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Apple Inc. (AAPL) Will Gut Pandora Media Inc (P) From the Inside Out

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At first glance, Apple Inc. (NASDAQ:AAPL)‘s iTunes Radio service didn’t quite fit the bill of being a “Pandora Media Inc (NYSE:P) killer.” The service itself is largely the same, offering users the chance to discover new music based on historical listening habits. iTunes Radio enjoys a pricing advantage, but the $11-per-year difference for paying subscribers isn’t breaking anyone’s wallet.

iTunes Radio. Source: Apple.

That being said, Apple Inc. (NASDAQ:AAPL)’s real threat to Pandora will come from within the music industry itself.

The Wall Street Journal has gotten its hands on some of the rates that Apple Inc. (NASDAQ:AAPL) is paying to independent record labels, which are similar to its terms with the major labels; the Mac maker is looking awfully generous next to its incumbent rival at a time when Pandora’s tensions with the record industry are at all-time highs.

For the first year, Apple Inc. (NASDAQ:AAPL) will pay 0.13 cents per song play, in addition to sharing 15% of net advertising revenue that’s proportionate to the record label’s share of music played on iTunes. Those figures jump to 0.14 cents per song play and a 19% ad share in the second year. In comparison, Pandora pays 0.12 cents per song played through its free service.

Apple Inc. (AAPL)

The real kickers
The rate per song isn’t dramatically different. Instead, the two things that investors should note is the ad share, as well as which way those rates are heading.

Apple Inc. (NASDAQ:AAPL)’s advertising business has always been for the benefit of content providers. iAd was launched as an additional way for developers to monetize their apps, and Apple is using a similar strategy here with iTunes Radio.

Sharing ad revenue is precisely something that Pandora Media Inc (NYSE:P) can’t do, since ads are its primary monetization strategy. Advertising revenue was 84% of total sales last quarter, and content acquisition costs (i.e., royalties) were 79% of advertising revenue.

Pandora Income Statement Data Q1 2013
Advertising revenue $105.1 million
Content acquisition costs $82.9 million

Source: 10-Q.

Pandora Media Inc (NYSE:P) remains unprofitable, and sharing ad revenue with labels would make its quest for black ink that much harder.

On top of that, Pandora Media Inc (NYSE:P) continues to seek ways to reduce the royalty rates it pays, which is a lot of why there’s so much hostility between it and the music industry right now. Just this month, it acquired small South Dakota terrestrial radio station KXMZ-FM in an effort to qualify for lower royalty rates. BMI, one of the organizations that represent artists, immediately sued Pandora Media Inc (NYSE:P) over the move, calling it a “stunt” to “artificially drive down its license fees.”

The episode is just beginning, but the point is that while Pandora Media Inc (NYSE:P) is trying to pay less, Apple Inc. (NASDAQ:AAPL) is willing to pay more. Whom would the record labels rather partner with?

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