Pandora IPO: Watch for Sirius XM to Retaliate With Music Fee Trap

Last Updated Jun 14, 2011 11:15 PM EDT

When Pandora (P) launches its IPO today, several weeks of negative commentary in the business press about the company's lack of profitability and its upside-down business model will be priced in to the stock. That still may not be enough to pull shares down from their offering price of $16; LinkedIn (LNKD) ran the same gantlet and still hovers at $76, way above its $45 initial asking, and with Facebook around the corner there seems to be no end to investor appetite for new Internet stocks. Pandora hopes to raise $235 million from the offering, which values the company at $2.56 billion.

But before you buy in hopes of a bump, do some research on the competition. Back in May, Sirius XM (SIRI) CEO Mel Karmazin gave a presentation to investors in which he compared Pandora to his satellite radio service. Obviously, Karmazin is biased. He hates Pandora because it's free (and thus threatens his business) and because it has a rapidly expanding mobile platform that is extending into vehicles (which threatens his business even more).

Nonetheless, when you place Pandora's numbers next to Sirius's, the comparison is bleak. Pandora's revenues are just 4 percent of the size of Sirius's:


Pandora has just 2 percent of the amount of subscribers belonging to Sirius:


And Sirius gets 84 times the annual revenue per user than Pandora does:


How "free" might not beat "paid"

There are two dynamics at play here. The first is that free beats paid, which makes Sirius look like the weaker competitor. Pandora's stock sales will cushion it from its losses while it sucks subscribers from Sirius (it's only selling a fraction of its equity so it can sell more later). From that angle, Karmazin's pretty charts simply represent the size of the pie available for Pandora to eat.

The second is whether Sirius's installed base of users contains high enough "switching costs" for customers who might consider transferring to Pandora, particularly in their cars. Once you've got a car radio, you tend to stick with it as long as it works. There is a built-in inertia to changing to a different format. But with more cars coming with a mobile phone hookup allowing passengers to play their Pandora app, and dedicated Pandora-playing radios become more available, it's becoming easier to switch. That makes the $17 per month Sirius fee look more and more like your plain-old-telephone service: the thing that makes you ask, "Why am I paying for this when I don't use it that much?"

Basically, the pair are locked in a race to the death. Sirius may have to offer discount pricing schemes to keep its customers. Pandora will simply bleed cash.

What both companies need is a way of sharing the space that damages neither of them. When competitors decline to encroach on their rivals' territories, they tend to be able to raise prices and margins. They had that opportunity when Pandora was mainly available on computers and mobile phones and Sirius was mostly in people's cars. Now that Pandora has trespassed into car stereo territory it poses an existential threat to Sirius, and Karmazin must respond.

One option Karmazin has is to tacitly encourage record labels to raise the license fee they charge for playing each song. That would hurt Sirius, but sound the death knell for Pandora by 2015. Pandora's music fees are 57 percent of the business's revenues. At Sirius, royalties and content fees are only 27 percent at most.

It won't be pretty.

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