Apple vs. Pandora: The music-streaming duopoly
Investors should prepare for slower growth going forward from the Internet radio service.
In only the first nine months of the year, shares of Pandora (P) have already tripled.
While the Internet radio giant has done well, overcoming tough odds and growing despite stiff competition from the likes of Spotify and Sirius XM (SIRI), Pandora has not shown that it can make enough money to justify investors' faith. With Apple's (AAPL) iPhones now available with iTunes Radio, which comes at a much cheaper cost than Pandora's subscription service, Pandora's already weak margins are suddenly under more pressure. Will the stock hold?
With listening hours up 16% year over year and subscription revenue surging 143%, I can't deny that Pandora is an exceptional growth story. As with Facebook (FB), Pandora is also benefiting from a dominant showing in advertising revenue, which continues to outperform Wall Street estimates, climbing up recently by 44%.
But eventually "the music stops." Given that content acquisition costs continue to rise, including a 35% increase in the recent quarter, Pandora will have to do better than the $8 million GAAP (generally accepted accounting principles) loss the company posted in the recent quarter.
Realizing that Pandora's dealing with liquidity issues in looking for ways to finance its operations, last week management announced plans to sell 18.2 million shares in an expanded stock offering at $25 per share. The offering, which is expected to close on Tuesday, is an attempt to attract advertisers away from terrestrial radio stations.
Given how the offering was structured, which includes a 30-day option for underwriters JPMorgan Chase (JPM) and Morgan Stanley (MS) to purchase 2.73 million additional shares, Pandora might be able to net a total estimated sum of $393 million, given that the underwriters exercised their option on Friday. Investors cheered the news, sending shares of Pandora to its highest level in more than two years. But I wouldn't get carried away just yet.
Assuming the local U.S. advertising market is a $15 billion industry, this seems like a good strategy for Pandora. Unfortunately, management has not shown that it can effectively monetize the 7.5% market it already owns of the U.S. radio audience. Plus, without knowing how Apple, which also plans to attract advertisers with iTunes Radio, will attack this market, Pandora may end up just throwing good money after bad, and diluting its own stock by as much as 9%.
I'm not saying Apple is just going to come in and kill off what Pandora has built. Worst case, I believe there's room for both to strive. As I've said, Pandora's death has been proclaimed by many companies and several music apps. It hasn't happened yet.
The problem, though, is that with iTunes Radio, which comes free on iOS 7, Apple has essentially launched a competing service that is targeted at more than 50% of Pandora's listeners.
Again, it's too early to say with any degree of certainty how viable iTunes Radio will be. This is where Apple's recent commercials, which have sent subtle messages to advertisers like "more people listen to their music on the iPhone than any other phone," becomes even more brilliant.
In other words, it doesn't matter what the radio market share for Pandora or anyone else is, Apple is still the brand of choice. No other company has been able to monetize music better.
To the extent that Pandora's new stock offering can help capture the lion's share of the radio ad market as management hopes, I can see the stock going higher. But with Apple now fully into the game, investors should prepare for slower growth performances going forward from Pandora. That's not necessarily a bad thing though -- especially if margins begin to grow.
Pandora's music genome feature, which gives the company the ability to customize music, is without a doubt revolutionary to the extent that it has helped Pandora become a very "sticky" service. From what I've seen so far from iTunes Radio, I will admit I have not experienced anything yet -- other than price -- that I believe would draw a Pandora faithful away. But the company's management has to figure out how to turn that popularity into profits.
At the time of publication, the author was long AAPL.
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