With the recent IPO of Pandora (NYSE:P), there have been a ton of comparisons drawn between the Internet radio provider, Sirius XM (NASDAQ:SIRI), and terrestrial radio. The loudest comparisons seem to be made by passionate fans of the respective mediums, with each yelling as loud as they can that their audio entertainment choice is the best and will bury all others. When watching all of these debates unfold, I am reminded of the battle between fans of Ford (NYSE:F) vs. Chevy (NYSE:GM), Coke (NYSE:KO) vs. Pepsi (NYSE:PEP), Budweiser (NYSE:BUD) vs. Miller, even the Red Sox vs. the Yankees. Of course, in the end, these loud clashes are simply rhetoric. All of the foot stomping and fist pumping in the world will not change the fact that all of these mediums can not only succeed, but also have profitable businesses.
The first thing that investors in Pandora and Sirius XM need to understand is that while they do compete on some level, they also have a core audience that will not shift away, no matter what. Some people will pay for radio, some people will not. In that dynamic alone, Pandora and Sirius XM are not really competing in the slugfest some think exists. This gives plenty of room for the Internet radio provider to become a success simply off of the substantial "scraps" left behind by Sirius XM.
Satellite radio is a wonderful product with a virtually unparalleled content offering. Even with all of that great content, 55% of those exposed to the service through their new car and promotional subscription decide that it is not a good value. Right off the bat, Pandora has a chance at becoming an audio entertainment choice for over half of the people exposed to satellite radio. If Sirius XM can be a profitable business by getting less than half (about 45%) to keep the service, there is certainly room for Pandora to be a ready, willing, and able solution for those that would rather not pay.
What we have here is the dynamic of people who want to pay for radio vs. people who do not mind hearing advertisements. There is certainly some overlap where the two will compete with vigor, but just how large that overlap is has yet to be defined.
Sirius XM is shifting toward making a more compelling presence in the Internet-delivered space. Meanwhile Pandora has developed a subscription tier that is also growing. Sirius XM will be launching satellite radio 2.0 this year, which promises more "Pandora-Like" features, and Pandora now sits side by side with iHeartRadio in Toyota's (NYSE:TM) Entune platform. Pandora has also made automobile connection inroads, via apps, into other automakers such as BMW (OTCPK:BAMXY), Ford (F), GM (GM), Hyundai (OTC:HYMLF), and Mercedes (OTCPK:DDAIF). This territory is new to Pandora; it is one that was once totally dominated by Sirius XM and, of course, terrestrial radio.
As of right now, Pandora's offering is limited to music and comedy. It is not in the content business, and perhaps never will be. Content, and especially exclusive content, is expensive. In 2010 Sirius XM spent almost $306 million on non-music programming and content (some of that was for limited-run artist channels). Pandora is not likely to move into the non-music content arena any time soon. Simply stated, it is cost prohibitive for the company at this point. Another reason that Pandora may avoid non-music content is simply that it may not need to be a success [in that respect]. If consumers already are satisfied with their local AM/FM offerings for talk radio, Pandora could be perfectly happy to simply be the music choice of consumers. Throw Clear Channel's iHeartRadio into the mix, and a Pandora listener can have all of the music they want and still catch Rush Limbaugh if they want via the Clear Channel offering on iHeartRadio.
At this point, Sirius XM has the advantage. Both Sirius XM and Pandora are trying to catch the eroding audience (bear in mind that terrestrial radio is still the overwhelming force in audio entertainment) of terrestrial radio. Sirius XM is getting exposure via promotional subscriptions that come with 60% of all U.S. cars manufactured. In essence, Sirius is getting the first dibs because it is there in the car in far greater numbers than Pandora apps. Of those that get exposed to satellite, 55% will elect to fall away from satellite. This is where Pandora can step in.
In a recent article, "Is The Combination of Pandora and iHeartRadio a Threat to Sirius XM", I outlined a typical situation in the sector that Pandora and Sirius XM investors may find very interesting:
Without even considering satellite radio churn, let’s look at this with a real life example:
100 Cars get manufactured
60 come with satellite radio (Sirius XM has between 60% and 65% penetration into new cars)
27 promotional subscribers elect to keep the service (45% take rate)
After the promotional period there are 73 cars seeking other forms of audio entertainment and 27 keeping satellite.
As you can see, there is a substantial pool of consumers for Pandora to try to attract to its service without even making a dent in Sirius XM for it to be a success. This is the dynamic that currently exists. As time passes, and smartphone integration and apps become more ubiquitous in the dashboard, this will change. But for now there is plenty for Pandora to chase without so much as an iota of meaningful impact on Sirius XM.
The battlefield is actually controlled by Sirius XM at this point. While most are not aware, Sirius XM does offer lower priced plans that offer just "mostly music". For $9.99 per month, subscribers can forego almost all of the non-music content offered by the satellite radio provider. Why is this package not known by most? The answer is that Sirius XM does not necessarily want to be aggressive with this plan at this point in time. That could change if Pandora starts to dip into Sirius XM's core of potential subscribers or if the Sirius XM take rate begins to feel pressure.
How might Pandora apply pressure? Earlier I stated that Sirius XM is essentially getting first dibs. Now consider a car like the 2011 Toyota Camry equipped with Entune. It puts AM, FM, Sirius XM, Pandora, and iHeart Radio standard in the dashboard. Now Sirius XM, Pandora, and iHeartRadio are all trying to attract consumers at the same time, and in the car. What if the combination of Pandora and iHeartradio for free is satisfactory to the consumer over the almost $15 per month Sirius XM wants to get from consumers? This will take years to play out, but the potential exists that at some point Pandora will be competing aggressively and in numbers substantial enough to impact Sirius XM.
One potential answer for Sirius XM is its Satellite Radio 2.0 product coming out later this year. Another is a marketing campaign geared toward its lower price and less robust subscription packages.
For Pandora, the challenge is getting to profits. The more ubiquitous the company becomes, the more it gains pricing flexibility. It would not surprise me at all to see a price increase on Pandora's subscription tier in the next 12 months. I would also not be surprised if the company does not go down a path of instituting a royalty passthrough just like Sirius XM did. Pandora boasts between 34 and 35 million active users. If it can pass through a modest $1.00 per month royalty fee to offset royalty costs (it would mean that Pandora is no longer "free"), the revenue line would instantly jump by $35 million each month, or over $100 million per quarter!
In its most recent quarter, Pandora's revenue was $52 million. This modest $1 per month royalty fee, if applied to last quarter, would have meant that revenue for the Internet radio provider would have been about $157 million. Instead of the company's royalty costs being 60% of revenue (about $30 million out of $50 million), it would have been a fixed 25% of revenue. A mere $1 per active user/per month instantly turns Pandora into a cash generating machine and profits. It also dispels one of the biggest negatives that the Street sees in the Pandora business model - its royalty expense. Even if half of Pandora's 35 million active users left the service over a $1 charge, the company still would have been profitable in the quarter and just shy of the fixed 25% royalty structure. If revenue was $157 million, the royalty fees would have been 25%, or $39.25 million. Yes, this number is bigger than the $29 million Pandora paid, but it represents only 25% of revenue rather than a substantial 60%. For those that are not aware, Pandora pays the standard royalty rate, or 25% of revenue, whichever is greater.
The bottom line is that the audio entertainment landscape has plenty of room for a successful satellite, Internet, and terrestrial audience. Sirius XM does not necessarily want to chase the Pandora core, and Pandora does not necessarily want to enter the non-music aspect that makes Sirius XM compelling. These companies can exist in conjunction with each other and be successful and profitable. They do not even have to fight each other to get to that point.
In the end, betting on a successful satellite, Internet radio and terrestrial provider may be a great way to play the audio entertainment sector. In a horse race, money is made for Win, Place, and Show. There is no need to fear the competition. In fact, that competition is healthy. Instead, investors should consider embracing, or at least appreciating that the landscape has a lot of room.
Disclosure: I am long SIRI. I have no position in Pandora