#112 - Throwing Spaghetti Against The Wall, Part 2

An Update on Spotify’s Podcast Business

Feb 20, 2022

Hi 👋 - Spotify announced its Audio First strategy in February 2019 and has been investing aggressively in podcasts ever since. From the outside, the ROI on these investments isn’t always clear. Today, a look at how the shift to podcasts is changing Spotify’s P&L. For context, here’s part one of the series, digging into Spotify’s content acquisition strategy, podcast penetration, and listener engagement. As always, thanks for reading. If you’re in the US, enjoy the long weekend.

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Audio First, Profitability Second

Spotify started off 2019 with a bang. In February, CEO Daniel Ek announced the Audio First strategy, expanding the company’s ambitions from music to podcasts and audio. In conjunction with the new strategy, Spotify acquired Anchor, a DIY creator tool for creating, distributing, and monetizing podcasts, and Gimlet Media, a podcast studio that produced hits like Reply All. An objective of the new strategy is shifting Spotify’s long-term consumption mix to 80% music and 20% audio (podcasts and other spoken word), approximating terrestrial radio1. If successful, this shift will have profound consequences for Spotify’s P&L, which is currently constrained by record labels and music rights holders.

Spotify’s Revenue Model

Spotify has a freemium business model, with a free tier that monetizes through ads and a premium, ad-free tier that monetizes through subscriptions:

Premium Revenue: Spotify’s subscription business. Revenue is driven by the number of subscribers and average revenue per subscriber (ARPU). This is the lion’s share of revenue, historically accounting for over 90% of total.

Ad-Supported Revenue: Spotify’s free tier. Revenue here comes from music ads for free members as well as podcast ads for both free and premium users. Ads were 12% of revenue in 2021 and 15% in Q4 2021. Long-term, they’re expected to account for at least 20% of revenue, and potentially up to 30-40%2. Spotify’s podcasting success is a swing factor in where ad revenue mix ultimately ends up.

Things are seldom black and white. Spotify’s financials are no exception. All podcast advertising revenue is accounted for in Ad-Supported revenue, so the distinction between revenue from Premium users and Ad-Supported users isn’t cleanly delineated. The $9.99 a month I pay Spotify for my subscription is Premium Revenue, while any podcast revenue generated off my ears is Ad-Supported Revenue. In a sense, podcasts are a lever for Spotify to increase the monetization of its premium users - likely its best customers - without raising subscription prices. It’s a back door price increase. (Inflation is real.)

Podcast Advertising

To generate ad revenue, you need an audience. Preferably a big one. While the actual numbers are hazy, Spotify has at least 100 million monthly podcast listeners. What’s more, listener engagement is growing (caveat: from a small base). For the subset of users that listens to podcasts, podcast consumption grew 20% y/y on a per user basis in Q4 20213.

Like all digital ad businesses, Spotify’s Ad-Supported Revenue has two primary levers:

Ad Impressions: The volume metric. How many podcast ads can Spotify serve? This is a function of how many users listen to podcasts (this is why MAU penetration matters), how many hours per month these users tune in for (this is why engagement matters), and podcast ad load (the number of ads per show).

Cost per Thousand (CPM): The price metric. Generically, how much do 1,000 impressions cost an advertiser? This is a function of advertiser density (how many advertisers are competing for your ears), measurement (helping advertisers understand how their ads are driving business outcomes and ROI), and targeting capabilities (ad personalization and relevance). Improvements in any of these areas should boost CPMs and Spotify of working to get better at all three.

Since announcing the Audio First strategy, Spotify has invested aggressively in podcast content acquisition, Original & Exclusive content (O&E), and podcast ad-tech. It has built or acquired the primitives for a successful podcasting ads business. Years of podcast investment are now paying off. Ad-Supported Revenue grew 62% y/y in 2021, outpacing Premium Revenue growth (+18% y/y) for the first time since 2018. Additionally, Ad-Supported Revenue grew 40% y/y in Q4 2021, accounting for a record 15% of revenue.

To be clear, not all Ad-Supported Revenue was driven by podcasting. Some is from music: Ad-Supported MAUs grew 19% y/y in 2021. Some is an optical illusion: Covid hammered advertising revenue in 2020 (+10% y/y), creating an easy comp that inflates 2021 growth rates. Still, executive commentary on podcast advertising was upbeat throughout the year:

Q1 2021: “The strength in Ad-Supported Revenue was led by our Podcast and Programmatic channels, with the former benefiting from the acquisitions of Megaphone and The Ringer along with our exclusive licensing of the Joe Rogan Experience.” 4

Q2 2021: “The strength in Ad-Supported Revenue was led by our Direct and Podcast sales channels, with the latter benefiting from a triple-digit y/y gain at existing Spotify studios (The Ringer, Parcast, Spotify Studios, and Gimlet) along with contributions from the Megaphone acquisition, the exclusive licensing of the Joe Rogan Experience, and Higher Ground.”5

Q3 2021: “Our Podcast business was driven by strong double-digit y/y growth at existing Spotify studios (The Ringer, Parcast, Spotify Studios, and Gimlet) along with the Megaphone acquisition and the exclusive licensing of the Joe Rogan Experience, Armchair Expert with Dax Shephard, and Call Her Daddy.”6

Q4 2021: “Podcast revenue strength was led by the Spotify Audience Network, where we saw a significant increase in inventory in conjunction with increased CPMs. Additionally, podcast revenue benefited from strong growth across existing Spotify studios and our exclusive licensing deals.”7

Similar to its podcast penetration disclosure, there’s some obfuscation here. For example, is strong double-digit y/y growth 29% or 89%? Business analysts and investors will always press for more disclosure, and companies have good reasons to limit them. That’s a tension with all public companies, not just Spotify. From what is disclosed, it’s clear that Spotify’s investments in podcast advertising, content, and technology are starting to move the needle. Ad-Supported Revenue drove Spotify’s growth in 2022 and exceeded €1 billion for the first time.

Source: Spotify shareholder letters. Note: There’s seasonality in the advertising business, which is why you see a spike every year in Q4.

There’s reason for optimism and for concern. Things are seldom black and white. We’ve learned from Google and Facebook that at scale, digital ads businesses mint cash. However, we’ve learned from Pinterest, Snap, and Twitter that cracking the digital ads duopoly is hard. Fortunately, Spotify doesn’t need to become Google-sized to succeed with advertising. Its long-term goal is to compound revenue at 20% per year8. To get there, Ad-Supported Revenue needs to grow roughly 25-30% per year, which isn’t unrealistic given the infancy of podcast advertising and the pools of audio advertising still spent on radio. Additionally, Spotify benefits from two monetization options: ads and subscriptions. The subscriptions business is expected to remain larger, so the ads business just needs to be a strong supporting actor.

Gross Margins: Treadmill or Dam?

Growing podcast consumption mix and Ad-Supported Revenue are preconditions for unlocking Spotify’s gross margins and profitability. Relative to music streaming, where Spotify pays out over sixty cents of every dollar to record labels and rights holders, podcasts have a more fixed cost structure. The goal with fixed costs is to drive as much volume over them as possible, decreasing the per unit cost and thus increasing profitability. This, in a nutshell, is what Spotify wants to do with O&E podcasts.

Success on this front has been less clear than Ad-Supported Revenue growth. If you boil down the debate Spotify into one metric, it’s gross margins. From 2018 through 2020, overall gross margins have been doggedly stuck around 25.5%. In 2021, they expanded to 26.8%. The future trajectory of gross margins are critical to Spotify’s financial success and market cap.

Lackadaisical gross margin expansion is partially by design (and mostly because of the economics of music streaming). Spotify is investing aggressively in O&E content like Alex Cooper (Call Her Daddy), Dax Shepard (Armchair Expert), and Prince Harry and Meghan Markle (Archwell Audio). This week The New York Times broke that Joe Rogan’s contract is worth at least $200 million, double previously reported amount. This expense will be amortized over several years, but for context, the price tag is about 15% of Spotify’s 2021 Ad-Supported Revenue. The company is all-in on Audio First.

All podcast-related costs, like Joe Rogan’s $200 million contract, are recorded as Ad-Supported Cost of Revenue. Spotify is running the if-you-build-it-they-will-come playbook, which requires upfront content investment. Due in part to these O&E investments, Ad-Supported Cost of Revenue mushroomed from about 9% of revenue between 2017 and 2020 to 11% of revenue in 2021. Despite this heavy investment, Spotify’s Ad-Supported Gross Margins also expanded in 2021. Encouraging, but like everything else with Spotify, not black and white. That’s because 2020 Ad-Supported Revenue and Gross Margins were depressed by Covid-19 making a 2021 rebound easier.

With pandemic headwinds subsiding (fingers crossed), Ad-Supported Gross Margins are a key metric to watch in 2022. Spotify CFO Paul Vogel is optimistic here, expecting podcasting gross margins to improve despite continued O&E investment9.

Continued Ad-Supported Gross Margin expansion will be governed by further consumption mix shift from music to podcasts, which grows ad impressions, and Spotify’s ability to improve podcast ad monetization by innovating on ad formats, improving measurement and targeting, and increasing advertiser density, which boosts CPMs. The company is throwing spaghetti against the wall on both fronts. I don’t mean this pejoratively. Spotify prides itself on a culture of experimentation. The spaghetti strategy is evident in its podcast ad innovation. Spotify is launching new ad formats like streaming ad insertion and call-to-action ads, building out the Spotify Audience Network, and enabling self-serve advertising, which is critical for attracting SMBs and building advertiser density. The spaghetti is also evident in podcast-related M&A, which is averaging a deal per quarter since 2019 (Anchor, Betty Labs, Charitable, Gimlet, Megaphone, Parcast, Podsights, Podz, The Ringer, and Whooshkaa). Spotify is taking a lot of shots on goal. Some will land, some won’t.

Ad-Supported gross margins is an area with high potential energy. The company ended 2021 with a mix shift hat trick, with revenue mix shift towards podcasting favorably impacting gross margins for three consecutive quarters:

Q1 2021: “Gross Margin finished at 25.5% in Q1, at the top end of our guidance range and flat y/y. While we continue to see strong revenue growth in podcast and non-music revenue, our non-music costs continue to grow at a slightly faster rate which is a modest drag on our Gross Margin.”10

Q2 2021: “Gross Margin finished at 28.4% in Q2, above the top end of our guidance range and reflecting 308 bps of y/y expansion…The Gross Margin improvement excluding these releases was driven by a favorable revenue mix shift towards podcasts, marketplace activity, and Other Cost of Revenue efficiencies (e.g. payment fees, streaming delivery costs), which were partially offset by higher non-music and other content costs and publishing rate increases.”11Crucially, podcast revenue inflected in Q2 2021 from growing slower than podcast costs, to growing faster than podcast costs.

Q3 2021: “Gross Margin finished at 26.7% in Q3, above the top end of our guidance range and reflecting nearly 200 bps of y/y expansion. The Gross Margin improvement reflected a favorable revenue mix shift towards podcasts, marketplace activity, improved music advertising operating leverage, and Other Cost of Revenue efficiencies (e.g. payment fees, streaming delivery costs), which were partially offset by higher non-music and other content costs and publishing rate increases.”12

Q4 2021: “Gross Margin finished at 26.5% in Q4, above the top end of our guidance range and flat versus the prior year period. The Gross Margin trend reflected a favorable revenue mix shift towards podcasts, marketplace activity, and Other Cost of Revenue efficiencies (e.g. payment fees, streaming delivery costs), which were offset by higher non-music and other content costs and publishing rate increases.”13

An optimistic take is that Ad-Supported Revenue and Gross Margin are like water behind a creaky dam, slowly building pressure and ready to burst at some point. A pessimistic take is that content streaming is a hedonistic treadmill requiring continual investment that saps profitability. (When’s the last time you listened to an episode of The Daily from 2018?) The truth is probably somewhere in between.

Daniel Ek is content to play the long game, measuring success over years, not quarters. The quote below from Sten Garmak, the company’s VP of Global Customer Experience, is instructive. It’s about Spotify’s connected speaker strategy, but applicable to podcasts:

If you have an ambitious vision for a future, you need to allow it to take significant time to materialize. You need some strong conviction in the beginning, and then you need - you need enough management support and cultural support to be able to keep that investment alive for a long time. The things that turned out to be important for the long run also tended to be things that took quite a long time to move from inception to actual impact. But looking at it like in financial terms here and now, it's not the kind of investment that makes sense. But I think that's true for a lot of the things that we've done over the years. And a lot of things that our kinds of companies do - you know, there are compounding effects on beliefs, compounding effects on metrics14.

From an external perspective, Spotify is stuck in the purgatory Garmak mentions where things are taking a while to happen. Investors can see the cash being shoveled into O&E content and other podcast investments, but the ROI isn’t clear yet, and might not be for some time. After two years of heavy investment, 2021 was the first year with signs of a payoff: the podcast library swelled, consumption hours shifted from music to podcasts, Ad-Supported Revenue growth accelerated in part due to podcast strength (as well as a low base and Covid-19 comps), and Ad-Supported Gross Margins improved. Spotify is a tease. Whether Audio First turns out to be a banger or a siren song remains to be seen. That’s what makes it so fun and so frustrating.