Is Apple Putting Pandora Back In A Box?

| About: Apple Inc. (AAPL)
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According to a tweet from the Wall Street Journal's Dennis Berman, Apple (NASDAQ:AAPL) is developing a streaming-music service that is similar to the service offered by Pandora Media (NYSE:P). This newest rumor comes less than a week before Apple's September 12 media event, where the iPhone 5 is to be unveiled. The rumor is poised to knock Pandora's shares down a peg. If the rumor proves to be true, the service would likely end up grabbing a significant share of the next-generation radio services market, and considerably lower the outlook for Pandora.

Apparently, Apple is in discussion with audio content owners in order to create a framework though which it can obtain the additional licensing required for providing such a service, or already has such arrangements set up and plans to unveil it with the release of its newest iPhone and the software upgrade to Apple's iOS that will accompany it. Apple could actually launch a Pandora style service without the permission of content owners because of compulsory licenses that allow for such use content for a set fee, but the company may be looking to establish a lower fee and/or improved functionality.

In any event, most of the labels and audio content owners will probably be delighted to enter further deals with Apple. Though Apple may have initially strong-armed the industry into the iTunes arrangement, most labels have come to recognize iTunes as a significant and growing new revenue stream, as most of their traditional revenue streams dry out. Thanks to the ubiquitous use of iPods, iPhones and iPads, all running iTunes, Apple is now the world's largest music retailer and still one of the fastest growing.

It is unclear to me how much of a benefit Apple could recognize through entering Pandora's market, but it does seem quite probable that the move would not be a good thing for Pandora. The reality is that Pandora's market has seen multiple competitors and in various forms, including serviced such as Spotify, a Swedish streaming music service that is growing globally, and Rdio, a music subscription service developed by the founders of Skype, and iHeartRadio by Clear Channel Communications (CCMO).

Other competitors for the radio listening audience would include Sirius XM (NASDAQ:SIRI) satellite radio, though it is not an analogous business, simply because individuals paying for their radio service are more likely to use it than some other service. New competitors in the digital device world, such as Android-based phones selling music through a marketplace run by Google (NASDAQ:GOOG), and Amazon (NASDAQ:AMZN) selling content through its suite of Kindle tablets will only further fractionalize this market.

Apple's service would probably work on the iPhone, iPads, Mac computers and possibly through other mobile operating systems that have iTunes software. Apple also often allows pre-existing iPhone models that can accept a software upgrade to include new functionality like this. Such a service would also likely be available through the company's AppleTV device, which already allows users to play items in their iTunes library through their television.

Apple's significant presence in the smartphone and tablet markets would immediately make it one of the most competitive audio content providers out there. While there are about 55 million Pandora users, which is a substantial sum, there are also already over seven times as many iTunes accounts, with most of those Pandora users also having an iTunes account for their iPod, iPhone, iPad and/or computer. Moreover, Apple's iTunes and iCloud could provide the service with a significant amount of data regarding a listener's preferences, allowing it to more precisely custom tailor the content it provides. The synergies could lead both ways, where listeners may then choose to add what they hear to their library.

Music would also likely be peppered with ads, with other ads shown on the device's screen, and the company may include a subscription service that would allow for ad-free listening. If Apple were to establish a deal with the bulk of content owners, allowing it to obtain a preferable rate compared to the compulsory fees that services like Pandora generally have to pay, the competitive advantage could be large. Beyond potentially reducing the cost structure, it may allow for Apple to provide richer features or more precisely mimic traditional popular radio stations and their adherence to playing a relatively small list of pop hits. While this concept may sound more limited, there is demand for it and compulsory license regulations that type of frequency in playing songs.

Pandora has performed exceedingly well recently, but this news is clearly going to weigh on its shares. In the last month, shares of Pandora have appreciated by about 29 percent, with most of that occurring last week after Pandora reported and beat its Q2 expectations, while also raising its outlook. That outlook did not include the possibility that Apple was gunning for it. In initial pre-market trading on Friday, September 7, Pandora dipped by more than ten percent.

The company reported $101.3 million revenue. Due to the royalty costs associated with the above-mentioned compulsory licenses that Pandora uses to gain access to the music it provides, Pandora has not yet reported a profit. In the second quarter of 2012, Pandora's revenue increased by over 50 percent, but its content costs grew by almost 80 percent, causing Pandora to lose $5.4 million.

Currently, the Internet radio industry is so small compared to Apple's already existing businesses that estimates for the tech giant's future revenues are unlikely to be significantly affected by the addition of this business, or it never materializing. Nonetheless, the potential damage to Pandora's future business is substantial, and many investors will probably not want to sit around and wait for Apple to make an official announcement of its intention to dominate this industry. Moreover, many recent investors in Pandora should have recognized significant appreciation last week and many such investors may, upon hearing of this potential forthcoming Apple competition, take what profit remains and run. For these reasons, Pandora appears a highly risky investment and one likely to decline in the coming days.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.