Pandora's Moment of Truth Arrives


Last week was supposed to be the week Pandora was brought to its knees.

On Wednesday, Apple finally released iOS 7, and with it the long-rumored iTunes Radio, its own Internet radio service, which some have considered a Pandora-killer since its inception. When the idea first landed on Wall Street on Sept. 7, 2012, Pandora shares fell 17%, closing at $10.47. However, its stock has come roaring back, more than doubling since then, as the chart below shows.

P Chart
P Chart

P data by YCharts.

What Wall Street once feared was the Grim Reaper waiting in the closet seems to be nothing more than a mouse in the house. Pandora shares have even spiked nearly 50% in September alone as the online DJ named a new CEO, won a favorable court ruling, and pulled off a successful secondary share offering despite a record-high price. In the three days since iTunes Radio came out, Pandora shares are actually up more than 5% following the share dilution. Clearly, the market doesn't believe the new Apple product is a serious threat even with mostly positive reviews.

The breakdown
On Twitter, dozens of posters gleefullly announced their defection from Pandora to iTunes Radio. Apple's key advantages seem to be a lower price tag for the commercial-free version ($25 versus $36), which is free if users pay $25 for iTunes Match, and a much larger library of songs (27 million versus 1 million). Both of these are significant. Pandora, meanwhile, is starting with a 70 million-user advantage, and the switching costs built in from subscriptions and customized stations. Pandora also presumably has the better predictive algorithm due to its history, data collection, and origin as the Music Genome Project, but this is a highly subjective category. (Based on my short sample of iTunes Radio, I found its predictions to be weaker than Pandora's.) Pandora also has wider distribution, available on Apple devices and PCs, as is iTunes Radio, but also on Android, Blackberry, and vehicle dashboards. Pandora also seems to be the more sophisticated of the two, offering lyrics, band histories, and analyses of musical components, while iTunes Radio presents a novel feature allowing the user to customize the predictive algorithm between "hits" and "discoveries." A side-by-side comparison of the two reveals the interfaces to be essentially the same. Apple's star key offers users the "thumbs-up" and "thumbs-down" options.

iTunes Radio's interface is essentially a clone of Pandora's. Source: My phone.

With the larger library, lower price tag, and smoother iOS integration, Apple certainly seems to offer an appealing value proposition. As the new arrival, however, being equal to Pandora won't be enough. iTunes Radio will have to be significantly better for there to be a mass exodus from its competitor.

What else is in Pandora's box?
With the release of iTunes Radio, it appears clear that Pandora cannot remain successful standing still. The company recently updated its iPad app, and a new survey sent to subscribers indicated the company was interested in testing ideas including different pricing models, visual effects, and features such as a double "thumbs-up" button that would make the weight of a given song stronger. The survey suggested that Pandora, after focusing on listener growth for years, is shifting toward profitability as that once-meteoric growth has moderated. The company said in its recent follow-on offering that it may use some proceeds for "potential acquisitions or businesses, products or technologies," any of which could help give the company a better product. With nearly $400 million added to its war chest from the secondary offering, and minimal debt on its books, I'd expect Pandora to put its newfound cash to good use.

Finally, new CEO Brian McAndrews appears to give the company additional strength in the advertising department. McAndrews was previously the CEO of aQuantive, which he made into the fastest-growing digital-marketing company before it was bought by Microsoft for $6 billion in 2007. Pandora clearly sees its future in mobile ad revenue, its fastest growing revenue stream, and McAndrews seems to be an excellent fit to hone that channel.

Even if Pandora continues to struggle, iTunes Radio has the contrarian benefit of making the pioneer a more attractive acquisition target. While shares are dearly priced right now, if they come down the company could make an appealing target for Google, Samsung, or another one of Apple's rivals looking to keep pace with the iPhone-maker. In this market, the added success of iTunes Radio only makes Pandora look better for a potential acquisition. Additionally, the success of iTunes Radio could also drive greater attention to Internet radio advertising, boosting Pandora's revenue along the way.

Is the music over?
The competition between Pandora and iTunes Radio isn't the first time we've seen modern music rivals square off. Since Pandora's IPO, many analysts have argued that its arrival, and Internet radio with it, would bring the demise of satellite-radio provider Sirius XM . However, that's been anything but the case thus far as Sirius shares have gained 30% this year, and have more than doubled in the last two years.

Music is a huge space, and Internet radio is still growing at a robust pace. There's plenty of opportunity for both iTunes Radio and Pandora to survive and thrive, but with iTunes' lower price tag and bigger library, Pandora will probably have to step up its game to ensure long-term success. I'd look for McAndrews to drive improvement in the mobile ad revenue model, and for the company to make an acquisition in the near future or a serious R&D investment. We'll get our first sign of Pandora's continuing health when it reports September listening metrics in the beginning of October. In August, the company reported a 16% year-over-year increase in listening hours to 1.35 billion hours, a radio-listening market share of 7.46%, and 72.1 million active listeners. A sequential decline in any of those categories could indicate a rush toward Apple.

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Fool contributor Jeremy Bowman owns shares of Apple. The Motley Fool recommends Apple, Google, and Pandora Media. The Motley Fool owns shares of Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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