Pandora Media Inc (NYSE:P) announced earlier this quarter that it is putting a cap on the amount of time that their listeners can stream music on their mobile devices. At 40 hours a month, this affects a very small portion of their clientele. However, moves like this are signs of a much larger trend: Pandora’s business model is slowly eroding and beginning to mimic that of Spotify.
A little over a year ago, Swedish music streaming service Spotify began operating in the U.S. Since then, they have grown at a rate that rivals the early days of Facebook Inc (NASDAQ:FB). This is less than a coincidence. Sean Parker, who served as the first president of Facebook Inc (NASDAQ:FB) and is an old friend of Mark Zuckerberg, joined the Spotify team as an investor and board member in 2010, and a strategic alliance with his former employer was announced later that year.
This not only facilitated Spotify’s viral growth in the U.S., but it has enhanced the service tremendously. Spotify and Facebook have come together to make sharing music easy, and thanks to the contracts that Sean Parker negotiated with major record labels, Spotify has a massive catalog for users to choose from.
Unlike the other spam-apps that clutter the newsfeed, Spotify’s feed has been embraced by Facebook users. Most people don’t want their friends and family to know that they spent fifteen hours playing Farmville, but people define themselves by their taste in music, and the songs they listen to on Spotify have become an integral part of many Facebook profiles. Pretentious hipsters, thirteen year old Glee fans, and everyone in between has been warming up to the idea of displaying the music they listen to, as they listen to it, on Facebook.
But is Spotify really in competition with Pandora? Tim Westergren, Co-founder of Pandora Media Inc (NYSE:P) and Chief Strategy Officer, doesn’t seem to think so. In response to investor worries, Tim Westergren has repeatedly stated that he believes Pandora operates in a completely different segment than Spotify. Yet, people use both services on the same devices in the same settings, and for the same purpose — to listen, explore, and discover music.
Spotify even offers a radio feature that operates in a similar, and not necessarily less effective way to Pandora Media Inc (NYSE:P). They both depend on a mix of subscription and advertising revenue, and are both popular among the same demographics. To be frank, if these companies aren’t competitors, I don’t know who is.
Spotify vs. Pandora Media Inc (NYSE:P)
The main differences between Spotify and Pandora Media Inc (NYSE:P) are their marketing strategies, the size and restrictions of their catalogs, the features that they offer exclusively to paying subscribers, and the way that they pay their royalties. In every category except one, Spotify is objectively superior to Pandora.
Marketing
Spotify’s integration with Facebook gives them a substantial competitive advantage in marketing their product that Pandora can’t match (Pandora Media Inc (NYSE:P) has some Facebook features, but not nearly to the extent that Spotify has).
Catalog
Spotify’s massive catalog (20,000,000 songs and growing) offers almost any song you can think of, and allows you to play it as often as you want. Pandora offers only a few songs from each album (1,000,000 in total), and is severely restricted by their licensing requirements.
Users of Pandora Media Inc (NYSE:P) can only skip past several songs and can never restart or go back to an old song. This puts the user at the mercy of Pandora’s algorithms once the limit is reached, and this alone can be enough to send a user elsewhere (imagine an angry student trying to study, screaming at his desktop, “If you play Nickelback one more time…”).
Subscriptions
Since the dawn of the tech boom, internet start ups have made a crucial mistake in the way they price their services. In exchange for rapid growth, they offer things that they paid money to create for free. The dream is that, once they gain a wide enough audience, they will somehow find a way to monetize their loyal clientele by selling ads or by finding things to charge for.
Unfortunately, unless they become a giant staple of the internet that everyone feels the need to go to everyday (Facebook, Google, etc.), it is extremely difficult to generate an adequate return from advertisement alone, and “finding things to charge for” is something that very few websites who began with an everything-is-free business model have been able to successfully do.
The reason is that they spent decades, and millions of dollars in marketing costs, training their users to be extremely price elastic, and when they try to charge even a tiny amount for any part of their website, all of their competitors eagerly soak up the massive exodus of users who are completely unwilling to accept this new cost.
The best internet companies find a way to offer enough of their service for free to facilitate growth, while reserving some of their more valuable features for their paying subscribers, and they do this from the start. The chart below graphs the relationship between the profit and losses of internet companies and the percent of their features that they charge for:
Spotify has walked this line better than almost anyone else. The part of their service that they offer for free is everything a user needs to listen to, discover, and share music on Facebook.Once they have tested out Spotify’s free features and realized how great it is, they can opt to pay $9.99 a month in exchange for the ability to listen to Spotify anywhere, with or without the internet.
The beauty of this deal is that, once Spotify’s songs can be listened to offline, they take on all the characteristics of an MP3, and, at $9.99 a month, anyone who is used to purchasing music at iTunes rates will have a hard time justifying not making the switch to a Spotify subscription. This is the recipe that Spotify has used to create their disciplined and viral customer base.
And then there’s Pandora. The parents who couldn’t say no. Now they are dealing with the harsh economics of a very spoiled user base, and, not surprisingly, advertising revenue just doesn’t seem to cut it. Their subscription offers little more than an adblocker; you still have the skip limit and you still need an internet connection.
With no other options on the table, Pandora has imposed a modest listening limit on mobile devices (mentioned earlier) in an attempt to cap their royalty costs. This is a clear signal that Pandora’s business model needs tweaking and probably a lot of it. As so many other internet companies have found out, there’s only so much tweaking you can do before your customers take their business elsewhere, and this leaves Pandora in their current predicament. Que the execs jumping ship. CEO Joseph Kennedy announced his plans to retire earlier this year.
Licensing
Some might say that this is the catch 22 of all the things about Spotify that seem too good to be true and, to be honest, the deals that Sean Parker managed to work out with the major labels seem like something Kevin O’Leary would offer an greedy entrepreneur on Shark Tank as a joke.
The exact figures have not been disclosed, but it is rumored to look something like this: every year, they pay the major labels a predetermined amount (in the hundreds of millions) or 70% of revenue, whichever is greater. Some of Spotify’s equity was also given to the major labels (you know, just to sweeten the deal). Although this seems excessive, it aligns the interest of the labels with that of Spotify, which is essential to the survival of a company that is more or less at their mercy.
Pandora went the typical radio route, forgoing direct negotiations with label execs and accepting the standard per song royalty rates. With this came their burdensome restrictions.
One of the biggest differences between these two deals, beyond the obvious freedoms that Spotify’s method provides, is that Spotify’s costs vary with revenue while Pandora’s vary with play count. Since Pandora’s revenue doesn’t necessarily increase when more songs are played, there is a distinct possibility that their users will play more songs than they can sell ads and send them deep into the red. While Spotify’s deal isn’t pretty, they don’t have to worry about teenagers leaving their playlist on repeat all summer and running them out of business.
The future of Pandora Media Inc (NYSE:P), Spotify, and internet radio
Pandora and Spotify aren’t the only players in this sector. Apple Inc. (NASDAQ:AAPL)‘s iTunes has long dominated online music sales and is now rumored to be creating their own radio feature. Considering the amount of bright minds at Apple Inc. (NASDAQ:AAPL) and their track record for innovative products, Pandora investors should consider this a serious threat.
Sirius XM Radio Inc (NASDAQ:SIRI), although not quite an internet radio company, has carved out a substantial chunk of the mobile market that Pandora and Spotify have focused so much of their attention and resources on, and has done something that neither of them has been able to do: make a profit.
And then, there’s the myriad of websites that Pandora has successfully out competed for the past decade. Last.fm, 8track, Grooveshark, and more, have all maintained a modest share of the market and would eagerly soak up any orphaned demand caused by Pandora alienating users with new fees.
As this sector becomes more and more crowded, the winners will be separated from the losers by their ability to grow their user base while adding to their revenue. Spotify has matched its explosive growth in users with an equally impressive growth in subscribers. As a result, it’s becoming easier and easier to imagine a world where monthly Spotify subscriptions are the new normal way to listen to music, finally replacing both overpriced MP3 downloads and the notorious torrent with a service that generates real revenue for all the rights holders.
The article Pandora: The Road to Obscurity Is Paved With Price Increases originally appeared on Fool.com and is written by Joseph Orsi.
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