September 10 marked Apple's (AAPL +0.00%) official product announcement of two new iPhones, the 5s and the 5c. While many articles have been written about the hardware, few have concentrated on the newest software updates; iOS 7's effects on the greater landscape should not be underestimated, and, in one case, may change the value proposition of one company.
Pandora should be afraid
Pandora (P +0.00%) has a relatively simple business model -- it receives revenue dollars from advertisers for the right to broadcast ads in-between songs. For the fiscal year ended Jan. 31, this was 88% of the top line, and will continue to be the company's main revenue source.
The company's main expense is the cost of content; this is what they have to pay to stream that new Lady Gaga hit to your smartphone or desktop. This expense grew from around $70 million in 2011, to nearly $260 million in 2013. It now accounts for a whopping 61% of total revenue, up 10 percentage points from 2011.
Revenue growth has been phenomenal, but unfortunately, has been outpaced by content acquisition costs.
Pandora is a company that is growing revenue at a very healthy clip; however, these gains are being more than offset by the cost of content. Pandora's new CEO, Brian McAndrews, needs to focus on continuing to grow revenue, lowering content costs, or some combination of the two. Pandora appears to be focused on lowering content costs by its insistence on the Internet Radio Fairness Act, and recently scored a victory that could potentially pave the way toward lower royalty rates. However, one thing Pandora always had going for it was its market-leading position.
Enter the 800-pound gorilla
iOS 7 has the potential to change this. In addition to the high-optics hardware upgrades (5c's colored case, fingerprint scanner, etc.), Apple finally rolled out iTunes radio with a better value proposition at both the free and ad-free versions than Pandora. The ad-free version is free with a subscription to iTunes Match ($24.99 per year) -- which includes storage for up to 25,000 songs.
Also, iTunes radio is built into the iOS, and feels more intuitive. It is easily accessible from the music icon on your phone. And that is important; while there will be some switching costs due to users being accustomed to Pandora's algorithms and stations, many iPhone users (particularly ones with iTunes Match) will make the migration quickly, weighing on revenue for Pandora.
Apple doesn't have to win here...
It's important to look at Apple's motivation. Apple doesn't have to win here. Matter of fact, Apple is looking to create a "stickier" user experience and to bolster its fast-growing iTunes software and services unit that grew 25% year over year last quarter. iTunes radio should increase revenue from this unit, both directly by increased purchases of iTunes Match for commercial-free radio, and indirectly by users purchasing songs through the iTunes Match interface.
... but Pandora does
Pandora is a pure play on Internet radio -- it does one thing, which is currently unprofitable. Increased competition from a competitor that has 20 times its market capitalization in cash, and can afford to pay more for content, makes for a worthy competitor. Pandora is aware of this; the company announced it will issue more shares -- hopefully netting $280 million. The question is, will this be enough?
