Why is Pandora Buying a Radio Station ... in South Dakota?

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In the 1994 film "Airheads," a rock band takes over a lowly radio station to get heard.

Now we find Pandora (P) taking over a small radio station for a very similar reason.

The company behind the leading music streaming service turned heads on Tuesday with its move to acquire South Dakota's KXMZ-FM. What's a company with more than 70 million active users doing with a tiny terrestrial radio station?

Well, there's a method to Pandora's madness. Radio station operators that run streaming websites pay lower royalties per online song than Pandora. It's an inequity that Pandora has tried to rectify legally -- taking its case all the way to Congress last year, but to little avail.

If You Can't Beat 'em, Join 'em

Pandora's legal counsel believes that the acquisition will now qualify Pandora for the lower royalty rate that all but four of the 20 largest Internet radio services currently enjoy.

It's a gutsy move, but Pandora doesn't feel that it has much of a choice. It's at a disadvantage to most of its rivals if it has to pay out more per song than Clear Channel's (CCO) iHeartRadio and other fast-growing music apps.

Apple Interference

It also didn't help that Apple (AAPL) introduced iTunes Radio the day before Pandora announced the purchase of KXMZ.

When Apple's new service rolls out later this year it will be eerily similar to Pandora. Music fans will be able to enjoy free personalized radio if they're willing to put up with ads. They can also pay $25 a year -- less than Pandora's $36 a year Pandora One subscriptions -- for ad-free streaming.

It's bad enough that Apple is going to build iTunes Radio into iTunes, but now the company that's best known for its premium consumer electronics is undercutting Pandora's premium platform on price? Pandora can't seem to catch a break. But even if the new royalty rate results in saving just 1 percent of its revenue it could make a big difference for a company that has struggled with profitability.

Big Music, Little Profit

Pandora is coming off of back-to-back quarterly losses. Folks love the platform. They gravitate to Pandora's ability to serve them relevant tracks fine-tuned to every individual listener's preferences. The problem is that Pandora can't get those music fans to pay up.

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Just 2.5 million of the service's 70.8 million active listeners are premium subscribers. The vast majority of its users are willing to accept ads, usage limits, and the inability to skip as many songs as they would like.

It remains to be seen if Apple's presence will help or hurt Pandora. It may hurt initially, but Apple entering the market may also educate consumers into paying for streaming music. Pandora wouldn't mind losing millions of its freeloaders if it meant increasing its Pandora One subscribers.

Turn it Up

For now, Pandora is as popular as ever. There were 70.8 million active listeners last month, a huge 33 percent uptick from the 53.3 million that were tuning in a year earlier. Listener hours are up 22 percent to 1.35 billion, and that could be problematic.

If listener hours aren't growing as quickly as active listeners it means the average listener is tuning in less.

Pandora's still the undisputed champ, and those 1.35 billion hours served up last year would be good enough to command 7.29 percent of the total U.S. radio listening market.

Taking control of a radio station may have been a silly idea. It certainly seemed that way when characters portrayed by Adam Sandler, Steve Buscemi and Brendan Fraser stormed a radio station in "Airheads." However, when something isn't fair -- and those in control aren't doing anything about it -- you sometimes have to take matters into your own hands.

Rock on, South Dakota.

Motley Fool contributor Rick Munarriz has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple.

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