Why The Subscription Business Is Important For Pandora And Where Is It Going?

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Pandora Media (NYSE:P) earns the bulk of its revenues through advertisements by providing ad-supported free music to its users. However, with burgeoning content acquisition costs and sales & marketing expenses, the need for an alternate sustainable revenue source has arisen. This is where Pandora’s subscription based music service comes in. Though less than 5% of Pandora’s users pay for its ad-free services, the subscriber count has grown rapidly over the past five years. Going forward, we believe that the company will look to increase the subscriber penetration rather than overall user base, so as to partially offset the impact of the upcoming rise in royalty rates.

There are some factors that can help Pandora increase its subscriber base. The company can reintroduce the listening cap on its music at some point of time, but there is significant risk involved given the highly competitive nature of the music industry. Expansion in Australia and New Zealand is one area where the company can leverage the lack of competition to sell more subscriptions. Also, the continued increase in smartphone sales in the U.S. can help Pandora improve its subscriber penetration rate to an extent.

Our price estimate for Pandora is at $21, implying a premium of about 15% to the current market price.

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Subscription Business Is Much More Productive Than Ad Business

Given that Pandora pays royalties on per performance basis, growing overall user base will just increase its streaming hours and subsequently, content related expenses. And if the company is not able to monetize the increase in the user base effectively through advertisements, it can easily aggravate its losses. Since increasing the user base is imperative for Pandora as it helps in attracting more advertisers, the only way out of this predicament is to increase the proportion of subscribers in overall user base. The subscription based business is much more productive for Pandora than the advertising model. Over the last four years, Pandora’s paying subscriber count has increased at an average annual rate of almost 60%. During the same time, penetration rate of subscribers has gone up from 2% to 4.2%. While subscribers account for a very small proportion of Pandora’s overall user base, they contribute over 20% to its net revenues.

p user basep revenue breakdown

While it is evident that growing subscriber penetration will to a world of good for Pandora,  it will not be easy for the company to convince free users to pay for ad-free music. The music streaming industry in the U.S. is highly competitive with a number of ad-supported and subscription based services such as Spotify, Sirius XM, Google Play Music and Apple Music competing to reach users’ ears. And Pandora does not have much of a competitive edge over its counterparts, given its comparatively weak content. In fact, most of Pandora’s users do not mind commercials at the beginning of the session, as long as the service is free. Hence, growing subscriber base relative to its overall user base will be an arduous task for the company.

 Factors That Can Help Subscriber Growth

Probable re-introduction of listening cap: In early 2013, Pandora introduced a cap on free mobile listening, wherein mobile users could listen up to 40 hours of free music every month and had to pay $0.99 to continue listening for the remainder of the month. The listener hours cap encouraged customers to sign up for Pandora’s subscription service, and the subscriber count increased a staggering 83% in 2013 to 3.3 million. The company removed the cap in September 2013 as it started making some progress on cost control, which brought down the rate of increase in number of subscribers to just 9% in 2014. However, the re-introduction of the listening cap is very much possible given that royalty rates are bound to increase next year, and Pandora can lose control over its expenses. Nonetheless, given that competition has increased considerably over the past year, the Internet radio company will have to carefully assess this option as it can easily drive users to other free services.

International expansion: Pandora launched its service in Australia and New Zealand in 2012, where it hit the landmark of 2 million subscribers in less than two years. We expect the company to target additional markets in the coming years, most probably English speaking nations, where it can use its existing content. This geographical expansion in countries where competition is not as intense as in the U.S. can fuel the growth in paying users for Pandora.

Growth in mobile devices:  The number of smartphone users in the U.S. increased 13% in 2014 and they are expected to grow at a compound annual growth rate of about 8% through to the end of 2018 to reach 220 million. [1] This represents a significant opportunity for a number of mobile apps to increase their respective user base. Pandora, being one of the most popular apps downloaded on iPhones, Blackberry, Android and Windows mobile, can benefit from this rise. As the smartphone market grows, there will likely be a direct positive impact on paying subscriber growth.

Automobile deals: Pandora has struck deals with world’s leading automotive manufacturers, to provide its services in their cars. In the middle of last year, the company’s vice president of strategic solutions, Heidi Browning, stated that about 135 models from 26 different automobile makers coming out in 2014 would have pre-installed Pandora services. This figure was roughly one-third of all the new models of 2014. The 2010 deal with Pioneer and subsequent deals with automobile manufactures such as BMW, Chevrolet, Ford, Mercedes-Benz, GMC and Lincoln are expected to push Pandora’s subscription penetration higher.

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Notes:
  1. Smartphone users in the U.S., Statista []