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In our previous reports on Pandora (NYSE:P), we had analyzed the company's chances at creating shareholder value and talked at length about its long term growth. We believe that an increase in the company's revenues can be a bit misleading to investors. This is because of a basic deficiency in Pandora's business model: any increase in Pandora's revenues result in increased content acquisition costs. This is why the company has failed to create shareholder value, despite a steadily increasing user base. The company's shares have lost almost half their value already since it began trading on the New York Stock Exchange. We believe that competition from Apple (NASDAQ:AAPL) can be lethal to an already troubled Pandora. Approximately 42% of Pandora's active users come from Apple products such as the iPad and iPhone; if Apple gives users an alternative, most will jump the sinking ship. Apple will be able to acquire the same content at much cheaper rates because it can bypass the middleman and go directly to artists and record labels. Due to these reasons, we maintain a sell rating on Pandora.

Apple Radio

A few days back, the Wall Street Journal broke the news that Apple will soon be launching its own radio service, which will allow users to make their personalized radio channels, much like Pandora . This news had a very adverse impact on Pandora's stock price, as can be seen in the graph below.

Source: y-charts

After the news broke, Pandora's shares lost approximately 14%. The stock was on an upward movement after positive quarterly results.

Pandora

Pandora derives its revenues from Pandora Internet Radio. The company provides users with the option of listening to their radios with advertisements, or subscribe and listen to the radio free of advertisements. Pandora has successfully integrated its services into smartphones, and is generating considerable revenues from this platform. The ability to generate revenues from smartphone advertisements is a feat that even Facebook (NASDAQ:FB) has not been able to achieve. According to company disclosures, it has approximately 125 million users, out of which 38% are active users. The key areas of concern for Pandora are its extremely high content acquisition costs. Apple on the other hand relies mainly on its hardware sales for revenues and margins. The online services segment does generate profits, but has the primary function of keeping people locked up in the Apple ecosystem. Moreover, Apple already has relationships with record labels and artists because of its iTunes store. Therefore, it can considerably lower content acquisition costs, building an unbeatable competitive advantage.

Acquisition Rumors

There have been rumors that Pandora can be a good acquisition target for Apple; we disagree. Apple certainly has enough cash (approx $125 billion) to buyout a company worth a meager $1.65 billion. Buying Pandora would give Apple the Music Genome Project, which has been a key success factor behind the increase in Pandora's user base. However, a key point remains the existing user base of iTunes. Any attempt to run Pandora as a separate online radio under the Apple umbrella would directly cannibalize the revenues of iTunes. Therefore, we believe Apple will most likely introduce a new online feature in the existing iTunes, rather than acquire Pandora.

Conclusion

We reiterate our sell rating on Pandora. We believe Apple's radio ambitions can seriously hurt Pandora. Out of 47 million active Pandora users, approximately 42% come from Apple-based devices. If Apple starts offering the same services for discounted rates, most users in the Apple ecosystem will shift to the Apple radio product.

Source: Pandora To Get Destroyed By Apple Radio