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The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.
According to the Wall Street Journal (“WSJ”), Apple (NASDAQ:AAPL) is currently in discussions to license music for a service similar to Pandora (NYSE:P). The competing service would work only on Apple devices (iPads, iPhones, and Mac computers) and potentially Windows PCs, but not Google (NASDAQ:GOOG) Android devices. Discussions with record labels have only recently been re-initiated, and it could take months before a launch. We do not expect the Apple service to be unveiled at the September 12 event widely expected to be the iPhone 5 unveiling. Apple reportedly has ended free service discussions in the past over content acquisition costs, which accounted for ≈ 60% of Pandora’s revenue last quarter and have severely impacted its profitability.
Also according to the WSJ, Apple is negotiating its own licensing deals for the new service to offer greater interactivity than the compulsory licenses used by Pandora and others. For example, when we initiated on Pandora shares last year, we noted that users are unable to rewind a song and have limited skips (six per hour, or twelve per day for free service listeners). In addition, Pandora cannot play more than four songs credited to an artist name in a three-hour period. We believe Apple could try to take share from Pandora through greater flexibility around song selection or skips, among other items.
We believe that creating a free service makes sense for Apple and benefits the record labels due to unparalleled cross-selling opportunities. Due to the dominance of iTunes and the depth of integration with Apple devices, we envision that an Apple Internet radio offering would allow users to purchase and download songs during play on Internet radio virtually instantaneously. Apple has a well-deserved reputation for integrating software well with its devices, and we expect the company to integrate Internet radio and the opportunity to purchase songs with its new service. This feature would benefit record labels immensely, as it is highly likely to lead to an increase in music downloads. Although Pandora already offers a similar service for its listeners, the popularity of that service appears to be minimal due to less emphasis and integration.
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. Pandora had ≈ 150 million registered users and ≈ 55 million active users as of July, giving it unrivalled scale among free music service providers and a significant head start over Apple. In addition, the presence of Pandora on Android devices should limit the appeal of Apple’s service among Android users (Android-only listeners, and those with a Pandora account on a mix of Android and Apple devices). In addition, it is unclear whether Apple’s iTunes Genius can be successfully adapted for a free music service. While it is true that Apple has significant user data on purchases, it is not clear that the company can mine this data to understand why users buy particular songs. In our view, suggesting a song that the user may want to purchase is a different proposition than suggesting one that the user will want to listen to for free, as Pandora’s Music Genome Project already does so well. However, as Apple had over 400 million iTunes accounts as of June (also according to the WSJ), Apple service reports are likely to negatively impact Pandora shares for the foreseeable future (we note that Pandora shares have traded down pre-open as of the time of writing).
Maintaining our Pandora estimates, our OUTPERFORM rating and 12-month price target of $14 until we learn more about the features and timing of the Apple music service. According to the WSJ, Apple’s licensing negotiations have only recently been re-initiated, meaning the near- and long-term impact of the Apple service on Pandora usage could be unclear for many months. Given Pandora’s superior growth outlook to its peers, we are assigning a 19x multiple to estimated CY:15 EPS of $1.00, discounted back to CY:12 at a 10% discount rate.
Risks to the attainment of our price target include increasing competition from larger and more established companies, changes to the royalty rates paid for streaming music and other content, the implementation of data caps by Internet service providers, and the proliferation of native music/radio applications for computers, mobile devices, and other connected devices.
Michael Pachter is an analyst at Wedbush Securities.
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