Apple Planning Pandora Rival: Is Web Radio Ready for Prime Time?

Apple's interest in launching a web radio service represents a threat to market leader Pandora, but it also validates the huge potential for streaming music.

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They’re the most terrifying words in tech, as AllThingsD‘s John Paczkowski observed on Friday: “Apple is entering your market.” One can only imagine what went through the minds of Pandora founder Tim Westergren, CEO Joe Kennedy, and colleagues, when news emerged via The Wall Street Journal that Apple is in talks with the major record labels about launching a streaming music service. (Existential dread?) Web radio is a tough-enough business as it is: Despite its huge popularity, Pandora is not profitable, in part because of the massive royalties it must pay the labels and other rights-holders to stream songs. If Apple enters the space, Pandora’s already-uphill battle to make money could become more difficult. Pandora shares fell nearly 17% on the news Friday.

For Apple, moving into web radio makes sense — but this is not about money for the tech titan, at least not in the short-term. In fact, Apple could launch a streaming music service tomorrow that loses $100 million a year, and the Cupertino, Calif.-based behemoth would barely notice. Let’s recall that Apple has booked over $50 billion in profit over the past 12 months. Pandora, needless to say, does not have that luxury. Over the last year, the company has lost nearly $30 million on $340 million in revenue. (Given Pandora’s $1.75 billion market value, Apple, with over $100 billion in cash reserves, could absorb the web radio company for breakfast and still be ravenous by lunchtime.)

For Apple, launching a streaming music service is about adding another piece of the puzzle in its quest to control the digital media ecosystem, as CNBC’s Jon Fortt noted on Friday. From music to movies and TV shows, to smartphone and tablet applications, to e-books and even digital magazines and newspapers, Apple’s strategy has been to build a digital environment in which the user feels intuitively comfortable conducting transactions. Apple has had more success in some of these areas, like iTunes, than others, like Apple TV. (That’s because the companies that control the rights to broadcast and cable TV shows have little interest in helping Apple create a viable alternative to the traditional, bundled cable TV scheme, as Pacific Crest’s Andy Hargreaves observed recently, via Fortune‘s Philip Elmer-DeWitt.)

(MORE: Pandora’s Sour Tune: No Profit For a Year, Tumbling Stock)

In a clear indication of Apple’s ecosystem-based approach, the new streaming music service would work on all of Apple’s familiar products, like its Mac desktop computers, and well as the iPhone and iPad. But it would not work on Google’s Android mobile operating system, according to The Journal‘s report, which cited people familiar with the situation. If Apple’s web radio service is successful, it could be a strong motivator for consumers to eschew Android devices in favor of Apple’s family of iOS products. And that is the name of the game: Apple is, after all, in the hardware business.

For over a decade, the major record labels and the top technology companies have been fighting for advantage as the music business undergoes a grinding transition into the digital age. The labels used to consider Apple their bête noire, but those days are over, as Peter Kafka observes. That’s why the labels might be amenable to Apple’s apparent desire to strike individual licensing deals that will grant users more flexibility than the generic, industry-wide compulsory licenses utilized by Pandora. Such enhanced flexibility and features — for example, allowing users unlimited listens of a given song, something that’s curtailed under Pandora’s current licensing scheme — could give Apple’s service an advantage over its competitors.

For Pandora, news of Apple’s desire to get into web radio, while likely alarming, isn’t all bad, as Wall Street blogger “Downtown” Josh Brown noted on Friday. For one thing, Apple’s interest in the space validates Pandora’s model. In other words, Apple wouldn’t even be exploring web radio if it didn’t think the market was now worthy of its participation. In short, Apple’s apparent desire to get into streaming music suggests that the web radio space is finally ready for prime time. “The mere fact that Apple is discussing this business underscores the value of the Pandora platform,” Stifel Nicolaus analyst Jordan Rohan wrote in a note to clients. For another, web radio need not be a zero-sum game. This huge market has the potential to accommodate several players. As it is, in addition to Pandora, there are several other buzz-worthy players in the space, including Spotify, which recently introduced radio-like features, Slacker, and Clear Channel’s iHeartRadio. Then there’s Songza, a mobile application that delivers playlists based on your mood, which has attracted a significant amount of buzz in recent months. And let’s not forget Sirius XM, the satellite music leader.

(MORE: How the Business of Streaming Music Will Change Culture…For the Better)

Wall Street analyst reaction to news of Apple’s interest in web radio was mixed. Citigroup’s Mark Mahaney issued a note calling the report a “negative” for Pandora. He expressed surprise at the news, “given the trouble that mobile-first services such as Pandora have had monetizing mobile usage, and the high percentage of revenues that are must be paid back to record labels in the form of royalties. Said another way, we didn’t expect Apple to find the ad-supported, radio streaming market to be interesting enough to warrant pursuit.”

On the other hand, Pandora does have some advantages, specifically its estimated 75% market-share of the web radio space. The company also has deals with over a dozen automakers, including BMW, Ford, Honda, and Toyota, to provide in-dash functionality. Michael Pachter at Wedbush Securities is taking a wait-and-see approach, writing: “We believe Pandora holds certain key competitive advantages that should limit market share losses, at least in the near-term, upon the launch of Apple’s service.” He’s maintaining his “outperform” rating on Pandora shares, “until we learn more about the features and timing of the Apple music service.”

Pandora has spent a decade working to become the web radio leader by building on top of its original platform, the Music Genome Project, which pioneered music recommendations based on taste. In digital music, it’s all about “discovery” — finding new music. Apple’s efforts in this area, specifically its “Genius” iTunes integration, haven’t been as successful. So why doesn’t Apple just buy Pandora, instead of diverting attention from its core products to confront a much-smaller company with a dominant market position? After all, Apple’s market capitalization fluctuates on a daily basis up and down more than Pandora’s entire valuation. Apple could buy Pandora for a couple billion dollars tomorrow. But that’s not the Apple/Steve Jobs-style. Apple is not the acquiring-type — especially not big consumer-facing Internet companies like Pandora. Steve Jobs preferred to build his own technologies in-house, and although Apple could swallow Pandora and not even notice, there’s little reason to believe that Apple doesn’t think it can build a better service — and negotiate more favorable licensing deals — than Pandora.

Ultimately, Apple’s interest in web radio is a positive development for consumers. Users want to access music when and where they choose, across their devices. In 2012, the technology exists to create a giant library of all extant music in the cloud, accessible anywhere. Choose your business model: ad-supported, subscription-based — there need not be one answer. For years, the major record labels have been fighting the future, hoping to preserve a 20th-century business in the face of technological disruption. It’s high time the labels get with the program and start thinking about satisfying the consumer, not preserving an entrenched and crumbling legacy business model. Streaming, web-based music is the future, and Apple’s interest in the space validates that. Since the beginning of its renaissance 15 years ago, Apple has delighted millions with its products and services. Just imagine what it could do for web radio.

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