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Will Apple Open Pandora’s Box?

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite the fact that Pandora (NYSE: P) is the most popular online radio provider, the company’s stock has been whipsawed up and down this week based on news from Apple (NASDAQ: AAPL). When Apple left any mention of music out its Tuesday announcement of its holiday product line, Pandora surged 8%; the feeling was that if Apple was staying on the sidelines, Pandora was in a better position to perform. Thursday, Bloomberg News reported that Apple was in “intensifying” talks with the record labels, aimed at a 2013 release of a new music service; this report sent Pandora shares tumbling, being halted briefly when they hit the 10% decline circuit breaker. While this week’s volatility is largely attributable to initial overreactions, Pandora’s future faces some serious challenges that should be of concern to shareholders.

A Greek Tragedy

Just as in the classic story, Pandora holds the original entry into the marketplace in its dominion. With that in mind, the company has struggled to monetize its popularity, facing many of the same challenges as other widely used online services like Facebook (NASDAQ: FB). Where Facebook is an interactive experience, however, Pandora tends to be used more passively, meaning that advertisers get less visual impact than they might with other options. The company has begun to include audio advertising, which has had a positive impact, but Pandora has yet to turn a profit.

The sensitivity the stock has shown to news out of Cupertino demonstrates that shareholders have real concerns about Pandora’s ability to compete. This is not to suggest that taking on Apple in any direct competition is not a formidable task, but this level of volatility is not a great sign. Pandora already faces a variety of competition from other music providers, but the Apple ecosystem would take this to a new level.

Structural Differentiation

While Pandora does offer its fans a subscription-based option, the basic structure of how Pandora operates is regulation-driven. The company’s model is based on a specific license that it is granted based on restricting listeners from specifically selecting either the song or album that they listen to; the number of times a given artist may be played within an hour is also controlled. These broadcasting limitations have allowed Pandora to operate as an online broadcaster rather than as a music purveyor that would be forced to charge for access to music. This has allowed the company to become as popular as it is, but is one of the main challenges it faces in monetizing that popularity.

The fact that Apple is in direct discussions with various music labels offers some insight into the model it may be pursuing. Rather than looking for ways to directly compete with Pandora, Apple is likely building a more user-controlled option. This model is more likely to lead to immediate revenues, but may impact the adoption rate the company is able to achieve.

This is not dissimilar to Apple’s foray into providing video content through iTunes. While the service has gained some traction, Apple’s pricing tends to be significantly higher for some content than options offered by competitors. For example, where Netflix (NASDAQ: NFLX) gives users access to unlimited content for a set fee, Apple charges users on a per-episode basis. Apple does get access, therefore, to newer content in many instances, but the price differentiation is significant. This is a facet of its music release which should be monitored when judging its threat to Pandora and others.

The Trade

While Pandora is another stock that we all want to love, the entry of Apple into the market weakens an already tenuous investment thesis. While I believe Pandora may find a way to become more financially viable, and certainly makes an interesting takeover candidate, it is currently on shaky ground. Those looking for a speculative play may wish to maintain exposure to the stock, but until more factors solidify, Pandora is not a good core holding.

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Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Facebook, and Netflix and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Facebook, and Netflix. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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