While progress has been slow, hitting 24.7% in Q3, Spotify's reduced focus on podcasting and increased emphasis on its Marketplace unit suggests that the 30% target might be attainable in the medium term. With careful cost management, growing user numbers, and potential price hikes, Spotify aims to achieve a 30% gross margin in the long run. Spotify has been heavily investing in podcasts, but now it's scaling back on that investment, which should improve its gross margin. I believe both of these tools have promising runways and will contribute to margin upside. Marquee has been experiencing significant growth with strong revenue gains and has substantial potential for improving margins. On the other hand, Marquee is a self-service advertising tool that enables sponsored recommendations for new releases. It has low barriers to entry, with no participation costs, although artists must forego some royalties on the streams generated through it. The first tool, called Discovery Mode, was introduced in 2020 and serves as a marketing device that allows artists to benefit from algorithmic promotion. In 2022, Spotify's Marketplace business generated approximately 210 million euros in gross profit, primarily driven by two artist tools. This success has led Spotify to set a target of reaching a 30% gross margin within the next 3-5 years and eventually aiming for a long-term goal of 35%. This was partly due to its two-sided Marketplace business, which contributed to a 75 basis points annual expansion in gross margin between 20. In 2021, Spotify's core music business achieved a gross margin of 28.3%. Spotify expects podcasting to be a $20 billion market in the long term, which is why the company has continued to invest in this side of the business heavily in the past. its third-party, better-monetized business. Spotify owns exclusive programs such as "The Joe Rogan Experience," which causes margin pain vs. A flip in the narrative hinges on scaling up podcasting ads, and with the hefty investments done, guidance for breakeven in the next 1-2 years may be achievable even as economic weakness limits visibility. With the US podcast market expected to double over the next few years from $1.8 billion in 2022, the company has been investing heavily in technology to improve monetization, though this has created a heavy pull on margin. Spotify dominates US podcasting, with $215 million in 2021 revenue and around $300 million in 2022, yet it dragged down 2021 gross profit by $110 million. Podcasting Investments To Pay Off In the Long Term Gradual price increases should help with profitability although the impact may not be significant in the short term, I expect it to contribute positively to profits in the long run. While Spotify continues to experience strong user growth, the industry is shifting its focus toward profitability rather than rapid expansion. Reducing spending on podcast content (after investing $1 billion over the past four years), trimming marketing expenses, and workforce reductions are expected to contribute to this effort. The company has been emphasizing better discipline in managing both new and existing projects, which suggests there's room for further cost-cutting. In January, it reduced its workforce by 6%, and in June, it carried out another round of layoffs, particularly in the podcasting division, as part of a broader restructuring. Spotify is now paying more attention to cost control. However, executing these strategies effectively is key. Expanding the gross margin is crucial for the company, and it has strategies in place, including efforts in advertising, podcasting, and its Marketplace business. In the third quarter, the gross margin was reported at 24.7%, slightly below the targeted 25.2%, and the company is expected to post GM margin of 24.5% in the fourth quarter. Spotify performed better than expected in terms of user metrics in the third quarter, but there are challenges ahead for improving its gross margin. I am positive that the company will continue to improve on its user growth and profitability metrics in the future and hence assign a buy rating to the stock at current levels. The company's robust revenue growth, monthly active user growth, and additions of premium subscribers provide a solid foundation for its margin improvement and valuation. I believe Spotify's ownership of podcast content could be a significant driver for growth, especially as the pressure from previous heavy investments begins to ease. Its path to sustained profitability largely depends on effectively leveraging podcasts, as music content owners hold a strong position in negotiations. The company currently boasts 195 million premium subscribers and 456 million monthly active users. Spotify Technology S.A.'s ( NYSE: SPOT) growing exposure to podcasting and advertising could counterbalance any potential slowdown in user growth and ultimately improve its profitability in the long term.
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