, and I think Spotify is turning a corner. The 31% growth in advertising, at a time when Meta's revenue was down 1% and Alphabet's revenue was up just 13%, is a great sign.
A balance sheet for building its advertising
Spotify hasn't reached maturity in its podcast or advertising businesses, but it's still a cash-flow-positive company. In the second quarter it generated 37 million euros (about $38 million) in free cash flow, and has averaged over 200 million euros each year over the past three years. And now, it has 2.8 billion euros in cash on the balance sheet to 1.1 billion euros of debt.
I think Spotify has turned the corner and will be a double-digit revenue growth company with expanding margins for the next decade. If it is, this will be a great stock to own long-term at today's price.
