While plenty of analysts and writers (including myself) have been assuming that it was a “when, not if” sort of situation, the buzz around Apple (Nasdaq:AAPL) launching a streaming music/internet radio service to compete with Pandora (NYSE:P) has gotten quite a bit louder. This service would not be a huge contributor to Apple all on its own, but it would offer the company yet another way to monetize its large user base and further establish its presence in services and mobile advertising. To that end, anything that develops those potentially lucrative lines is a net positive for the stock.

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Stay Tuned

Apple being Apple, of course there is nothing official from the company regarding its potential interest in developing an ad-supported streaming music product. That hasn't stopped news sources like Bloomberg and the New York Times from reporting relatively detailed accounts of what Apple is supposedly about to unveil.

The media reports indicate that Apple has been working hard to sign licensing agreements with major record companies like Warner Music Group, Vivendi's (OTC:VIVHY) Universal Music Group, and Sony (NYSE:SNE) prior to an anticipated launch next week at the annual developers conference. Perhaps not surprisingly, there has reportedly been some squabbling between Apple and the rights holders, as the record companies have been pushing for minimum payments and solid royalty rates.

Like Pandora, But Not Exactly

Assuming that Apple gets all of the major companies to sign on the dotted line, the service will likely resemble Pandora in many functional respects. The service will reportedly offer streaming music organized by channels, with users able to indicate their preferences and influence the music that plays.

At least initially, it appears that Apple's internet radio service will be supported by display ads, with Apple hoping to leverage its iAds business even further. Given the amount of data that Apple collects about its users, the company should be able to offer pretty highly targeted ads and those tend to be the most lucrative. I would be surprised, though, if there were many (if any) audio ads initially, as that tends to take more effort to establish.

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A Potentially Large Audience And An Opportunity For Leverage

With roughly half a billion estimated accounts, Apple has one of the largest potential user bases out there – it's over seven times the size of Pandora's user base and two and a half times the size of Amazon's (Nasdaq:AMZN) base, with only Facebook (Nasdaq:FB) having more. That makes almost any new service that Apple wishes to offer interesting right from the start.

According to Morgan Stanley's analyst Scott Devitt, Pandora generated $4.42 per user in revenue in 2012 excluding audio ads. Laying that over Apple's user base, it's not hard to generate some impressive potential revenue numbers (over $400 million at 20% penetration, $1.1 billion at 50% penetration, and so on).

Although an extra billion dollars in revenue actually isn't that significant for Apple (a company that generated $169 billion over the trailing twelve months), the impact to the company should run deeper than just the revenue generated from the radio service. Offering more services ought to make that Apple user base even stickier, and a popular free-to-use music service could be a powerful tool in building Apple's mobile ad business against the likes of Google (Nasdaq:GOOG). As a result, I think this business could be more profitable to Apple than a quick look at Pandora's financials would otherwise suggest.

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The Bottom Line

For Apple, this is a logical step and consistent with my expectation that the company will continue to emphasize services and look for ways to leverage that huge (and in many cases quite loyal) user/account base. It doesn't really change my fair value for the stock all that much, and I continue to see the stock as undervalued even with concerns about slowing mobile sales.

This is potentially a much bigger deal for Pandora, as suggested by the greater than 10% decline in the shares on Monday's articles discussing Apple's intentions. While I've been valuing Pandora with the assumption that Apple's entry was a “when, not if” event, apparently there were those hoping that Apple's arrival would come later than this. With the stock moving closer to $15, the shares of Pandora do seem undervalued, though I expect above-average volatility at least until Apple lays out its plans at next week's conference.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.