Pandora only halfway to on-demand music with Rdio purchase

Online radio giant Pandora Media (P) is finally going after the on-demand music market, but buying the assets of failing Rdio is just a start -- the much tougher work lies ahead.

Pandora announced Monday night that it would pay $75 million for most of the assets of bankrupt Rdio, a Spotify-like service that never caught on with listeners. The planned purchase includes technology, employees and intellectual property but not Rdio's critical license agreements with the major record labels. And until Pandora negotiates its own deals with the labels, it won't be able to offer much of an on-demand service.

That's why Pandora shares have continued to fall, down 8% in morning trading on Tuesday to $12.36. The rollercoaster stock was as high as $22 just a few weeks ago, but Pandora's last earnings report showed a contracting user base, and investors panicked. Increasing competition from Apple (AAPL), Google (GOOGL) and Amazon (AMZN), among others, appears to be taking a toll.

CEO Brian McAndrews said licensing agreements wouldn't ordinarily come along with an acquisition. "That's normal in the industry," he said on a call with analysts on Monday. "We will not be operating the business at this time, so we don't need licenses to operate. We'll be working on getting those licenses as we roll out the product."

Pandora has previously struck one deal. The company announced a multiyear agreement with Sony/ATV, which holds rights to everything from the Beatles to Taylor Swift, on November 5. Other major labels include Warner/Chappell Music, Vivendi's Universal Music Publishing Group and BMG.

The Rdio move is just one piece of Pandora's strategy to diversify beyond its simple radio-like offerings. Last month, Pandora agreed to acquire live event ticketing service Ticketfly for $450 million. The two moves come as the company's original business model remains at risk -- a government board is reviewing the mandatory licensing fees Pandora pays for its radio service with a decision expected in December. The Copyright Royalty Board's decision could dramatically increase Pandora's cost of doing business if it agrees with the music industry's demands for higher rates.

Rumors that the board would side with Pandora and other so-called webcasters helped drive Pandora's stock up to the $22 level in October. Under the mandatory licensing system, Pandora hasn't had to enter into individual negotiations with each label for its online radio service. But if the board sides with the labels and hikes the mandatory rates, Pandora would likely have to try to negotiate lower rates on a case by case basis.

Thus, adding live ticketing and an on-demand service could increase Pandora's leverage with the music labels, says Nomura analyst Anthony DiClemente. The two deals "better position Pandora for business diversification as well as direct-label deals following December’s CRB outcome," DiClemente wrote in a report on Tuesday.

Even if Pandora gets the rights to offer an on-demand music service using Rdio's technology, there is no guarantee it will be a rapid success. The company has almost 80 million listeners for its radio service, but many already subscribe to competing on-demand services from Spotify or Apple. And Spotify remains unprofitable despite its 60 million users.

Still, Pandora would only need to convert about 1.4% of its current audience to break even, Credit Suisse analyst Stephen Ju estimated. "While we note that Spotify has already been in the U.S. market for some time, if Pandora's product is of equal or better quality, it is still likely not too late," Ju wrote on Tuesday.

Pitching the new service to existing customers will help Pandora save money on marketing and advertising, so expenses will be far less than competitors, CEO McAndrews said.

"The amount of data and knowledge we have about our listeners will allow us to not just do a blanket offer or really expensive customer acquisition," he said. "That can help us short-circuit the entire process."