History has shown that when Apple (AAPL) enters a new market, on average, it is better to bet on the California fruit company than against it. This happened with the music industry (iTunes), the mobile phone industry (iPhone), and the tablet industry (iPad). And in many cases, the previous industry leaders suffered greatly. RIM (RIMM) is in chaos, Nokia (NOK) has had to do a 360-degree pivot to save itself, and virtually all MP3 player companies have withdrawn from the market. The latest rumor from Cupertino, courtesy of the Wall Street Journal, is that Apple is looking to enter the streaming music market. If this is true, it would seem to place Pandora (P) directly in the cross hairs of the world's largest company by market capitalization.
Pandora's stock fell by almost 17% on Friday, September 7, the day after this report was published, as investors worried that Pandora may have finally met its match. After examining the Wall Street Journal article, we do not believe that Apple's service, if it does indeed launch, will be a direct replica of the Pandora experience. And, furthermore, we believe that Apple's efforts would be best served not by competing with Pandora, but by buying it, and we explain our line of thinking below. But before we do so, an overview of where Pandora stands is in order, as well as an overview of Apple's intentions.
Pandora: King of the Internet Radio Hill
Pandora is the clear leader in Internet radio at the moment, and its results prove this. In its latest quarter, Pandora captured 6% of the entire US radio market, and grew revenues by 51% to $101.3 million. Mobile revenue grew by 86% to $59.2 million, meaning that Pandora now gets a majority of its revenue from its mobile business, which demonstrates the dramatic improvements in monetization that have occurred over the past few quarters. While Pandora did post a GAAP loss of 3 cents per share this quarter, this is due primarily to stock-based compensation expense. Excluding that, Pandora posted non-GAAP net income of $734,000. Pandora's user growth is leading to rising content costs. Even though revenues may have grown 51% this quarter, content acquisition costs grew by 79%. This issue will likely persist until user growth moderates. Pandora's critics argue that the company simply cannot succeed because there are too many players in this industry. But, we disagree. On a standalone basis (without the presence of Apple), we think Pandora can succeed. The company has proven that it can hold competitors such as Spotify, Rdio, and Slacker at bay (thanks to a differentiated approach to music via the Music Genome Project), and is beginning its international rollout, with service starting in New Zealand and Australia.
As the largest Internet radio company, Pandora enjoys the benefits of a network effect, similar to many other social companies. Pandora is available on desktop/laptop computers, the leading mobile platforms, and is being integrated into more and more cars and home entertainment devices. As such, Pandora enjoys a scale that few of its peers in Internet radio are able to achieve.
Apple: Why Bother With Internet Radio? User Retention.
Why should Apple even bother creating an Internet music service? Surely Tim Cook and his lieutenants are smarter than the incompetent executives at Pandora, who foolishly think that they can ever turn a profit from Internet radio. We think that such a line of thinking is simplistic, however. Companies such as Pandora and Spotify operate in the Internet radio industry to generate profits from doing so. Pandora's business model, at its core, is predicated on building as large a user base as possible and then charging advertisers for access to those users. Apple, however, is primarily a hardware company (one that happens to understand how crucial software is in creating a quality experience for users). iOS and Mac OS are designed to get customers to buy iPhones, iPads, and Macs. They are a means to an end, just like this rumored Internet radio service would be.
Apple's streaming service is not meant to be a profitable new business line for the company (although it would be an added benefit if it were profitable), but rather another way to attract and retain users of the company's operating systems. This service gives Apple another way to keep users in its ecosystem, and with the smartphone/tablet "wars" becoming more and more about ecosystems, this is an important point.
Apple's Service is Unlikely to Kill Pandora
Pandora's shares plunged on September 7 because investors felt that Apple, should it enter this market, will teach Pandora the meaning of competition. Keeping any number of music start-ups at bay is one thing. But keeping Apple at bay is another matter entirely. Apple's essentially unlimited financial resources ($117.221 billion in cash & investments on the balance sheet) give it the ability to create any kind of streaming service that it wants. But while that cash pile may allow Apple to easily create the service that it wants, as well as swallow some losses on content costs, it does not guarantee that its service will kill Pandora.
For starters, Apple is set to be seeking a different type of music license than Pandora. Pandora pays royalties to SoundExchange (for statutory performance) and to ASCAP, SEASAC, and BMI for publishing. As a result, Pandora's system allows users to only skip a small number of songs per hour. Apple, however, is said to be negotiating directly with artists and record labels to provide a more "active" experience for users than what Pandora can provide today. Secondly, Apple is likely facing an uphill battle when it comes to its negotiations with artists and labels. Everyone knows who won during the last major round of negotiations between Apple and the music industry before the launch of iTunes. And this time, the music industry may not be willing to give ground so easily. In addition, the industry may not want to risk cannibalizing iTunes sales. As a result, any potential service is likely months away. Albert Fried & Co. predicts that Apple is 6-18 months away from launching a streaming service, which would give Pandora time to develop some sort of alternative strategy.
It is also important to remember that Pandora's service is available on multiple platforms, as well as a growing number of cars and home entertainment devices. Apple's service will likely be available only on Apple devices. Otherwise, we fail to see a compelling reason to launch a streaming service. This service is all about differentiating Apple's devices from competing devices, and giving Android/Windows users access to it defeats the purpose of launching it in the first place. Pandora, however, is available on all those platforms, and even if every single Mac/iOS user stops using Pandora, there is still a wide user base that will remain accessible to Pandora. It is unrealistic to expect that every smartphone and tablet will be an iPhone/iPad [even if we would like this to be the case (as Apple investors)], and Apple's service will not change that fact. The only users who may completely drop Pandora are those who live 100% within the Apple ecosystem, both at work and at home. And even though Apple's user base stretches into the hundreds of millions across all its devices, the number of people who use only Apple devices is much smaller. We do not believe that Apple's streaming service presents direct competition to Pandora to the extent that the markets think it does. And in any case, Apple's interest would be served best not by competing with Pandora, but by buying it.
Taking Control of Pandora's Box of Tricks
As we outlined earlier, what gives Pandora an edge over other streaming services is not only its different approach to music (via the Music Genome Project), but its scale. Facebook (FB) and LinkedIn (LNKD) have advantages of scale because everyone is on the networks. You joined Facebook because your friends are all there, just as you joined LinkedIn because that is where all the professional opportunities are. And you stay with Facebook and LinkedIn because everyone else does as well. You joined Pandora, however, because it is the platform with the most reach. You can have Pandora not only on your phone and home/work computers, but in your car or home entertainment system as well. Pandora has gone further than any other streaming music service in integrating itself into the daily lives of its users. And Pandora is succeeding in mobile monetization, something that even Apple is struggling with. iAd, Apple's mobile advertising business, is set to generate just $75 million in revenue this year. In contrast, Pandora brought in $59.2 million in mobile revenues in its last quarter alone, a testament to the company's skill in monetizing its mobile business.
If Apple's streaming service includes advertising, it will have to build a sales staff, provide user and audience metrics, and build a platform to give advertises access to performance data. These are things that Pandora has spent a decade on, and we doubt that even Apple can replicate the way Pandora operates its streaming service. That is just as important as the service itself. However, buying Pandora solves not only that problem, but also further enhances Apple's strategic goals, and we break down the rationale behind a takeover of Pandora below.
- An existing sales force and advertising relationships: Buying Pandora will allow Apple to simply use Pandora's existing sales staff, as well as existing advertisers. Many advertises are finally becoming comfortable with using Pandora's service, and they are unlikely to embrace Apple's service overnight simply because it is run by Apple. Apple will have to lure advertisers, and that is something that takes time. But buying Pandora takes care of this issue, for it preserves existing relationships and allows Apple to leverage Pandora's expertise in the mobile sector, which Albert Fried & Co. sees as the primary reason why Apple should buy Pandora.
- Provide even more differentiation to Apple's ecosystem: We do not believe that Apple's efforts in the streaming music sector are about creating a new profit stream for the company. As we explained earlier in this article, we believe that this rumored service is about differentiating Apple's ecosystem, and providing customers with another incentive to join and/or stay within that ecosystem. Allowing only Apple's mobile devices and computers access to this service will help that goal (assuming that Apple launches a quality service). But buying Pandora and removing access from Android/Windows devices will do more to strengthen Apple's differentiation goals than its own music service could. Pandora's success stems in large part from the Music Genome Project, which is covered by patent protection. If Apple truly wants to create the best streaming service, it needs the Music Genome Project, which it can only get by taking control of Pandora. The big question here is whether or not a takeover of Pandora would run afoul of anti-trust regulations. It is clear that in a perfect world, Apple would likely shut down access to Pandora for non-Apple mobile devices, a move that regulators could see as anti-competitive. Even if that is the case, Apple should still buy Pandora, and the reasons why are covered in point #3 in our case for buying Pandora.
- Pandora will fit into Apple's long-term goal of integration: Apple is all about integration. Its software and hardware are tightly knit, and Apple's long-term goal is to gain control of as many screens as possible. Apple has already done this through the iPhone, iPad, iPod, and Mac, but several screens still need to be addressed. Namely, the TV and car dashboard. And taking control of Pandora will go a long way towards achieving that goal. Apple could rebrand Pandora, naming it iRadio, or iStream, or iSomething, and integrate it into its ecosystem just as iCloud or iTunes are part of it today. And Pandora will give Apple a foothold into a new market: cars. Pandora already has partnerships with 18 carmakers, and that number is growing. Taking control of Pandora will give Apple access to those partnerships, as well as the ability to expand them to cover new areas, such as iTunes. As for anti-trust concerns, they too can be soothed by preserving most of what Pandora is today, but integrating it much more tightly into Apple's ecosystem, similar to iTunes. While both iTunes and iCloud are available to Windows users, they are clearly designed to work best inside the Apple ecosystem, and when and if Apple takes over Pandora, the service will likely be revamped along those lines. iRadio, or iStream, or whatever Pandora could be called once it is part of the Apple ecosystem, will likely be available on multiple platforms, but really meant for Apple's platform.
In our view, the rationale for a takeover of Pandora is clear. Apple can gain control of the Music Genome Project, which is key to building a leading streaming service, a growing mobile advertising business, and existing partnerships with 18 automakers, which we believe will become quite important in the years ahead. However, we believe that Apple has an ace-in-the-hole that few observers have considered: an ad-free streaming service, provided to Apple users, for free.
Advertising and the Financial Aspects of a Deal
We believe that Pandora's results prove that as of today, it is the leading streaming service, and that it can hold existing competitors at bay. But, because Pandora needs to generate profits from its streaming service, it must show ads to its users, which dilutes the quality of the user experience. Pandora without ads is much better than Pandora with ads. Users can buy a subscription to Pandora One, but that costs $36 per year. Apple, however, could buy Pandora, integrate it into its ecosystem, and remove the ads all together, at least for Apple devices. Keeping ads on non-Apple devices would serve to highlight the benefits of being in the Apple ecosystem, at least from a marketing aspect.
Apple can certainly afford to run Pandora at a perpetual loss. Pandora had $106.57 million in expenses in its latest quarter. Of that $23.457 million was for sales & marketing, a number that would fall dramatically if Apple shrinks Pandora's ad business. Content costs came in at $60.522 million. For the sake of conservatism, we will assign a loss of $150 million per quarter to this theoretical Pandora, accounting for a dramatic rise in content costs, as well as a reduction in sales & marketing expense. We will also cut Pandora's revenue by over half to account for the loss of advertising and subscription revenues from Apple devices. Pandora posted revenues of $101.267 million in its last quarter, a number we cut to $50 million. Therefore, Apple may have to spend $400 million a year to run this new Pandora. Is it worth it? We think it could be, and break down the math needed to cover this expense below. Our calculations include the following assumptions.
- Apple's margins on the iPhone, according to court filings, were between 49% and 58%, while iPad margins came in at 23-32% (53.5% iPhone margins and 27.5% iPad margins at the midpoint).
- Apple's average selling price for the iPhone was $624.13 in its latest quarter, and $538.14 for the iPad (data taken from Apple's latest earnings release).
- Using the midpoint of historical margins (Apple does not explicitly reveal margins on a product-by-product basis), Apple's gross profit on each iPhone is $333.90 and $147.98 on each iPad.
Based on these assumptions, the cost of running Pandora at a $400 million annual loss could be covered by selling somewhere around 800,000 extra iPhones per year ($267.12 million in additional gross profit) and an extra 897,960 iPads per year (for $132.88 million in additional gross profit) (these numbers shift depending on the ratio of iPhones to iPads that is used). While this calculation is only an estimate, it gives an idea of the additional sales needed to justify running Pandora as a loss leader. We think that Apple could manage to bring in that many additional iPhone and iPad users. If Apple is indeed considering launching its own streaming service, it has likely taken into account how many additional units of iPhones and iPads it can sell by running it, and we think that an ad-free version of that same service, one that uses Pandora's technology, would bring in even more users.
From a financial aspect, a takeover of Pandora would be Apple's largest deal ever, surpassing the $400 million takeover of NeXT that brought Steve Jobs back to the company. Based on its September 7 close of $10.47, Pandora has a market capitalization of $1.77 billion (the company has 168,878,677 shares outstanding. Assuming a premium of 50%, Pandora could be bought for $15.71 per share, or $2.653084016 billion. Given that Apple has over $117 billion in cash and investments on the balance sheet, and generated over $41 billion in operating cash flow in the last 3 quarters, we believe that Apple has more than enough financial firepower to complete this deal. If Apple chooses to run Pandora at a perpetual loss, then this $2 billion+ purchase could be seen as an investment in Apple's future, and a way for Apple to gain access to another screen (cars) and further integrate all of its devices and drive incremental sales. And should Apple choose to run Pandora as it is now (with likely changes in branding), we believe that Apple can make Pandora into a business that can pay for itself, given that Apple has the financial capacity to invest much more quickly in sales, marketing, and technology than Pandora can on its own.
In our view, there is a compelling case to be made for Apply buying Pandora. Given that Apple's rumored streaming service is designed to make its devices stand out in the marketplace even more, rather than be generate meaningful profits, we believe that the best way to accomplish this is to take control of the leading streaming service, as opposed to creating one from scratch. Thanks to the Music Genome project, Pandora's technology is stronger than that of its peers, and it has proven that it can monetize its mobile business (an area where it is beating even Apple). Taking control of Pandora will allow Apple to further its mission of integrating its ecosystem across as many screens as possible, and gives the company access to 18 automakers, something that we feel will become very important in the years to come. Just as with iTunes, Apple does not necessarily need to block access to Pandora from non-iOS devices. But Apple can restructure Pandora so that it works best within the Apple ecosystem, just as it has done with iTunes and iCloud. Apple may eschew large acquisitions, but it does not avoid acquisitions that strengthen its competitive position or give it compelling intellectual property and/or talent. A takeover of Pandora gives Apple a stronger competitive position and gives it control of the Music Genome Project as well as an experiences advertising sales force. Instead of trying to build a service from scratch, Apple should take control of Pandora's box of tricks and take control of the world's leading music streaming service.