Many investors including myself have questioned Pandora's (NYSE:P) business model. This terrific service offers everyone free radio from their favorite artists anywhere they have a connection to the Internet. The problem is, Pandora has to pay every time a track is played so literally the more the service is used, the more expensive the business is to operate. However, just as the company seems to be getting on track (pun intended) the long-term prospects for the business are doomed.
"Imitation is the sincerest form of battery"
In his books "Beating the Street" and "One Up On Wall Street," one theme of Lynch's was consistent, he preferred companies with near monopolies to ones that had to fight in the hottest industry. Aside from online video streaming, there might not be a hotter industry than streaming music.
With companies like Google (NASDAQ:GOOGL), Apple (NASDAQ:AAPL), and others like Spotify and Microsoft all getting into the streaming music business, the field is getting crowded indeed. Even with this massive crush of competition, it seemed like Pandora was beginning to turn a corner.
In the company's last quarter, Pandora reported that total revenue grew by 50%, while cost of revenue increased by 34%. This is a huge win for the company as it means Pandora actually grew the top line faster than the cost to produce this top line growth. While the company's overall expenses did grow faster than revenue, the remainder of this cost growth is controllable items like marketing, SG&A, and other items.
With over $400 million in cash and investments, it seems like Pandora is moving in the right direction. With a listening base of nearly 71 million active users, Pandora is growing and could be on the verge of consistent profits right?
Bigger, better, more value
There are a few certainties in this war that Pandora is fighting. First, its competition has more resources. In the last few months, Pandora's improved performance still led to negative core free cash flow of about $3 million.
By comparison, in the last three months, Google generated over $1.3 billion in core free cash flow (net income + depreciation-capital expenditures). Where Apple is concerned, in the last year the company generated an average of almost $3 billion in core free cash flow each month. To say that these companies can outspend Pandora is a vast understatement.
Where Google Music and Apple's iTunes Radio are concerned, both services arguably offer better options, with more value than Pandora can offer. Google Music offers the storage of up to 20,000 tracks for free, which is something Pandora doesn't offer at any price. iTunes Match offers the storage of 25,000 tracks for $24.99 a year, which is the equivalent of $2.08 per month. By comparison, just to get rid of ads and get better audio quality Pandora requires $3.99 per month or at least $3 a month if you pay $36 for an annual fee.
The fact that Google Music offers radio with unlimited skips for $9.99 is more expensive than Pandora, but when you combine the music storage that Pandora can't match, and unlimited ad free listening, this actually is a very good deal. Apple's iTunes Match is arguably a much better deal than Pandora because of the 25,000 song storage, plus unlimited ad free radio. In addition, Apple offers iTunes Match songs at a higher quality audio than Pandora's One service.
The bottom line is, between Google Music and iTunes Radio with iTunes Match, these offerings are significant competitors to Pandora, but surprisingly these may not be the biggest threat to the company.
How do you compete with this?
It's one thing for Pandora to worry about Google Music or iTunes Match, but a bigger worry might be new offerings and the renewal of offerings by other competitors.
One newer competitor is the upcoming Beats Music. This service appears to only be for AT&T customers, but with the Beats name backing this business, this company could be a thorn in Pandora's side.
A much bigger worry for Pandora should be the recent changes to the Spotify business. Side by side, Pandora looks like a very weak substitute for Spotify at this time. Pandora offers free radio stations on multiple devices. Spotify offers the same service. The difference at this point is, Spotify offers free shuffle play of any artist, album, or playlist on any mobile device for free. In addition, on tablets and computers, Spotify offers the play of any track in the catalog for free at any time.
With significant competition from Google and Apple, Pandora already has its hands full. Though Beats Music might be a thorn in Pandora's side, Spotify's offerings seem to be a large sword that could cut Pandora straight down the middle. Just as Pandora seems to be turning a corner, its competitors could cause this company's new beat to start skipping tracks.