Apple's and Oranges

By Declan Fallon - September 20, 2012 | Tickers: AAPL, P | 0 Comments

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The number of volume movers has been coming thick and fast in recent days as stocks warmed to the Fed announcement, although the hangover has already started.  One stock to make a repeat appearance after enjoying a new period of volume buying was Pandora Media (NYSE: P).  The stock is up 7% since I last reported on it, although the last few weeks have been a bit of a roller coaster for the stock. 

Pandora is an internet radio service provider which offers personalized radio stations driven off a genomic music algorithm to match music to the user's tastes.  It operates in a competitive space occupied by the likes of Last fm, Songza, and Grooveshark and amongst others.  But it also competes against traditional radio companies like Clear Channel Communications and SIRIUS XM. Apple's (NASDAQ: AAPL) announcement added another potential combatant into the mix. 

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The War

Pandora's trials have been managing royalty costs.  Revenue in from advertising is outpaced by increasing licensing costs going out; to the extent nearly 60% of current revenue was going to support royalty costs.  This was a sharp rise year-on-year from the 50% of the last fiscal year.

There is a potential shining knight in the unlikely form of Congress and the FIRST Act.  The goal of the FIRST Act is to match royalty payments for cable and satellite consumers to those paid by online internet radio.  Whether Congress can ride to the rescue on this is up for debate, but as soon as it's passed there will be lots of lobbying to get royalty costs reduced (or at least stabilized) by cable and satellite firms.  This can only help Pandora. 

The Battle

Buyers jumped when the company released strong earnings at the end of August; over 40 million shares traded on the news, nearly half of the company's Float changed hands.   Revenue was up 51% year-on-year.  Revenue and earnings guidance was raised for FY 2013. Listenership increased to 56 million active users and 1.2 billion hours.  And U.S.  market share nearly doubled to 6%. The company also announced plans to enter new markets.  All looked rosy, despite the ongoing royalty cost concerns. 

But then Apple came in to spoil the party.

The Black Knight

Before the iPhone 5 hullaballoo, Apple's (NASDAQ: AAPL) announced it would allow its users create virtual "radio stations" in iTunes.   The timing of the announcement killed the momentum generated by the positive earnings and the stock gapped lower.  However, volume selling was below the buying generated by earnings.  In addition, buyers continued to support the stock in the mid-$9s, as they have done since mid-May.

Red Herring?

Apple's announcement doesn't help Pandora, but it doesn't necessarily hurt it either.   First point is whether Apple proceeds with the plan at all.  In the absence of the FIRST Act there may be little benefit to press ahead until royalty costs are stabilized.  

What's in it for Apple?

Apple would presumably be passing royalty costs to its users, unless it starts hovering up record labels.  In the absence of standardized royalty costs it will face the same issues troubling Pandora; offsetting rising license costs against income generated.  But in Pandora's case, 90% of its revenue is from advertising.  Given control is central is to Apple's ethos it's unlikely to adopt an advertising model. But it does have its iTunes platform to sell subscription access - a big plus.  However, internet radio users appear happier to click ads than pay directly.   And when they do pay the subscription typically runs at about $3 a month.  Is there enough of a market for Apple to make the jump?

Even if Apple can generate a healthy subscription service, how will that cannibalize its iTunes sales? Assuming it prices itself at the same level of its competitors, then consumers of large amounts of music will have less reason to buy individual songs and just stick with a subscription model.  If Apple accepts this and prices itself above its competitors, then it will risk been overlooked altogether and paying costs of supporting an infrastructure which isn't used.  

External factors may also play a roll.  Given Apple's success in the mobile market, will a streamed service place too heavy a load on its network carriers? Songza and Grooveshark already offer successful iOS apps, but their success may be tied to the smaller number of users they have to support.  Plus, their service is free (with ads).  Unfortunately, network management is not something Apple can control.  

There may be consumer issues to consider.  How good will its music algorithm be? How much will it cost? Will "fanboys" love or hate it? Will it hurt iTunes sales?

Will Apple entering the market help its competitors more? Given there is unlikely to be a direct overlap in revenue sourcing between Pandora and Apple, can Apple's influence help lower Pandora's costs.

Is there reason for Apple to do any of this now given the momentum around the iPad and iPhone?

Known Knowns and Known Unknowns

There isn't enough of an existing competitive tie in between Pandora and Apple for Pandora's stock to react the way it did to Apple's news.  Apple made an announcement based on a proposal for a service it may provide, which may or may not impact on Pandora.  Pandora is a well-established internet radio provider which continues to expand.  It has a clear income model heavily dependent on increasing advertising revenue to outpace rising royalty costs.   Apple entering the market doesn't change this. The only (likely) direct competition between the two companies is whether Apple's move makes it more difficult for Pandora to convert its existing users to paid subscription users - but if Apple got its pricing wrong it may drive people to Pandora??? Who knows...?

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