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The rise of on-demand music streaming services may have taken the life out of Pandora Media (NYSE: P). With its third-quarter earnings results, the company reported just 77.9 million listeners. That's less than the 78.1 million it reported in the third quarter last year, and its third consecutive sequential decline.
But Pandora plans to launch its own premium on-demand service, Pandora Premium, by the end of the year to help stanch its user losses. The service will compete directly against Apple's (NASDAQ: AAPL) Apple Music, Spotify, and Tidal. Management laid out its expectations for the service at its analyst day on Oct. 25.
11.3 million subscribers by 2020
Pandora expects to grow Pandora Premium to 11.3 million subscribers by 2020. That's relatively modest, considering Apple Music had 17 million subscribers after 15 months and Spotify has 40 million subscribers worldwide.
But even that number may be difficult for Pandora to reach given its track record of converting its listeners into paid subscribers. Pandora has offered a subscription tier for its internet radio service since 2009, but it's converted only about 5% of its listeners to subscribers.
At the investor day, CEO Tim Westergren said that "Pandora Premium is essentially the full interactive on-demand service. Again, it will be -- radio will be at its core. The notion of listening, continuous listening will be at the center of this product. It will have all the features of Plus, so the rewinding, skipping, offline, et cetera, but it will now include the ability to search and play, the ability to build and share playlists, taking everything offline and many, many more Pandora-esque features that we can't reveal now for competitive purposes that I think will bring a unique flavor to how this product surfaces for the consumer. We're going to reinvent the interactive experience just the same way we invented online personalized radio."
75% already listen to on-demand
At Pandora's analyst day presentation, product chief Chris Phillips gave some details about the demand for on-demand streaming within Pandora's listener base. Most notably, 58 million of Pandora's 78 million listeners already use an on-demand streaming service and 20 million of those are paid subscribers.
While Phillips holds this up as an opportunity for Pandora, it's more like an opportunity lost. These are customers who have spent hundreds of hours using another product. They've made their own playlists, developed a profile, and taken advantage of the unique features of Spotify or Apple Music. That completely negates the advantages Pandora is leaning on, such as its listener data.
There are significant switching costs for listeners -- even free listeners -- that Pandora is ignoring. And it's relying, at least to some degree, on having customers switch from Spotify and Apple Music to Pandora Premium.
That leaves just 20 million Pandora listeners as the company's biggest opportunity to attract new subscribers. Yet those are customers who have yet to express much interest in other on-demand services, which means they'll probably be difficult to convert. And given Pandora's history of converting listeners into subscribers, that doesn't bode well.
Content costs going up
Pandora is facing a tough environment, and its subscription services will be key to navigating through it. The company has seen its content costs increase this year after agreeing to pay for licenses for songs recorded before 1972. Those content costs will rise even higher going forward after striking deals with the record labels for on-demand streaming.
Pandora paid $93.3 million in additional prepaid content acquisition costs in relation to the deals it made with record labels for on-demand streaming last quarter. Note, however, that those are minimum guaranteed payments that Pandora will be able to recoup if it streams enough songs.
Still, the standard revenue share for Pandora Premium (70%) will be higher than it's used to in years past. In 2014, Pandora paid out 48% of its total streaming revenue to record labels. That number climbed to 53% last year. Through the first three quarters of 2016, content costs are up to 56% after paying back some one-time costs associated with pre-1972 licensing. That number is poised to climb even higher following its recent deals with record labels.
Pandora's management is making a big bet on on-demand streaming. And while it does have some advantages going for it, the vast majority of its user base already uses another service. Just because they still listen to Pandora radio doesn't mean they'll subscribe to Pandora Premium. In that light, even Pandora's modest 11 million user estimate seems aggressive.
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Adam Levy owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Pandora Media. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.