How Can Pandora Catch Up to Spotify?

Pandora (P) made headlines last week for shifting multiple seats in its C-suite and selling off the Ticketfly property. Following a huge buy-in from Sirius XM (SIRI -4.59%), it seems like the company might be working on turning its yearslong downtrend around, but it might be too late to get back the advantage it once had in the online music-streaming space.

In this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu explain what Pandora's new strategy seems to be and what investors need to know about the company's long-term viability.

Also, the duo discuss news from Apple (AAPL 0.52%) Music, and examine head-scratching reports that Tesla (TSLA 3.62%) is looking to get into the digital content streaming space.

A full transcript follows the video.

This video was recorded on June 30, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 30, and we're checking in on the music streaming space. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan, what's up? Do you have any big plans for the 4th of July?

Evan Niu: Actually, I'm going to take a road trip down to Texas over the weekend. That'll be fun. Haven't driven that far in my car before.

Lewis: Those are your old stomping grounds, right?

Niu: Yeah, my family is down there. I'm meeting the wife and the kids down there, so it'll be nice. And I have a Tesla, and I've never taken that long of a road trip in a Tesla before. So, it'll be interesting to see what it's like, to drive two days and use the Superchargers and all that good stuff.

Lewis: Yeah, that'll be a cool experience. When you guys take road trips, are you a podcast family? Are you a playlist family? Books on tape? How do you guys occupy your time?

Niu: We have kids, and kids don't really mix with podcasts. [laughs] So, we just tend to listen to whatever they want to listen to. They kind of call the shots there.

Lewis: Yeah, I guess you have to listen to the boss. [laughs] Well, we're going to be doing a rundown on music streaming and some updates from some major companies on today's show. We have news from Pandora, Apple, and, surprisingly, Tesla. Which, that's a head-scratcher, and we'll get on to that in a little bit. But, why don't we kick things off with Pandora? A lot has happened with the company in the last month or so. In early June, they announced that Sirius was taking a $480 million stake in the business, and that the company was selling off its Ticketfly online ticket property. Why don't we unpack that first part there? It looks like Sirius is taking what amounts to about a 19% stake in the business. For longest time, there's been this "will they, won't they" with these two companies. They've talked about possibly doing an acquisition, there's been rumors for a while. This is not a full acquisition. But it gives Sirius a meaningful stake in the business, and three seats on Pandora's board. In your eyes, Evan, what makes Pandora attractive to Sirius?

Niu: One of the main factors is the fact that Sirius is still very reliant on the automotive market. No one listens to satellite radio outside of the car. It's based in a stand-alone device, and no one really does that anymore. So, they are still very tied to the auto market. And that's under threat by the fact that cars are becoming increasingly connected to a wider array of music options. So, if you're tied to this market, and that's your only real market, and it's getting a lot more competitive there, then you have to start exploring other avenues. For them, it's a way to get exposure to internet radio, just more digital radio services. They also lack an on-demand service, which is something that Pandora is just now finally getting up and running. So, to me, I think that's part of it.

Lewis: A lot of people think of Pandora as a laggard in the online music-streaming space, but they do have something like 70 million users. They certainly have a large installed base to pick up on and work off of, if you're Sirius. I do want to hit that second point of that news, them selling Ticketfly. I have to say, I'm a little bit annoyed about this, because I'm a Pandora shareholder, and frankly I was thinking about getting out of my position right around right before they announced that acquisition. And, I was like, this is really interesting, I want to see what happens here. Just looking at the numbers, first off, they sold it for $200 million, and they paid around $330 million for the property in 2015. The original sticker price was $450 million, but because of the stock side of the deal, it wound up coming in at less. So, they're already eating cost there. And for me, the Ticketfly segment was actually what made them really interesting. You think about the economics of a pure music-streaming business, you're basically working with a commoditized product. Consumers have decided they're paying $10 a month, and all the providers have basically said, "Yeah, that's what we're going to offer it at." So, you don't have any pricing power there. And then, licensing fees eat up a lot of the margins for these companies, and there's not a lot of room to negotiate there. So, you're in two major elements of your business where you don't have a lot of control. The ticketing business is super high margin, and I felt like it fit in so well with their core offering, I'm kind of surprised to see them shutter that side of the business.

Niu: I didn't really follow the Ticketfly deal too closely. I've seen it as it's played out. I remember back then when they announced the deal, thinking, "That does make some strategic sense." Like you mentioned, music streaming, turning that into selling tickets for online shows, that does intuitively make some sense. But, I can also see the case, how it's hard to integrate those together in a seamless way, and maybe that was the problem. It sounds like it fits, but operationally maybe they had a hard time figuring out a good experience to integrate these two aspects. So, maybe they just figured it was too hard and they should focus on shoring up the core business, maybe. It is a weird deal, in more ways than one.

Lewis: And that's what I've heard a little bit of, some rumblings that they were having some technical issues and that it was a little bit of a nightmare in that sense. But, I think it's a little bit frustrating for me, because I see that, Ticketfly's growth wasn't outrageous, but it was a 20%-30% clip year over year, and that's far outpacing what Pandora's core business was doing. So, you have a strong asset that is performing. It's small compared to the revenue base of their subscription and ad businesses, but it's still moving along a lot faster than the rest of it is. So, to give up on that, particularly after paying more than what you wound up selling it for, as a shareholder, I was a little frustrated. And really, I think the motivation, I understand they needed to raise cash, and they have some things that they're going to be chasing in the next year or so, and they want to make sure they have the money on hand to do that. In my mind, it felt like a cut-off-your-nose-to-spite-your-face decision, where they were basically getting rid of this very solid-performing asset to sure up what was going on more short-term with the business. I think, long-term, it might not be the greatest decision. 

There is more news, though. It's not just limited to selling off Ticketfly and the Sirius stake. Following on Sirius being more involved in the business, we have an update on what's going on with Pandora's management team.

Niu: Yeah. The co-founder and CEO Tim Westergren is stepping down. The former CFO is also leaving, the chief marketing officer is leaving. So, pretty big shake-up there. CFO Naveen Chopra will serve as the interim CEO as they search for a new CEO. And they added a new director, too. So, a lot of changes there at the top.

Lewis: And this isn't all that surprising when you talk about having an outside investor take a major stake in a business and get board seats. They are going to have their influence felt very quickly, because they probably have an idea for how things should be run. So, it's not shocking that there's some management shake-up. There's also, we hinted at this before, a little bit of a refocusing here in where they want to put their capital. They're doubling down on their domestic business now.

Niu: That too. But, as far as Westergren goes, I think it's arguably also overdue. Shares jumped just on the rumors that he was going to be leaving, before it was official. When you think about it, Pandora, in my mind, has really dropped the ball on shifting to on-demand. They created internet radio streaming. They were the first mover, and they've slipped into irrelevance because they didn't really give much attention to on-demand, and they made a lot of strategic missteps. Someone has to be held accountable for these mistakes, and I think shareholders for a while have been frustrated with Westergren. I think that's why shares jumped, and maybe this will help them turn the corner, if they can find someone else who can navigate that transition better. To the next point, being international, they also announced they were going to be pulling out of Australia and New Zealand, which are the only two international markets they've ever operated in, beyond the United States. Which boils down to licensing. They've disclosed that they don't have the direct licensing agreements in place to launch on-demand services in Australia or New Zealand. They recently rolled that out in the U.S. The whole idea now is that these other markets just aren't really that great, and they don't have the licensing in place, it's just not going to work out well. So they want to focus on the U.S. side of the business. But it's really competitive in the U.S., too. It's not such an easy thing to make a name for yourself when you've slipped and dropped the ball on this one, like we mentioned.

Lewis: Yeah, the push for the company over the next couple years is going to be on-demand streaming in the United States. And that space is absolutely dominated by Spotify and Apple Music right now.

Niu: Right. None of these companies break out their user numbers geographically. But at a high level, Spotify has 50 million paid subscribers, about 90 million free ad-supported users. Apple Music is at 27 million paid subscribers, does not offer a free ad-supported tier, so zero free users. Whereas Pandora is at under 5 million paid subscribers, less than 10% of Spotify, and has about 70 million free ad-supported users. And they haven't really grown that much in terms of the total number of users. Pandora is not a growth company, in terms of attracting users, because everyone is going to Spotify now for music. And that's very specifically because they haven't had this on-demand aspect. Chopra actually spoke at a Bernstein conference earlier this week right after the announcements, and he basically said Pandora's strategy is to "nail the passive listening experience." Which, music streaming is split between active and passive. Some people like passive. I personally like passive more. A lot of people like active, too. You need to have both. You need to have the on-demand active listening side. I think Pandora's mistake has been focusing too much on the passive side, which is why they're in this predicament. So it's kind of weird that he's still like, "We need to do the passive side really well." Like, that was never your problem. Your problem was lacking the on-demand.

Lewis: Right. I think part of the problem, too, is that Spotify has done such a good job with their curated playlists, and delivering people, on a weekly basis, new music to check out, new Discovery playlists. That is passive, in a sense. It's not something that you're actively curating. And it might be kind of a discovery engine for listeners, which is exactly what I think Pandora is for a lot of people. We talked about how they have tens of millions of users total, not necessarily paid. But, a lot of those people might be using another on-demand streaming service in addition to Pandora. So, it's not like they're going to be able to convert that entire user base over to on-demand streamers.

Niu: Right, exactly. Everyone has passive radio curation. That was also a big part of why Apple bought Beats, not just the algorithmic side, but the human side. They had a whole team of human editors and curation team, including people like Trent Reznor --

Lewis: Nine Inch Nails, right?

Niu: Right, exactly, which is kind of crazy, because I grew up listening to Nine Inch Nails and now he's an Apple executive. Which is a funny thing to come full circle on. So, everyone has had this passive radio curation. Spotify and Apple Music both work to make sure they're able to deliver the radio side that basically competes directly with what Pandora has. But Pandora never turned around, until just a few months ago, and expanded into the active side, the on-demand side. So, everyone wants to have both, and Spotify and Apple are working hard to provide both, whereas Pandora did not. It's not really surprising that they're slipping. Whether or not they can turn it around and bring it back, they're really facing an uphill battle, especially in terms of paid subscribers. The recording industry highly prefers paid subscribers, because they don't want people assuming music should be free, just as far as a value perception. And the fact that Pandora is so weak in terms of actually getting people to pay up, it doesn't really put them in a good position with the record labels, either.

Lewis: Right. I think if you're an investor looking from the outside-in here, and you don't have a stake in Pandora, my guidance would be to stay away. [laughs] You basically have this business that's going through a major leadership shake-up, they're scrapping expansion plans, they're focusing on a core product, and like I said, they sold off this performing asset in Ticketfly so that they could build up their cash hoard. Things are really messy at the company right now, and I don't think that's going to change anytime soon. I'm not planning on selling my shares anytime soon, because I think there's a possibility that maybe they get bought at some point, or there's some blip that gives them a little bit of upside, but I certainly wouldn't be buying in now as an investor.

Niu: Yeah, I've never liked Pandora's business model, honestly. And it's not like things have gotten better. [laughs] Like we've been talking about. It's just been getting worse. I would definitely be staying away, too.

Lewis: We talked about Apple Music a little bit before. I thought we should come back to it. There's some news that's recently come out about their cost intentions with the service, and looking to bring things down, maybe make it a little bit more profitable.

Niu: Right. There have been reports that Apple is trying to negotiate lower rates with the record labels. Right now, reportedly, the record labels keep about 58% of revenue, which is easily the largest direct cost associated with the service. Which suggests that it has a gross margin of about 42%. Which is higher than the corporate average, so you can immediately appreciate it there from a profitability standpoint. But if they can get that licensing cost down even more while Apple Music is growing -- because I think that's a big piece of it, because they agreed to pay higher royalties. But if they can grow users, which the industry likes, then they have a better position to negotiate a lower percentage royalty take. And Spotify is supposedly around 55%, and dropped to 52% recently after some negotiation. So, it does seem possible that Apple can get a better deal, provided it can continue to grow subscribers. Both companies are growing pretty well, and they're kind of going in lockstep together. The whole industry is expanding, the industry for paid streaming subscribers is really growing, and Apple Music and Spotify are really driving that. But, as they keep growing, I think they definitely have a good case to take to the record label and say, "We're really helping your industry, give us a little bit of a better break on these royalties." That could definitely help profitability a little bit.

Lewis: We don't talk too much about Apple Music because it's such a tiny part of the company's business. What would this look like, in terms of the segment for them? How big is it right now? You hear that costs could come down from 58% to 55% or 52%. It won't be something that meaningfully moves anything for them, but it's a nice bump, right?

Niu: Right. Alone, I don't think it's a huge thing that's hugely important. But I think Apple Music is going to be a critically important piece to the overall ambition to double the services business over the next four years to about $50 billion. Right now, the services business overall is about $25 billion, and they want to grow that to $50 billion by 2020. There's lots of different levers they can pull to get there. But I think Apple Music is one of the most important ones within that portfolio of services that they're growing, and really putting more focus into.

Lewis: And I think right now, it's a $3 billion business, or something like that. Is that right?

Niu: Yeah, roughly, based on 27 million subscribers at a run rate of about $10 a month, that puts you in about $3.25 billion, roughly. But, obviously, that number is always moving as they're growing the subscriber base, and it's not clear how many people are on individual plans versus family plans. They actually just introduced a new pricing tier for a year-long subscription that gives you a little bit of a discount, it's $100 for a year as opposed to $120 for a year if you pay on a monthly basis. I think that also appeals to the users because they can get a little discount, and for Apple that gives them more visibility because now they have a year-long subscription. So, they definitely have a few things they can do.

Lewis: Still not a needle-mover for the company, but something to keep tabs on.

Niu: Yeah. I think it contributes to an important strategic element. But in itself, it's not a huge thing.

Lewis: I think contributing to an important strategic element is something that might be the best way to describe what we're going to talk about in our next segment on Tesla.

I don't know how to tee this up. I think this is one of the weirder pieces of tech news that I've seen in a little while. Tesla has music-streaming ambitions. Who knew?

Niu: There are reports that Tesla is negotiating with the record labels to get some licensing deals going, which is really weird. Anyone that watched the annual meeting, which was earlier this month, might not have been as surprised because Elon Musk dropped some hints that they would have some announcements later this year for music streaming and matching algorithms, and everyone was like, "What are you talking about?" [laughs] Everyone was scratching their head at the meeting. And, of course, this report comes out a week or two later. It's a very weird -- like, why?

Lewis: Yeah. You think, with so many other things going on, with them bringing SolarCity into the fold, everything that he's trying to do in terms of upping production to meet estimates on what they're going to be delivering for cars, there are a lot of balls in the air over at Tesla right now. It's amazing to me that they want to take on something like media as well. But I don't really feel like betting against Elon Musk.

Niu: Yeah. It seems like it might be a distraction, but at the same time, the whole thing is really confounding, because if the whole point is to come up with better matching algorithms, it's really hard to imagine Tesla doing that better than Apple or Spotify, specifically when it comes to just as far as the matching and the curation. Apple and Spotify have entire teams dedicated to just that, and Tesla does not. Should they really be focusing on that right now? The flip side of this, Morgan Stanley has an analyst, Adam Jonas, who's generally a longtime Tesla bull, he kind of made the case for why this makes sense from a content perspective. He argued that Tesla should be owning the content experience that's coming through their vehicles, which makes some sense, specifically because Tesla is a fan of vertical integration. I think there's a difference, though, because right now, when you say content in a car, primarily that's just music streaming right now. Today, it's just music. Because regulations prevent video playback on a car for entertainment systems, so there's no video in the mix right now.

But if you look longer term, and we start talking about this whole autonomous driving thing, and as regulations loosen and we approach autonomous driving from a technical perspective, then you can see more of a case where the types of content that you'll have in your car will expand. When you're not driving, you're going to want to watch something, once regulations say it's OK, if you're not actually driving at all. So, over time, it does seem like there's going to be more types of content beyond just music, maybe video. And it makes some sense that Tesla would want to own that or control that, or basically be the one that's providing that service. At the same time, it's not like they're going to become Netflix, I hope. [laughs] You could see a case for why it would make sense that they'd want to own more of the content coming through the car, particularly as that content expands in the years ahead. But the timing is hard to reconcile. That's a pretty longer-term goal, because autonomous driving is probably still a few years out, both in terms of technology as well as regulation. So, they have some time to figure this out, so it's kind of like, why are they doing this now when they have so much other stuff to focus on?

Lewis: I guess the thought with Tesla has always been, "Let's get things as ready for the future as possible." They're shipping vehicles that are technically kind of autonomous-ready, it's just that they're not actually functionally autonomous at the moment, and they require drivers. And maybe the media ambitions here are the same, where it's like, we're going to position ourselves for the next 10-20 years now, because we can see this is going to be a major thing. I think, as an investor, you just have to say, this is something that Elon Musk is interested in, and just hope that it doesn't take too much time from him, because they still have a lot of other things to live up to.

Niu: Right, I think that's the crux of it. It's one thing if they're just exploring this, and maybe laying down the foundations for something that's to come later. So long as that's all they're doing, and they're not really putting a ton of energy into this, and it's not distracting them from the more important things, I think it's fine. Hopefully it's just a small little thing that they're like, "Let's go explore this a little bit." As long as they're not letting it distract them, then I think it's probably OK.

Lewis: Who knows, Evan? Maybe 10-15 years from now, your drive down to Texas will be just you sitting in the seat watching Netflix with the kids.

Niu: [laughs] You have to trust Elon. Tesla investors generally trust Elon for whatever he wants to do, so hopefully he can keep delivering.

Lewis: Absolutely. That's certainly been my mindset with the company. That's kind of what you're forced to do at this point, because he's one of those visionary leaders. Anything else before I let you go, Evan?

Niu: No, I think we're good.

Lewis: All right. Safe travels this weekend, hope you have a good time with the family.

Niu: You too.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or you just want to reach out and say "Hey," you can shoot us an email at [email protected], or tweet us @MFIndustryFocus. We love getting questions and comments. It makes our job a lot easier in coming up with ideas for the show. If you're looking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for pinch-hitting behind the glass today. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!