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Pandora Media Inc (P) Flees From the iMonster and YouTunes

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Internet streaming radio, which has been around since the 1990s, has become a crowded market in recent years, thanks to the increased adoption of smartphones and tablets. In fact, streaming services accounted for approximately 10% of all digital music revenue last year, according to the International Federation of the Phonographic Industry (IFPI).
Yet is this market, currently dominated by companies such as Pandora Media Inc (NYSE:P) and Spotify, really as important as financial media makes it out to be? Now that tech giants Apple Inc. (NASDAQ:AAPL) and Google Inc (NASDAQ:GOOG) are rolling out their own Internet radio services, will smaller competitors be pushed into obscurity? Let’s take a look at the factors fueling the growth of Internet radio, the challenges it faces, and the possible future of the industry.

Pandora Media Inc (NYSE:P)

In an increasingly fragmented Internet radio industry, Pandora Media Inc (NYSE:P) is the market leader, with 70.1 million active users at the end of the first quarter – a 35% gain from the prior year quarter. It also added 700,000 paying subscribers to its commercial-free Pandora One service, which costs $3.99 per month or $36 annually, to reach a total of 2.5 million paid listeners. By comparison, Spotify only has 20 million total users, but boasts 5 million paid subscribers.

Pandora Media Inc (NYSE:P)’s total listener hours also rose 35% to 4.18 billion. More importantly, Pandora’s total revenue per thousand listener hours, which is generated by advertising and subscription revenue, rose to $30.01, up from $26.09 last year. Revenue generated by mobile devices nearly doubled to $83.9 million, fueled by a 47% rise in total mobile listening hours.

As a result, Pandora Media Inc (NYSE:P)’s revenue spiked 55% to $126 million in the first quarter, but the company still posted a net loss of $0.16 per share, or $28.6 million, down from the loss of $0.12 per share, or $20.2 million, it reported a year earlier. The problem is simple – royalties and bandwidth costs are still crippling its bottom line growth. 56% of Pandora’s 2012 revenue went towards royalty payments – which doesn’t leave much room for bandwidth and expansion costs.

Pandora Media Inc (NYSE:P) reportedly pays $0.12 per 100 songs streamed from its site to record companies. By comparison, smaller services such as iHeartRadio pay an average of $0.22, and its main competitor Spotify pays a whopping $0.35 per 100 songs streamed. 

Considering that Pandora pays the lowest royalty rate in the industry and still has trouble squeezing out a profit, then it stands to reason that a business model solely based on streaming Internet radio is fundamentally flawed. While Pandora Media Inc (NYSE:P) has expressed faith that its newly introduced 40-hour listening cap will encourage more free listeners to sign up for its premium service, that new strategy remains untested.

In addition, larger companies, such as Apple Inc. (NASDAQ:AAPL) and Google Inc (NASDAQ:GOOG), can afford to pay higher royalty rates to undercut Pandora Media Inc (NYSE:P). Apple and Google can easily offset losses in their Internet radio businesses with their respective core businesses of hardware and display advertising.

Despite this apparent advantage, Apple Inc. (NASDAQ:AAPL) initially only offered record labels $0.06 per 100 songs streamed on its upcoming iRadio service. At first, record companies appeared to accept Apple’s low offer, due to the appealing idea of allowing its streaming content to promote iTunes purchases. Eventually, record companies demanded higher royalties and Apple relented, reportedly raising its royalty rate to $0.12 per 100 songs, in line with Pandora’s royalties.

However, having the same royalty rate does not shield Pandora Media Inc (NYSE:P) from Apple Inc. (NASDAQ:AAPL)’s real weapons – iTunes and iAd. Apple’s iRadio app will be integrated with iTunes, allowing direct purchases of streaming content. Record labels generally take a 70% cut of iTunes purchases, which means that they will not only enjoy a constant stream of royalty payments, but also profit from higher purchases of its digital tracks.

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