By Jennifer Saba
(Reuters) - Apple Inc's potential launch of an online streaming music service ignited anew concerns about Pandora Media's business prospects.
Shares of Pandora, which streams music online, tumbled 17 percent on Friday, closing at $10.47 after the Wall Street Journal reported that Apple is in talks with record labels to launch a similar service.
The news served as a fresh reminder for investors that Pandora faces fierce competition from the likes of Sirius XM Radio, Clear Channel and Spotify as they battle for listeners in the burgeoning online streaming radio market.
But some see Apple, with its enormous purse and ties to the music labels, as Pandora's most serious challenger. "They are the biggest threat out there," said Capstone Investments analyst Rory Maher. "They have quite a bit of leverage through iTunes."
Representatives from Apple, whose talks about a streaming service are said to be in an the "early stages," and Pandora declined to comment on the report.
Questions regarding Pandora's long-term prospects have been dogging the company since it went public last year. The main concern about Pandora is: As its popularity increases, it must pay more to play music.
Last quarter, Pandora spent 60 percent of its revenue for content acquisition, up from 50 percent during the same quarter last year. The more people listen to music on Pandora, the more the company will have to pay in royalty fees to the music industry. More users equals more costs.
Pandora's active listeners grew 48 percent to almost 55 million last quarter and its Internet radio share increased to 72 percent from 60 percent in the same period a year ago.
"It doesn't matter if you get all the world to listen to your service if you have a flawed business model," Maher said.
Pandora makes the majority of its revenue from advertising. But it has yet to turn a profit since its costs, including building out a local sales force, have increased.
Founded in 2000, Pandora has gained a massive following by streaming music based on similar artists or genres to users through its Music Genome Project. The company licenses its music through SoundExchange, an organization that collects and distributes digital royalties on behalf of artists and record labels. The U.S. government sets the rates.
Rich Tullo, a research director at Albert Fried and Co, notes that there is a possibility the government could change how it sets the rates for music licensing to be more favorable to companies like Pandora.
He also points out that Pandora has room to boost its revenue by adding, for example, more commercial time.
Pandora's other strength is in its partnerships with 18 automakers, including BMW, General Motors Co's Cadillac, Ford, Honda, and Toyota. Those carmakers feature dashboards that sync with the mobile devices streaming Pandora so a driver can control the music.
Charles Koch, manager of new business development at American Honda, said the carmaker welcomes all types of players. "We're agnostic; we are trying to facilitate as many as possible," he said of streaming music services.
"We are working with Apple and I'm sure that our people are talking about the implications of all of this," he said, adding that he was not implying anything specifically about a potential Apple streaming service.
"From our standpoint I don't think we see this as a threat to Pandora; we see this as another service that is coming along."
According to the Journal report, Apple initiated talks for licenses with record companies only recently, and it could be months before an ad-supported service is launched.
While some see Apple's entry as a threat to Pandora, others see it as an endorsement of its business model.
"The mere fact that Apple is discussing this business underscores the value of the Pandora platform," wrote Jordan Rohan, an analyst with Stifel Nicolaus.
Not only has Pandora gained a following, it is making progress reaping mobile ad dollars -- something that is plaguing much bigger Internet stars like Facebook and Apple.
Mobile ad revenue at Pandora represented almost 60 percent of overall second-quarter ad revenue of $89.4 million. Rohan wrote in a note that Apple still has yet to prove its "prowess" selling through its ad platform.
Albert Fried and Co's Tullo believes Apple would be better served if it acquired Pandora. It would take considerable money for Apple to build what has taken Pandora over a decade to make, especially if Apple's service is ad-supported.
Staffing a local sales force is an expensive and time-consuming proposition.
"Why wouldn't Apple want to leverage Pandora's ad business?" asked Tullo. "Pandora is a great content acquisition."
(Reporting by Jennifer Saba and Phil Wahba in New York and Ben Klayman in Detroit; Editing by John Wallace, Lisa Von Ahn, Peter Lauria and Dan Grebler)