As Pandora Goes Public, Worries for Sirius XM

Jun. 8.11 | About: Pandora Media (P)

Pandora (NYSE:P) is getting ready to go public, and anticipates raising just under $150 million in their Initial Public Offering. Of that total, it is anticipated that the company will net just over $30 million after current investors cash out. Certainly $33 million is not enough for Pandora to make waves by signing content to take the service beyond music, but the reality is that the Pandora IPO could generate more money than is currently anticipated.

Whether or not Pandora, or Internet Radio for that matter is competition for Sirius XM has oft been discussed. Some say that Pandora is not radio and nothing more than a digital juke box, while others feel Internet radio is a new wave that has helped redefine the meaning of radio. Which side is right? The answer is that it matters little whether Internet radio is radio. It exists as a form of audio entertainment that is being used by millions.

As I look at the audio entertainment landscape, I define Sirius XM's (NASDAQ:SIRI) competition as virtually anything in audio entertainment. Let's face it, if you are listening to Pandora you can not be listening to Sirius XM simultaneously. Thus, in my mind, the competition for Sirius XM is terrestrial radio, Internet radio, and even iPods.

I have heard all of the arguments of why people do not consider Pandora competition. The most frequently cited is that Sirius XM's content is vastly superior to that which Pandora offers. Almost like a discussion of whether Toyota and Mercedes-Benz compete. In many ways they do not, but there are Toyota's out there that price out in the $40-$50 thousand dollar range and you can also pick up a Mercedes-Benz at a similar price point. While this argument can be made, I would step back and say that music is music whether delivered from satellite, Internet, or over the airwaves, and we are not talking about cars. The bottom line here is that there will be varied opinions o the subject and no one can deny that the purpose of audio entertainment companies is to provide a service in exchange for either dollars from consumers (subscription model) or advertisers (free model).

Rather than get into semantics about definitions, why don't we look at this in another way entirely? In 1996 terrestrial radio virtually owned the audio entertainment landscape. They had the entire revenue pie. As the new century rolled around, satellite radio came onto the scene and was scoffed at as something that was "certainly not a threat" to traditional radio. It is ironic that I see some of the same scoffing lingo associated Pandora now. Fast forward to 2011 and we see that satellite radio has about 15% of the market (see slide 20 in the Sirius XM presentation), while Internet radio has about 5% of the market. Somewhere along the way 20% of the market has shifted to services other than terrestrial radio.

In the classic sense, both satellite and Internet radio have been around a long time now. The holy grail for Sirius XM was getting into the automobile dashboard. It was not until satellite radio was able to penetrate the car market that they began to become successful, and even then it took years and a merger to make the business model work. Internet radio has never had the benefit of being in the car until the advent of the smartphone less than 2 years ago. Now smartphones are being connected to car dashboards. Thus, for the first time, services like Pandora and Slacker are able to get to consumer ears virtually anywhere now, and that is competition for Sirius XM.

In the last decade terrestrial radio has gone from having the whole audio entertainment pie to having 80% of it. Sirius XM took away 15%, and Internet radio 5%. Prior to the smart phone Internet radio likely had less than 1% of the market. The game changer here was not anything "incredible" offered by Internet radio, instead it was the smartphone that made using Internet radio easier and made these services available in more places.

If terrestrial radio owns 80% of the market today, what happens when their share erodes more and is down to 70%? What services pick up those 10 points? Will it be split between satellite radio and Internet radio, or will one service tend to be more dominant than the other? How much will go to Sirius XM vs. services like Pandora? In a very real and tangible way Sirius XM and Internet radio are competing heavily for the share chunks being lost by terrestrial radio. In this manner, even the most ardent satellite radio fan must concede that Sirius XM is competing with Internet radio.

Obviously the business models of Internet radio and satellite differ. Sirius XM's primary driver is subscription revenue, while services like Pandora (like terrestrial radio) rely on ad revenue to bring home the bacon. There is a key difference though. Services like Pandora can, and already have, shifted their model into a hybrid with "free" ad supported service as well as a "premium" subscription model. In their latest quarter 14.5% of Pandora's revenue was generated via subscribers.

This hybrid business model allows services like Pandora and Slacker (another popular Internet radio service) to reap the benefits from an advertising based model while at the same time dipping into a subscription model that also generates revenue. Slacker recently added an "On-Demand" tier and priced the service at $9.99 per month.

Taking things a step further, we now have people stating that Pandora is competition for terrestrial radio, but not Sirius XM. A recent N.Y. Times article points out that because Pandora generates most of their revenue from advertising, that they are a much bigger threat to terrestrial radio than satellite radio. The author states, "It might look like a rival to Sirius XM, the satellite radio monopoly. But Pandora’s primary competition is in the analog dashboard of terrestrial radio. Pandora generated almost 90 percent of its $138 million of revenue in the year through Jan. 31 from advertising. Sirius’s coin comes from 20 million paying subscribers."

I can see where the author is coming from, but what we need to do is look back in history to see the growth of satellite radio. As previously stated, it was not until satellite radio got into the dashboard that the real growth happened. Internet radio subscription models were a poor business model up until the smartphone. That was the first game changer for these businesses. Being available on a smartphone gave the concept of a subscription to Internet radio some value. Now, with connectivity to car dashboards, services like Pandora are just reaching the prized auto dashboard. The real story for Internet radio is not what has happened in the past 10 years, but what is going to happen in the next 10.

This is where I see the threat to Sirius XM happening. The Internet is going to get faster, more widespread, and more ubiquitous to society. Services that deliver their goods through the net are going to thrive as this happens, not whither away. What Sirius XM needs is an answer to what companies like Pandora are delivering. That answer, at least in part, is coming out this fall.

Sirius XM will be releasing satellite radio 2.0 sometime late in 2011. In many ways this is a direct response to the competitive landscape that indeed exists. Services like Pandora have had features that consumers love. Song skipping, and custom channels are all the advent of Internet radio. For about 10 years Sirius XM could boast superior content and commercial free music as ways to attract consumers, but with the advent of the smartphone is that enough?. Now that Internet radio is more viable than ever before, Sirius XM needed to adjust to the audio entertainment landscape or be left behind. One could say that Sirius XM's Satellite Radio 2.0 is a direct response to what other services like Pandora have been doing for a few years now on the computers of consumers.

For most users, satellite radio 2.0 benefits will come not via satellite, but via Sirius XM Internet Radio streamed through a smartphone app. Yes, satellite radio 2.0 radios will be sold at retail, but automakers will not integrate the new capabilities until much later. What satellite radio 2.0 delivers is "Pandora-Like" features bundled with a host of new channels. It is the answer to the competitive threat offered by Pandora.

For Sirius XM, and services like Pandora, there is a lot hinging on satellite radio 2.0. The product needs to be robust enough to stave off the advances of Pandora. It needs to be compelling enough to shift the battlefield to content (where SIRI has a distinct advantage) rather than on song skipping and other "neat" features. Because Satellite Radio 2.0 will offer "On-Demand" capabilities I think the company will effectively close the door on some advantages that were previously owned by Pandora. We will obviously know more this fall when it is launched. Until then it is a guessing game about how confident investors are in what Satellite Radio 2.0 delivers.

In the end what we have is an audio entertainment pie made up of companies that use advertising to make money, companies that use subscriptions to make money, and companies that use a hybrid model combining both advertising and subscriptions. All of these companies compete for the ears and dollars. Some of the dollars are paid via advertisers, while others come direct for the consumer. The key is watching things like this closely, and now that we have an Internet Radio company like Pandora going public we have a lot of metrics to watch and draw comparisons from.

One key element here is that smartphone integration into auto dashboards will be a huge positive for services like Pandora and something Sirius XM investors will want to watch closely. This connectivity makes a Pandora subscription far more valuable to a consumer than it once was. It took satellite radio years to get into the dashboard, but once there, the company was on a path to success. Will the same hold true for Pandora? The worry for Sirius XM is not that Pandora will woe existing subscribers away, but rather that they are competing directly for potential new users seeking solutions other than terrestrial radio.

I think Sirius XM, with a cash flow and established base, is a powerhouse that can and will be able to react to new waves of competition in the dashboard. I also think that Pandora will do fine and continue to grow. In the end there is room for terrestrial, Internet, and satellite radio. Perhaps investors in the media sector will want to place a small bet on all three. After all, there are many horses in the race, but it is the win, place, and show horses that pay off.

Disclosure: I am long SIRI.