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Two questions are consistently asked of Pandora’s business model: Can it sell more advertisements, and will it generate more revenue? The music industry sees a company that has placed market share ahead of revenue growth. People often wonder if Pandora could put more emphasis on growing revenue as it seeks lower royalties.

The short answer to both questions is yes, Pandora will sell more ads and generate more revenue. Although its business model has been widely criticized, the Oakland, Calif.-based company is well-positioned to turn its massive listening audience into profits.

The U.S. radio market is immense. Broadcast radio advertising totaled $14.2 billion in 2012, according to the Radio Advertising Bureau. About 242 million Americans listen to radio every week, according to Arbitron. Listenership is heavy across age groups: 90.9% of 12- to 17-year-olds, 90.8% of 18- to 24-year-olds and 94.5% of 25- to 54-year-olds. But only a handful of eventual Internet radio winners will be rewarded handsomely for their efforts.

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This is partly because radio is a traditional business that hasn’t yet experienced the same kind of digital disruption as, say, recorded music and newspapers. Even though Pandora, SiriusXM, iHeartRadio and Slacker have helped transform how people enjoy a “lean back” listening experience, traditional AM/FM radio still rules in 2013.

An investor tells Billboard he warmed on Pandora after recognizing that it’s a radio company rather than an Internet music service. The opportunity stems from the ubiquity of the mobile phone, this generation’s version of a transistor radio, he says. Pandora is simply using a different platform to engage listeners in a very familiar way. “If you just think of it that way, this is a really interesting story,” he says.

While on-demand services like Spotify have to foster an entirely new consumer behavior (renting music), Pandora benefits from the familiarity of radio. “These guys don’t have to create a new business,” the investor says. “They don’t have to change consumer habits.”

Perhaps Pandora’s biggest strength is its best-of-class status. No other digital radio company is so well-positioned to capitalize on a shift of ad dollars from traditional broadcast radio to Web radio. And no other platform can deliver both audio and display ads to more than 71 million monthly active users while allowing advertisers to target by demographic characteristic and location.

“If you’re unable to accumulate a huge audience—and today Pandora has 70 million-plus [users]—then you’re never going to stand a chance of monetizing it well,” CEO Joe Kennedy says. A service with five million or 10 million might have a great story, but it won’t be able to lure enough advertisers. “In this country that’s nothing in the media landscape. You’re not going to get anywhere.”

Pandora has made itself more appealing to radio ad buyers. It started providing metrics, compiled by Triton Digital, to ad buyers in May 2012. Then in March, the country’s two biggest media-buying platforms, STRATA and Mediaocean, started integrating Pandora’s Triton numbers. As a result, ad buyers compare Pandora’s local and national audience ratings to those of its broadcast radio competitor.

To understand how much revenue Pandora could be generating, compare the revenue and market shares of Pandora with broadcast radio. Pandora’s potential comes from the gap between the two.

Pandora had roughly a 7% share of U.S. radio listening in June (a figure the company calculates using data from Triton, Arbitron and the U.S. Census, and includes an assumption for satellite radio’s share). A 7% share of the $16 billion radio advertising market is worth $980 million to broadcast radio. Pandora’s revenue during the last four quarters was just $417 million. That implies Pandora’s current market share could generate an additional $563 million.

Morgan Stanley analyst Scott Devitt says Pandora will have a 15% share of radio listening and generate about $500 million of audio ad revenue by 2015. If Pandora achieved the monetization rate of terrestrial radio, that 15% share would be worth $2 billion.

More advertising inventory must be sold to generate more revenue. Growth of mobile RPM, or revenue per thousand listener hours, shows this is already happening. In Pandora’s 2009 fiscal year, desktop RPM was less than $20. Mobile RPM was $26.15 in the fiscal quarter ended April 30, up from $19.16 a year earlier, and should continue to increase. Stifel Nicolaus analysts forecast a mobile RPM of $29.75 in the current quarter.

While its business model takes shape, Pandora faces a range of difficulties and threats that could hamper its growth and profitability. The most obvious challenge is the high amount of revenue that goes toward performance royalties—61% last year and 66% last quarter. It has been one—but not the only—factor in net losses of $38.1 million last year and $28.6 million last quarter.

But Pandora’s royalties aren’t out of the ordinary and don’t rule out future profitability. Music download stores and subscription services generally pay out 70% of revenue to rights owners. Netflix, another best-of-class digital media company, is a better comparison. Cost of content accounted for 69% of domestic streaming revenue and 72% of total revenue during the last four quarters. But because of Netflix’s large subscriber base—28.6 million for domestic streaming alone, as of June 30—the company was able to turn a profit of $47.7 million on revenue of $3.9 billion. (Not all digital services pay the same, however. Satellite and cable radio pay far less as a percent of revenue. See the FAQ, page 22, for an explanation.)


Finally, this fall’s entry of Apple's iTunes Radio, a personalized radio service similar to Pandora, could affect Pandora’s listener hours and active users. ITunes Radio will offer personalization by tapping into its deep history of consumer purchases and using its Music Genius recommendation technology. Apple will need a very strong product to compete, though. Pandora has continued its growth in the face of low barriers to entry and numerous new services. Launches of new products by Spotify, Xbox Music and Google Play haven’t had a noticeable impact; nor has continued growth of iHeartRadio and Slacker hurt Pandora.

Morgan Stanley’s Devitt acknowledges Apple could be a threat but believes its entry into Internet radio could actually help Pandora. “Apple’s success could lead to an acceleration of the maturity of this segment in the eyes of advertisers and consumers,” he says.

The only factor that has hurt Pandora’s growth in listener hours was the listening caps it imposed on free mobile listening—limited to 40 hours per month—to stem the rise of mobile-related royalties. The tactic appears to have worked. Royalty obligations fell while increasing the number of subscribers to its paid, ad-free service, Pandora One. It goes to show that the only thing standing in the way of Pandora’s continued growth could be itself.