Why Is Spotify More Valuable Than Pandora?

Image source: Getty Images.

In the music industry, and perhaps all of tech, there may not be a better example of divergent paths than those of Pandora (P +0.00%) and Spotify.

Spotify's ascent as the most used digital-music service in the world has paralleled a similar increase in its private market valuation. As of its most recent round of fundraising, Spotify's valuation now sits at an impressive $8.5 billion.

Then there's Pandora. The online music pioneer's market cap peaked at slightly more than $7.5 billion in early 2014, only to see its stock plummet since then by roughly 75%. Today, Pandora's market capitalization stands as a mere fraction of Spotify's most recent private market valuation. So why is Spotify more valuable than Pandora?

Pandora's business model as a hurdle

Though they perform similar services, the differences between business models and geographic markets are the two most significant factors driving the multibillion-dollar valuation gap between Pandora and Spotify that exists today. These differences, as you'll see, are incredibly important.

Pandora operates as what's called a "passive" radio service. Like terrestrial AM and FM radio stations, Pandora users select a station, and its music-selection algorithms handle the business of selecting the rest of the songs. Since it largely operates like a radio station, Pandora is able to have its rights set by the same government entity that determines the royalty rate for the entire industry -- the Copyright Royalty Board (CRB).

This status has benefited Pandora by allowing it to pay lower rates than those the music industry has sought. However, relying on CRB rates in the U.S. has historically hampered Pandora's ability to secure international streaming rights from most major labels. This strategy is the reason Pandora operates in only four markets globally -- the U.S, Australia, New Zealand, and Canada -- while Apple (AAPL 1.68%) Music  and Spotify, which negotiate their streaming rights directly with music publishers, are largely available worldwide.

Pandora has made efforts to mend its relationship with publishers ahead of the planned debut of its on-demand streaming service. However, with Apple Music and Spotify so far ahead of Pandora, not to mention Pandora's stagnant user growth, the odds of success in this uphill battle seem increasingly remote.

It isn't necessarily all bad news for Pandora, though.

Subscriptions > Ads

At the same time, Pandora's assumed shift toward the on-demand, subscription-based model Apple and Spotify favor at least gives the company a fighting shot at eventual profitability. Look at the difference in average revenue per user (ARPU) between Spotify's two subscriber tiers and Pandora for the calendar year 2015.

Sources: author's calculation from Pandora investor relations and Music Business Worldwide. 

Though it offers both subscription and ad-supported tiers, 80% of Pandora's revenue comes from its free, ad-supported product. Especially when taken in content with Spotify's APRU from its free business, the takeaway is clear -- subscription streaming products are more lucrative than their ad-based brethren.

As such, Pandora's virtually given move to add its own subscription-based, on-demand product from the remnants of Rdio it bought last year should help significantly bolster its top-line growth.

The downside is that Pandora is late to the party in doing so. Apple Music has 13 million paying users, and Spotify has some over 30 million paid subs. What's more, Amazon.com will also reportedly launch its own on-demand streaming service in the coming months, adding another highly capable competitor to an increasingly saturated market for streaming services.

Pandora will assuredly convert some portion of its 89 million total users when it launches its eventual on-demand streaming product, most likely later this year. However, given the first-mover and scale advantages Spotify is carving out for itself, the valuation gap between Pandora and Spotify appears relatively justified.