How Pandora Plans to Protect Its Business From iTunes Radio

The radio industry has been on fire lately. Traditional radio is being challenged by online stations. Online stations are becoming increasingly popular, as they can customize their content according to the user's preferences. As a result, already more than half of Americans who go online listen to Internet radio services, and more than 55% of radio listeners feel that music on traditional radio is "not as good as it used to be." At the same time, online radio companies such as Pandora Media , Spotify and are experiencing massive user growth.

With more than 75 million people listening to its personalized radio stations throughout the U.S., Pandora Media has heavy exposure to the emerging online radio industry. However, an epic battle for the Internet radio business is about to start, as important challengers such as Apple  release their own radios, while traditional players like Sirius XM  -- the largest subscription radio broadcaster in the U.S. -- acquire premium content and reduce prices to remain competitive. In this challenging context, how does Pandora Media plan to protect its business against such competitors?

Source: Pandora Media, Investors Relations

Pandora's amazing technology
Founded in 2000, Pandora uses amazing technology for automated music recommendation: the innovative "music genome" algorithm.

This algorithm defines a song according to hundreds of keywords (like "metal influences" or "romantic"). A song is described by a vector containing these keywords, and these vectors are used to create lists of similar songs. Because a professional musician analyzes the song to describe it in keywords for more than half an hour, Pandora's algorithm produces excellent recommendations.

Naturally, Pandora's superior technology helped the company to gain active users quickly, reaching 72 million users in the second quarter of fiscal year 2014. 

Increasing competition
However, even a company as innovative as Pandora isn't free from competition. This was clearly understood after Apple showed some preliminary numbers for its recently launched iTunes Radio on Oct. 22. Since its release, more than 20 million iOS 7 users listened to Apple's radio. And roughly one billion songs were listened to in a single month. Furthermore, considering that 50% of Pandora's users access the service from an iOS device, iTunes Radio is a major threat for the company.

On the other hand, with more than 23 million subscribers in the U.S, radio broadcaster Sirius XM could also be affected by the arrival of iTunes Radio. Notice also that, if compared with most online radio services, Sirius XM services are more expensive.

Charging a price premium allowed Sirius XM to enjoy high margins for many years. Furthermore, in an industry that has traditionally seen high barriers to entry, Sirius XM's substantial scale advantages gave the firm strong economic moat.

Times change, people change. Increasing wireless access may force Sirius XM to adopt a new business model to remain competitive. In the meanwhile, the company is trying to differentiate its content as much as possible by paying more for streaming content (Oprah radio, Howard Stern, and other exclusive channels).

The plan
To prepare for the release of iTunes Radio, Pandora began reducing its exposure to iOS devices in the first quarter of 2013, when it started offering in-app subscriptions through Google devices. Furthermore, the company recently removed its 40-hour mobile listening limit for free mobile listeners, despite increasing royalty fees. This aggressive move is aimed at preventing non-premium users from completely changing Pandora with iTunes Radio, and should protect Pandora's ad revenue. According to eMarketer, Pandora is the third largest generator of mobile ad revenue, only behind Google and Facebook.

Pandora is also exploring opportunities in new segments, like the in-vehicle market, which could allow the advertisement-based company to expand its subscription revenue considerably. At the moment, this space is dominated by Sirius XM, which has its satellite radios installed in 70% of new vehicles, and generates most of its revenue through subscriptions. However, despite its late start and Sirius XM's dominance, Pandora reached 2.5 million unique activations through cars in June this year.

Final Foolish takeaway
Although Apple's new iTunes Radio has seen great early reception, it may not be a "Pandora killer," as many writers have mentioned. Ultimately, Pandora has vast experience in the field, and uses an amazing algorithm for recommending users music they truly like. However, in the short term, the company may see a decrease in its user base or user engagement metrics, as some of its users may move temporarily to iTunes Radio in order to experience the new service.

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Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple. 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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