Here Comes iTunes Radio, Threatening to Shake Up Music Streaming

Apple's iTunes Radio is a very dangerous monkey wrench that could unravel plans by Pandora and Spotify for long-term growth and profitability

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Josh Edelson / AFP / Getty Images

Several famous musicians, including Radiohead’s Thom Yorke and members of Pink Floyd, have recently made news by complaining about how little money artists make from Internet radio platform Pandora and on-demand music-streaming service Spotify. What often gets overlooked, however, is that these companies aren’t making much money themselves. Music-streaming companies routinely lose money in the here and now, even as analysts and investors continue to believe they have long-term potential for growth and profit.

But on the horizon is a new entrant that threatens to snatch away that potential just as it begins to seem within reach: Apple’s iTunes Radio.

Apple’s first foray into music streaming, which has already received a beta release and could get a launch nationally in the U.S. as soon as September, is worrisome for Pandora and Spotify for lots of reasons. Not only is Apple the world’s largest music retailer, the tech giant’s aims in establishing a streaming service appear entirely different from — and potentially damaging to — their own.

Until now, Apple has been content to sell digital tracks and albums to its customers. Now the company wants a piece of the increasingly popular music-streaming sector, in which Spotify and Pandora have carved out very successful niches. Pandora’s Internet radio service, powered by data collected about user listening habits and a team of music analysts, has exploded in popularity in recent years, doubling its number of active users to 70 million since 2011. Meanwhile Spotify, which allows users to play whatever songs they choose, has seen extensive growth since its launch in the U.S. that same year, and now boasts 24 million active users worldwide.

More users have not yielded more profits, though. Spotify’s annual losses are mounting as the company expands, coming in at $78 million in 2012, according to the New York Times. Pandora has yet to find a path to profitability, and posted a net loss of $38 million in the last fiscal year. The biggest expense for both companies is, unsurprisingly, music. Spotify pays almost 70% of its revenue to music-rights holders, while Pandora spent about 60% of its revenue acquiring music last year.

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“As users go up, licensing fees go up,” explains Catherine Moore, associate professor of music business at the Steinhardt School of Culture, Education and Human Development at New York University. “That’s almost the opposite of getting economies of scale, and that’s an inherent problem when you have to license the content.”

The companies are addressing this issue in different ways. Spotify is aiming to lure in more paying subscribers, imposing a 10-hour-per-month limit in many markets on the free version of the service, which is supported by advertising. The company has emphasized that it is still in a growth phase, with CEO Daniel Ek claiming that Spotify could be profitable today if not for its commitment to expansion. Many of its costs are associated with an aggressive rollout into more countries and plans to hire considerably more staff.

Meanwhile Pandora, which has been around much longer than Spotify, is focused heavily on advertising, and has been aggressively trying to expand that revenue source. The company is betting big on mobile ads as its greatest opportunity for growth. Right now it earns roughly double the revenue from desktop listening compared with listening on smartphones and tablets, but the vast majority of users have shifted to mobile use. It’s also aggressively expanding its sales staff in individual cities to compete against terrestrial radio stations for local advertising dollars. Getting Pandora into more cars is another priority, as Americans do about half of their radio listening there. One third of vehicles sold in the U.S. this year will come with Pandora preinstalled, the company says.

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If Pandora can crack the code on mobile and continue expansion to more vehicles, analysts say profitability could be around the corner. “I think they’re on that track,” says Aaron Kessler, a Pandora analyst at Raymond James. “For them it’s more about monetization and higher sell-through rate than it is that their model doesn’t make it profitable.”

Even if Pandora’s business model is sound, both it and Spotify will soon be going up against a foe that faces few of the same economic pressures. Unlike its smaller competitors, Apple’s iTunes Radio plan doesn’t appear to be aimed at generating big profits — not directly, anyway. The service, which will function like Pandora, seems to be aimed squarely at keeping users consuming music through Apple services on Apple products, instead of venturing away to other popular upstarts. The original iTunes Store began for similar reasons as a way to sell iPods, and the App Store was initially a tactic to sell iPhones.

“Music streaming is one of many elements Apple is attempting to tie together so that it can have the most comprehensive entertainment offering in the industry,” says Bill Kreher, an Apple analyst at Edward Jones. “The addition of iTunes Radio enhances the overall ecosystem.”

Unlike Pandora, which is automatically able to play all commercially available music by paying a rate set by federal law, Apple is negotiating contracts with individual record labels. This has allowed the company to offer higher royalties than Pandora to independent labels, according to documents obtained by the Wall Street Journal, suggesting that quick profits are not a top priority.

And while Pandora and Spotify had to build their user bases from zero, iTunes Radio will be immediately available to millions of users who download iOS 7 for their iPhones and iPads this fall, or update iTunes on their desktop computers. “It allows Apple instant scale,” Kreher says. “When the company released iCloud, they very quickly had over 100 million registered users.”

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Apple comes stocked with a powerful set of advantages, but there’s no guarantee they’ll slow the growth of Pandora or Spotify, which have established strong brands and loyal fan bases. Pandora, in particular, has shown resilience against much larger competitors. They’ve so far warded off tech giants like Yahoo and traditional radio behemoths like Clear Channel Communications. “We continue to be the only company that’s laser-focused on reinventing radio,” says Pandora chief technology officer Tom Conrad. “You’re just not going to see any of the other participants going at this with the same singular focus that we bring to the table.”

Still, the entrance of a company as synonymous with music as Apple no doubt presents challenges. Thanks to the ubiquity of Apple products, iTunes Radio will introduce music streaming to a whole new audience. Exactly which company will benefit most from this shift in the way people consume music remains to be seen. “Through it all we’ve expected competition,” Conrad says. “Out there in the real world, listeners are going to decide with their ears which service they want to spend time with.”