Will On-Demand Streaming Fix Pandora's Problems?

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Tim Westergren thinks on-demand will be big for Pandora Media (P). The company's CEO told the audience at the MIDEM conference last month, "We're on the path to do something big and something for the long term."

After acquiring the assets of the bankrupt Rdio for $75 million last year, Pandora is expected to launch an on-demand service later this year. Piper Jaffray analyst Stan Meyers believes such a service could attract 9.2 million subscribers, $750 million in revenue, and $120 million in EBITDA.

That could provide a huge boost to Pandora, which has seen its listener growth stall and has been unable to convert those listeners to paid subscribers at any significant rate. But on-demand streaming comes with its own set of challenges as well, making it unclear if an on-demand service will help Pandora get into the black.

Is anyone making a profit in on-demand?

The two leaders in on-demand streaming are Spotify and Apple (AAPL 1.27%) Music. Spotify has 30 million paid subscribers and around 70 million ad-supported listeners. Apple Music has 15 million paid subscribers.

Importantly, Spotify isn't making a profit with its on-demand streaming. The company lost 173.1 million euros in 2015, seeing its net loss grow year over year as it added more listeners. The company had to pay out 83.6% of its revenue as royalties to record labels and songwriters as a result of upfront fees and minimum guarantees.

There are no details on the profitability of Apple's paid-only service, but the margins are probably slim. Apple Music is still a small part of Apple's overall business, but with the decline in digital downloads it will become a cornerstone to Apple's ecosystem just as iTunes once was. Apple doesn't have as much pressure on it to drive a profit directly through Apple Music as it's largely seen as a selling point to the entire iOS ecosystem, the profits of which are driven by hardware sales.

Pandora benefits from a standard rate for its radio service set by the Copyright Royalty Board. That rate is $0.17 per hundred song plays this year, and it will ramp up every year. Overall, it paid out just 58% of its revenue in the first quarter. On-demand streaming requires negotiating directly with record labels, and as Spotify's results show, they ask for a much higher percentage of revenue.

Even with paid subscribers, Pandora's heavy investment in its ad sales team will keep its bottom line in the red.

But ad sales could be its saving grace

Westergren wants to offer an on-demand service somewhere between free and the standard $10 per month. Record labels set that price point, so Pandora may have a tough time negotiating a service at a lower price. But Pandora's strong local ad sales may be what helps it persuade record labels go lower.

Pandora grew ad revenue per stream 19% in the first quarter on the back of stronger ad sales. Piper Jaffray's Stan Meyers sees the ad-sales team becoming even more efficient over the next few years. He sees gross margin per sales person growing from 69% in 2015 to 74% in 2019.

If Pandora can use its ad sales team to offer a freemium service like Spotify, it stands a better chance of making it profitable than the industry leader. Record labels may be hesitant to jump into bed with another free streaming service; however, after loudly complaining about Spotify and YouTube. Pandora may be able to combine its ad sales with a premium offering like Hulu Plus, but that could be a hard sell to consumers.

Meyers' estimate of $750 million in revenue from 9.2 million subscribers suggests an average price of $6.79 per subscriber per month. With Pandora's current ad-free offering currently at $5 per month, that suggests he believes the majority of subscribers will take that service or Pandora's on-demand service will be priced lower than $10 per month.

Pandora's ad sales team may be good, but it won't help Pandora sell a subscription service. Less than 5% of Pandora's listeners used one of the company's paid offerings last quarter. That's compared with about 30% of Spotify's users who subscribe to its premium service.

If Pandora can effectively use its ad sales team in its on-demand service, it could find a profitable core business. That is if it ever stopped investing in its ad sales team, it would produce a profit. Those are two big ifs, though. With expectations that the ad sales team will continue to become more efficient, though, the latter isn't a huge problem. Getting record labels on board will be the real obstacle.