Apple Inc (NASDAQ:AAPL) has played a key role in Pandora Media Inc (NYSE:P)‘s fortunes in recent weeks. Last Tuesday, when the tech giant held its much-anticipated product release show, shares of Pandora popped over 8% because Apple execs did not mention a new streaming media service they are rumored to be working on. Just two days later, however, when new reports from Bloomberg had surfaced that Apple Inc (NASDAQ:AAPL) “has intensified talks with major music labels to start an advertising supported streaming-radio” service by early 2013, shares Pandora fell a whopping 11.7% between 3PM and 4PM on October 25th.
While the source of this information remains with Apple, but anonymous to the world, it only confirms the pattern of behavior that we’ve seen from the company over the past few months. On September 30th, Apple Inc (NASDAQ:AAPL) officially shut down Ping, its iTunes enabled music-centric social network, less than two years after it had been released to the public. The late Steve Jobs originally announced Ping in the fall of 2010, describing it as “a social network for music, sort of like Facebook and Twitter meet iTunes.” The service never caught on like the company had hoped, though, likely because sharing options were limited to iTunes media previews, and full songs only if users had purchased them. Another issue with Ping was its lack of Facebook Inc (NASDAQ:FB) and Twitter integration, which limited the network’s reach from the start.
With Ping’s closure, it makes perfect sense that Apple Inc (NASDAQ:AAPL) is looking for a new way to drive digital music sales on its iTunes platform. As streaming radio services like Pandora, Spotify, and Songza begin to give listeners other options besides directly purchasing their favorite tracks, Apple understandably suffers. That’s where the company’s new streaming music platform comes in. Described as a Pandora-killer by bears, Apple Inc (NASDAQ:AAPL)’s new service is expected to give users more flexibility than its peers, as the company is in the process of signing friendlier licensing arrangements with music labels. While Pandora employs the usage of a “compulsory license” that allows a specific number of track plays, Apple is seeking a way to provide unlimited selection – more similar to Spotify – with exclusive first access to newly released songs.
The real reason why Pandora investors are skittish over rumors of an Apple Inc (NASDAQ:AAPL) led competitor, though, is because of the company’s reach. Apple’s iTunes currently has over 400 million credit card-linked accounts, which is more than twice the size of Pandora’s total user base, and close to twenty times larger than that of Spotify. On the bright side, it appears that many music lovers have made the conscious decision to choose Pandora over Spotify, even with its Facebook connectivity.
Take, for instance, this trio of statistics, which were taken from Pandora’s audience metrics press release in September:
1) Listener hours for Pandora during the month of September 2012 were 1.15 billion, an increase of 67% from 687 million during the same period last year.
2) Share of total U.S. radio listening for Pandora in September 2012 was 6.53%, an increase from 4.03% at the same time last year.
3) Active listeners were 58.3 million at the end of September 2012, an increase of 49% from 39.0 million during the same time period last year.
Despite increased competition, the number of people using Pandora at least once a month is growing quite significantly, and more importantly, listener hours are expanding at a quicker rate. In short, this means that existing users are finding Pandora’s product more enjoyable over time. Most likely, this augmented engagement is a result of the company’s efforts to fine-tune its Music Genome Project algorithm, which is now weighted more heavily toward mainstream artists. While indie-loving listeners may hate these changes, Pandora executives have stated that “the majority like the changes,” and the numbers don’t lie. If Apple Inc (NASDAQ:AAPL) takes a foothold in this industry, though, things may change, and rather quickly.
Assuming Apple Inc (NASDAQ:AAPL) works out its licensing deals by the spring of next year, and launches a streaming music service in mid-2013, the company’s 400 million-plus iTunes user base would instantly become part of the picture. As the company’s iTunes 11 with Facebook integration will likely be in full swing by this time, initial engagement of Apple’s new service is expected to be exemplary. It remains clear that Apple Inc (NASDAQ:AAPL) will want to use its new streaming music service as a way to drive digital music purchases, and will leverage its existing iTunes user base, just as it did with Ping. If this is the case, Pandora will no longer be the largest player in the streaming radio space, and should no longer be valued as such.
At the present moment, shares of Pandora trade at a price-to-book ratio of 14.8X, over four times that of the radio broadcasting industry average (3.4X), and above peers like Sirius XM Radio Inc (NASDAQ:SIRI) at 2.7X, and Cumulus Media Inc. (NASDAQ:CMLS) 1.0X. Sales multiples show a similar premium, as Pandora sports a P/S ratio nearly twice the level deemed “normal” by its peers. Just for comparison, though they are far from direct, Apple Inc (NASDAQ:AAPL) trades at book and sales premiums of 8.5% and 100.0% respectively. Facebook, meanwhile, trades at a book value parity to its industry average, and a sales premium of 143.1%.
In terms of earnings growth valuation, which are more comparable across industries, Pandora is valued at a PEG ratio of 13.1, based on five-year expected EPS forecasts. Direct peer Sirius XM trades at a much lower PEG of 0.2, while Apple Inc (NASDAQ:AAPL) and Facebook trade at PEGs of 0.7 and 9.3 respectively. Typically, any PEG ratio above 2.0 signals an overvaluation, while any figure below 1.0 signals an undervaluation. No matter how you slice it, Pandora is expensive, despite its continued selloff.
In its most recent earnings report, Pandora impressed Wall Street with better than expected revenues, which totaled $101.3 million in the second quarter, an increase of 51% year over year and close to $1 million above consensus. Interestingly, the company did report a net loss of $5.4 million on the heels of higher content licensing and advertising costs, but investors didn’t bat an eye, pushing the stock to a double digit one-day gain after the Q2 release. Just as a side note: Apple Inc (NASDAQ:AAPL) is expected to face lower content licensing costs, as it already has existing relationships with labels via iTunes.
With that being said, it appears that Pandora is a stock that has been driven by its potential, not profitability. In this company’s case, its “potential,” so to speak, is measured by revenue and user growth statistics. As the threat of Apple Inc (NASDAQ:AAPL) looms, it is understandable why investors are worried about Pandora’s growth if the company becomes second fiddle. While there is no way to officially discern just how many users Apple could potentially take from Pandora, it also remains a viable concern. After all, it’s likely that a significant fraction of iTunes’s 400 million user base also maintains accounts with Pandora, and could easily switch over to Apple Inc (NASDAQ:AAPL)’s radio service when it comes online.
Thus, Pandora faces a two-headed threat: 1) the loss of its top spot – in terms of users – in the streaming music radio industry, and 2) switchover risk within its current user base. Both of these issues are likely what’s pushing Pandora down in the wake of Apple Inc (NASDAQ:AAPL)’s rumored entry into this space, and its not promising that shares of the company also trade at quite the premium valuation. As the tech giant releases more concrete details about its potential Pandora-killer, investors can expect the stock to continue to fall toward a fairer valuation.
Interestingly, Pandora has seen a number of insider sales in recent weeks, with many officers choosing to opt out of holding their company’s shares entirely. For a complete look at this situation, continue reading here on Insider Monkey.
