Pandora (NYSE:P) has now gone public and the comparisons between the Internet Radio provider and Sirius XM (NASDAQ:SIRI) have moved to a brand new level. The comparisons are warranted, as audio entertainment is an evolving medium that now includes streaming music through the Internet. This truth is undeniable when you consider that Sirius XM’s upcoming Satellite Radio 2.0 will rely heavily on features that will be delivered via the Sirius XM Internet Radio and apps platform rather than from the company’s satellites.

There are a couple of ways to look at the competitive landscape in audio entertainment. One is from a business perspective and the other is from a consumer perspective. Pandora is oft criticized for not being profitable. This is indeed true, but realistically this does not change whether or not Pandora and Sirius XM compete. They do. If someone wants to debate the level of competitiveness that is fine, but Pandora does indeed compete with Sirius XM as well as terrestrial radio. The simple existence of Pandora, profitable or not, exerts pressure on all audio entertainment providers. While the business side of this debate is compelling, it is the consumer perspective where things get very interesting.

Pandora is a essentially a “free” service (they do have a premium subscription tier). The company uses revenue from advertising to help offset costs, thus consumers are exposed to ads while listening as compared to a pure subscription model that offers no commercials, but instead charges a premium directly to the consumer. People oft associate Pandora as a service embraced by teens that “have no money”. This stereotype could not be further from the truth, and is oft attributed to satellite radio fans trying to “explain away” Pandora as a competitive force. There actually should be little worry from SIRI investors, as there is plenty of room for several audio entertainment services. The truth is that Pandora has numerous customers, many of which simply find that what Pandora offers meets their needs.

A criticism of Pandora is that they offer only music and can not match the superior non-music content offered by satellite radio. First things first…Sirius XM does indeed have superior non-music content. Whether Pandora enters the non-music arena, which is costly, may not matter. Is the combination of Pandora and iHeartRadio, or even terrestrial radio, a threat?

Consider a professional 30 year old man from Boston who has a 20 minute commute to work. Is paying for Sirius XM a prudent move for this man? Perhaps not. He has to consider that Sirius XM will cost him $12.95 for the base service, an additional $2.99 so he can listen on line at work, plus another $1.50 or so in royalty fees. This equates to over $17 per month. Compare that to the combination of “free” Pandora and terrestrial, or even iHeartRadio. This man can get his music fix on Pandora while getting his talk, sports and news fix from terrestrial or even Clear Channel’s iHeartRadio.

This is a classic example of someone who simply finds that satellite radio, while very good and compelling, is not worth the cost. Remember, about 55% of those exposed to satellite radio choose to not keep the service after a free promotional trial that comes with their car. This means that these people are finding another way to get audio entertainment. It used to be a choice of satellite or terrestrial. Now with the advent of smart phones and connectivity to the car dashboard, Internet radio has entered the promised land of the automobile, joining local radio and satellite. So at this point we have $17 per month vs. free.

Our 30 year old Bostonian can get his Boston Bruins fix from Sports Radio WEEI 850 AM, His news and talk fix from other local stations or one of iHeartRadio’s 750 channels, and his music fix from Pandora. If commercial free music is his gig, he can pony up $3.99 per month to get Pandora One. and combine commercial free music with commercial supported terrestrial or iHeartradio.

I know the next argument. “But the guy has to have a data plan and a smartphone. Data plans cost money. Welcome to reality. First, he is going to have a smartphone and data plan anyway. It is just the way it goes. The same dynamic that has satellite radio consumers perceiving that they are only paying $12.95 per month for Sirius XM will happen with Pandora. People do not associate the data plan as a cost coming from Pandora. It is really that simple. If they have a smart phone already, they simply look at Pandora and iHeartRadio as services available through that device. The cost of the data is not associated with these services in the mind of the consumer. Think of it this way. If you pay $50 per month for Internet access do you associate that fee as being part of the cost of the Amazon.com book you just bought for $9.95? Do you associate the cost of your Internet access with the Ebay auction you just won? The answer is no.

The first question satellite radio needs to tackle is how much money they can get out of their subscribers, and whether or not Sirius XM even wants to attract consumers interested in Pandora for their audio entertainment solution. Right off of the bat I would say that Sirius XM indeed has interest in the Pandora crowd, so long as they pay at least some money. Pandora is getting some people to subscribe at $3.99 per month. Sirius XM offers cancelled subscribers the chance to get 5 months for $25 (equating to about $5 per month). This shows me that at least on some level the satellite radio provider wants business even if the consumer is paying 60% less than the typical price. However, this is a fine line and Sirius XM does not want to butcher their Average Revenue Per User (ARPU) line in order to do it….at least not yet

What will determine the actions of Sirius XM will be churn, and take rate. If churn (existing customers cancelling the service) rises, it could be an indication that people find other audio entertainment solutions more compelling. If the take rate (people who sign up for the service after a promotional subscription that came with their new car) drops, it could be an indication that consumers do not find value in the service at the current price, or they again have another solution to meet their needs. As smartphones and dashboard integration continue to infiltrate the automobile marketplace, churn and take rate will be two very important metrics to watch. The impacts will not be instant. Remember, it has taken Sirius XM YEARS to get into about 40 million cars. Similarly, it will take years for 40 million smartphone connectable cars to be on the roadways. This dynamic is just now beginning to unfold.

What we know from the traditional data is that 45% of those exposed to satellite radio elect to become self paying subscribers. We also know that about 25%, on an annualized basis, of the self paying subscribers leave the service every year. This is the data we have to work with as we analyze the impact of Internet radio in the dashboard over the coming months and years. Sirius XM’s answer to this “threat”, at least in part is Satellite Radio 2.0 which promises to have some “Pandora-like” features. At the point that Sirius XM releases their 2.0 product we will have the battlefield established.

Will consumers pay close to $20 per month for Sirius XM or find some less expensive combination of other services to fill their audio entertainment needs? Personally I think that a combination such as Pandora and iHeartRadio is compelling, especially to those that spend less time in their cars. Toyota’s new Entune system Pandora and iHeartRadio front and center for consumers with app icons literally sitting right next to each other. What this will boil down to is content, how much money a consumer is willing to spend, and how much advertising they are willing to listen to.

CONTENT IS KING

Sirius XM has the best content on radio right? That is the popular mantra. The company does have a very robust offering that can appeal to many people across the nation. The big question is how appealing is it to your average consumer. Although all of these services offer hundreds of channels, the reality is that most people actively listen to less than 10 channels. Sirius XM’s Howard Stern is a huge draw for the satellite radio company, but in contrast Rush Limbaugh is a huge draw that iHeartRadio can boast. Sirius XM has NASCAR Radio, but if I am not a NASCAR fan does it really matter to me? Mel Karmazin has always stated that he would rather have and pay for top talent and find a way to make money on it than to have to seek out a way to compete against it. Top tier talent that can draw dollars away from consumers is hard to find. It is top tier content with national appeal that sets the stage, and while we all love to talk about the vast array of content only a select few personalities really make the difference.

In January of this year Bubba The Love Sponge left satellite radio. It was also the same time-frame that Dr. Laura was introduced to satellite on an exclusive basis. Churn for that period remained at 2.0% (normal for the company). The fact is that Bubba and Dr. Laura, both great content, did not move the needle at all in terms of subscribers. There was no mass exodus when Bubba left, and no huge influx of subscribers when Dr. Laura cam on board. They are both great content, but not differentiators.

One argument I would make is that even though top tier difference makers in content are rare, the overall package of content is compelling. This is where Sirius XM has an advantage. It is expensive though. In 2010 Sirius XM spent nearly $306,000,000 on non-music programming an content. That equates to $15.30 per subscriber per year, or 10% of what an annual subscription runs. Consider that the Stern channels eat up about $100 million per year, Major League Baseball about $60 million, the NFL at about $30 million, Oprah at $20 million, and $210 million out of that $306 million is gone. All of the other compelling content, including the NHL:, NBA, NASCAR, CNBC, Fox News, CNN, ESPN, Martha Stewart, Rosie, Covino & Rich, Opie & Anthony, Jamie Fox, Blue Collar Comedy, and dozens more are left to divvy up about $100 million. While that is still a sizable sum, it demonstrates that some pretty compelling content can be had without a massive price tag.

Sirius XM has been good at keeping a lot of this content on board, but there are “defections” that happen that are fan favorites. Recently Bill Mack left satellite radio, and the comments under my article show the frustrations of listeners. When it appeared that Rosie was leaving there were similar comments. Ultimately Sirius XM found a way to keep Rosie content.

This premium content is a double edged sword. Getting a top tier performer is the first key. Supplementing it with other compelling content is what makes the overall package compelling. Doing all of this requires a lot of work and near constant negotiations. Being in the non-music content business is a long and arduous process that the likes of Pandora can not do overnight. However, Pandora may be perfectly happy sticking to music only and letting consumers turn to iHeartRadio, terrestrial radio, and even satellite radio to get the rest.

DOES COST PLAY A ROLE?

Forget the state of the economy for a moment. Even in the worst of times Sirius XM has been able to be a success. That is a credit to Mel Karmazin and his management of the company. In their best days Sirius XM approached a 50% take rate in the auto channel. This most recent quarter we saw the take rate come in at 45%. The company attributes most of this drop, never really that big on a quarter over quarter basis, to the influx of newer OEM partners that are still in the learning curve. While certainly that is a part of it, the economy has had some impact too. However, even if only 2 points were attributable to the economy, that is an impressive feat.

Cost plays a much bigger role than many may think. A full 55% of those exposed to satellite radio with a new car do not keep the service. In addition, the company loses about 550,000 subscribers per month while adding about 700,000. This means that there is a big pool of consumers that simply do not find value in what Sirius XM offers. This also means that there are plenty of potential listeners for terrestrial radio and Internet radio, and ultimately why both of these other mediums (terrestrial and Internet radio) will succeed.

Without even considering satellite radio churn let’s look at this with a real life example:

-100 Cars get manufactured
- 60 come with satellite radio (Sirius XM has between 60% and 65% penetration into new cars)
- 27 promotional subscribers elect to keep the service (45% take rate)
- after the promotional period there are 73 cars seeking other forms of audio entertainment and 27 keeping satellite.

You can see with this example that there is indeed plenty of room for terrestrial and Internet radio. Even if these two platforms split the remaining pie, it would mean that 27% went satellite, 36.5% went to Internet, and 36.5% went to terrestrial. The good news for SIRI investors is that this model already makes Sirius XM profitable.

The real question is what is the sweet spot for cost? Obviously the vast majority of consumers find that satellite radio is not compelling enough to separate them from a $20 bill each month. Is it better to get a higher price from fewer people, or to get more people with a lower price? Only time, and the competitive landscape will bear that out.

The whole new dynamic here is that consumers will now have three dashboard choices instead of 2. Terrestrial (AM/FM/HD), Internet (Pandora, Slacker, MOG, and Cloud services), and satellite. Instead of satellite competing with one opponent (terrestrial) in the car they are now competing with two (including Internet radio). What used to be a choice of satellite or a consumers local market terrestrial offerings (sometime quite meager in terms of selection), is now a choice of satellite, local terrestrial, or a massive selection of content via the Internet.

Satellite radio will come in at a minimum cost of about $14.50 per month (including royalty fees) and almost $17.50 per month if you want to stream over the net. Other services can range from free (terrestrial, iHeartRadio, MOG, Pandora, and Slacker) to about $10 a month for Mog or Slacker On-Demand.

The real question is whether any particular service, or combination of services deliver the content that consumers want. Yes, if you want Howard Stern you need to have Sirius XM, and if you want Rush Limbaugh you need terrestrial, but outside of these top tier names, what will satisfy consumers?

I am a satellite radio subscriber that also listens to a smattering of terrestrial radio (Sports Radio WEEI in Boston), Slacker, and my iTunes library. In my case Sirius XM is a big winner. There are however people who find a free Pandora combined with terrestrial and something like iHeartRadio compelling. The new dynamic is this:

Let’s assume you live in a market that has 12 FM stations and 10 AM stations. Out of these 22 stations you only like and listen to 2. In this situation satellite radio may be a compelling solution. Now add Internet radio into the mix. You suddenly have access to 750 channels on iHeartRadio, and customizable music on Pandora at no cost to you. Will that compel you to leave satellite radio? For some the answer will be yes. It boils down to how much money your audio entertainment is worth. The addition of Internet radio to the dashboard is new. There simply is not yet enough data to draw a conclusion. However, we already know that satellite radio is not a good value to over half of those exposed.

CONCLUSION

I oft get harassed by overly passionate satellite radio fans for “having the gaul” to even mention Internet radio on this site. I have been characterized as having a “belief” that Internet radio will be the death of satellite, and even been accused of being a Sirius XM basher. The fact is that I have NEVER stated that Internet radio will kill satellite radio. What I have stated is that Internet radio will exist, succeed, and perhaps even prosper. My stance is that there is plenty of room for success in satellite, terrestrial, and Internet radio. What is obvious to anyone that looks at the audio entertainment landscape with an un-jaded eye is that there is indeed room for several players.

Pandora (as well as other Internet radio providers) and terrestrial radio compete with satellite radio. Until now the dynamic has been satellite radio eroding the terrestrial radio market share. Now, companies like Pandora are also working to erode that share. This is not a major concern to the satellite radio core as yet. People that pay up to $20 per month for Sirius XM are in a different category than those that seek out free, or less expensive alternatives. Think of it as an overlap. Each type of service will have their core group of users. In this respect there is no threat of competition. Where the competition happens is in the areas of overlap. The three circles can shift to favor one service over the others, or a combination of services.

This is the competitive dynamic I oft speak of. The audio entertainment landscape is not an either/or situation. None of these players will dominate the world no matter how much passionate fans of satellite, terrestrial, or Pandora may want. Even at its peak terrestrial radio’s Clear Channel did not have everyone listening.

For Sirius XM the trick is not letting their own loyal audience erode because of the advent of some pretty compelling Internet radio offerings. So long as they can keep their core subscribers, and add to that core they will be doing fine. They could even raise prices like they have discussed in quarterly reports. However, if their churn increases, or the take rate begins to suffer, the pricing elasticity may not be there. As I have said before, there is plenty of time for satellite. Internet radio in cars is brand new and will take years to reach penetration levels that satellite radio already has. The ultimate look of the overlapping circles will not really be determined for at least another year, and will continue to shift thereafter.

In the end the threat of Pandora and terrestrial, or any combination of other audio entertainment is limited to the overlapping areas of the circles and not at the core of satellite. This is a stark contrast to terrestrial radio which is seeing its core erode. The key for satellite, and Pandora for that matter is continued growth of audience, and BOTH can accomplish that without any meaningful loss of their core.

Position – Long Sirius XM, No Position Pandora