Pandora Media's (NYSE:P) stock took a hit when Spotify reported that it has crossed the milestone of 10 million paid subscribers. Is the market's reaction justified? Although Spotify does seem to have some advantages, recent evidence suggests that Pandora hasn't felt any significant impact of growing competition from the company. However, if the situation changes in the future, Pandora's management may need to invest more in sales and marketing resources, which could dent profits going forward. The headcount may increase substantially over the next few years, thus making it difficult for Pandora to become profitable. At the moment, Pandora sees no threat from Spotify.
Our current price estimate for the company stands at $24, implying a slight discount to the market price.
Spotify announced it currently has around 10 million paying subscribers and 40 million total active users globally.  In the U.S., the company is estimated to have around 3 million paying subscribers, which is slightly below that for Pandora.  The company boasts of a large music library and offers good streaming quality and tools to build customized playlists. Spotify also has radio features which puts it one step ahead of Pandora in terms of music formats offered. Spotify seems to be doing better than Pandora in terms of converting its free users to paid subscribers. Paying users as a percentage of active users stands at 25% for Spotify compared to merely 5% in the case of Pandora. Spotify has the additional advantage of paying its royalty costs as a certain fraction of revenue, which implies that provided a sufficiently large subscriber base, margins can improve due to economies of scale kicking in its marketing and administrative departments. This is where Pandora loses out as it pays on a per song basis. In this light, Spotify does look like a serious threat to Pandora. But the evidence so far suggests that Pandora is doing alright despite growing competition.
Monetization And Listener Hours Are Growing Strong Despite Rising Competition
In Q1 2014, Pandora's ad RPM levels (revenue per 1,000 listener hours) for both desktop and mobile jumped significantly. Desktop ad RPM rose to $52.75 compared to $44.63 during the same period a year ago.  Similarly, the figure for mobile platform went up from $20.43 to $29.46, registering a year-over-year growth of 44%. Total RPM, which includes both free ad-supported service and subscription model, maintained a similar growth trajectory. While the majority of the growth in its RPM can be attributed to sale of more mobile ad inventory, higher ad pricing has also played a notable role. As Pandora can precisely measure the usage metrics for every user, it can help advertisers in targeting the right customers. This growth occurred despite growing competition from Spotify, which implies that Pandora's brand catalog of user-created stations and device reach have found a strong reception among customers.
Improvement in monetization hasn't come at the cost of usage growth. The number of active users jumped 8% compared to Q1 2013, increasing from 69.5 million to 75.3 million.  That covers roughly a quarter of the U.S. population. It is interesting that despite the addition of new users, the average number of listener hours per user is going up.
Disclosure: No positions.