Why Pandora may end up acquired by Google

The personalized radio station is estimated to top $100m in revenue this year

This analysis is the latest installment from Steve Carpenter, an Internet entrepreneur, who's one of the few providers of financial insight about the high-profile yet opaque private company sector.

This week, we take a look at Pandora, the popular personalized radio station. In our interview, Steve predicts Pandora will more than double its revenue to $125 million this year, due to its popularity on the iPhone and its ability to extract more money from advertisers, thanks to its skyrocketing subscriber base. Steve estimates that Pandora will have more than 100 million registered users this year.

But while Pandora is undoubtedly the biggest personalized radio station that exists today, it could face stiff competition from Apple down the road. Yes, Pandora has three assets: 1) huge distribution 2) killer recommendation engine 3) great relationships with music labels. Apple, however, also has huge distribution and great relationships. It's just a matter of building out its recommendation engine technology that it acquired with the purchase of Lala last December.

Why Google and Pandora complement

Once Apple gets serious, it "will be challenging to stay a stand-alone" company, said Steve, in this interview, suggesting that Google would be a logical and likely acquirer. "Pandora and Google, I predict, will be very cozy over the next couple years."

Indeed, Google might find that Pandora gives it something it wants. Part of Google's vision is to bring the Internet to you, or to be able to help you discover what you don't know. Pandora does just that - for music. Pandora is an endless stream of pleasant surprises.

Steve predicts that Pandora's latest valuation is somewhere in the neighborhood of $300 million pre-money, and that its acquisition price could be impressive at a half-billion.

Watch our interview for more on that prediction. For more analysis by Steve, check out our interviews below about Zynga and Chegg.

Below is more analysis from Steve's blog - The World According to Carp - about Pandora's revenue and its risks.

Pandora Makes Money, Pennies At A Time

Pandora has three tiers of service, 40 hours/month of free ad-supported music, $.99/month for unlimited listening after 40 hours, and $36/year Pandora One, and it makes a little off of affiliate fees from track downloads- but nearly all of its revenue comes from advertising.

Based on revenue and average user numbers released by the company in 2008 and 2009, and using simple ratios, I estimate the company will average just over 70MM registered users for the year and generate close to $.15 per user per month, on average, or $1.75/year, up from $.138 and $1.66 respectively last year.  To be clear, this is not to say that Pandora will average 70MM listeners over the year.  This is clearly a scale business since royalties are variable with each hour listened and there is little margin for error.

Traditionally, CPM’s for Internet and radio have been the lowest compared to every other form of advertising, other than outdoor.  Online, audio, and mobile (another low CPM medium) are the three advertising channels available to Pandora.  While a home page takeover can garner a $20 CPM, an audio ad can be as low as $4, and a little banner on the iPhone $.50 CPM.

The company has stated that they are getting average CPM’s of between $8 and $10.  ((https://vator.tv/news/show/2009-05-26-pandora-sees-revenue-up-80-this-quarter) But not all ads are created equal and early mobile advertising has been in the $1 to $2 range.  Depending on where a user listens, ad type and frequency, sell-thru rates, and frequency caps, Pandora is generating different CPM’s by the hour.  I assume the company will run two ads per hour with some being of “high quality” CPM’s of $10, some of “medium quality” of $7, and some of “low quality” of $4 across its inventory to get the following chart: 

Based on those assumptions, I project the average Pandora listener who listens to 11.6 hours a month generates $.228 in revenue and $.0767 in gross margin.  Depending on the customer lifetime value (how many months the average customer listens), this does not leave a lot of money left over to spend on marketing to acquire new users.

There are passionate Pandora customers that easily surpass the free 40 hour per month limit.  Because of the chart above, you can see that if the company does not monetize its heaviest users smartly, it could literally go bankrupt from the variable royalty fees.  I assume that when a listener pays the incremental $.99 she is likely go to way over.  Based on my analysis, Pandora breaks-even on its royalty fees at 120 hours a month (4 hours every day). 

Pandora Is Still At Risk

Despite reaching nearly 100MM by the end of 2010, the company still faces many challenges:

1. Size Matters: Compared to all the other music streaming services, Pandora’s catalog is quite small.  Comprised of 700K tracks, the company has made a conscious decision to filter out many albums.  While this may not be a big deal to many listeners, it does mean that Pandora tends to repeat songs more than the others.
2. Limited Reach: Because of the restrictions placed upon the company by the royalty holders, Pandora is only available in the United States.  This situation will need to change over the next few years or Pandora’s upside will be severely impacted.
3. New Entrants: Rdio, Spotify, Google (https://www.dmwmedia.com/news/2010/06/15/cnet-google-music-service-could-debut-fall)
4. AT&T Data Plan Changes:  AT&T’s decision to limit data plans could be potentially disastrous for Pandora.  This situation will have to be watched closely.
5. Limited Listening Options:  While the simplicity of the product makes Pandora such a compelling, frictionless experience, customers may miss no rewind or repeat, limited skipping, and the inability to pick whatever they want to listen to.