By Kevin Kelleher, contributor
FORTUNE -- For all its promise and popularity, online music has proven to be pretty tough soil for companies to farm. Profits take years to produce and offer slim margins once they show up. Musicians complain about how you're treating them, even as the labels try to bleed you dry.
And yet so many cash-rich companies are dying to get into this business. Pandora (P) was the early homesteader, building its music recommendation service on the Music Genome Project, a project dating back to the Napster era. The project aimed to categorize songs based on 400 attributes and create algorithms that identified similar sounds.
The scope of that project was as ambitious as it appeared quirky at the time. But it gave Pandora an early lead in the online radio market, and it helped the company beat back other startups adopting the business model like Mog and Rdio, which appealed more to hardcore music lovers, as well as archrival Spotify and its cozy partnership with Facebook (FB).
Now Pandora is facing competition from bigger, cash-rich web giants. Notably, Apple (AAPL) launched its iTunes Radio service in September. Microsoft (MSFT) is rolling out its Xbox Music service to iOS and other mobile platforms, while Google (GOOG) is rumored to be preparing its own Pandora/Spotify-like service based on YouTube. And others like Amazon (AMZN) could gain entry overnight by buying a small Pandora rival.
Somehow, Pandora manages to keep shaking off this growing crowd of competitors and growing its users and market share. In August, Pandora's active listeners rose 25% to 73 million from a year earlier, while listener hours rose 18% to 1.36 billion.
The company's share of the U.S. radio listening market rose to 7.8% from 6.5% in September 2012, although that figure is down from the 8.5% share in February, when the company began a 40-hour-a-month listening cap. Pandora removed the cap in September ahead of the launch of iTunes Radio.
MORE: All eyes on Apple Inc.
But a question still lingers over the company: How long can it last? Pandora is approaching a kind of crossroads: It can solidify its lead in the online-radio market the way that Netflix (NFLX) has in the equally competitive industry of online video, or it can watch its market share erode away as Apple, Google, Microsoft, and others try to elbow their way in.
A year ago, when reports of Apple's planned entry into its market began to emerge, Pandora was seen as vulnerable, a company needing to be acquired to survive. But since then, its stock has risen 231% against the 32% rise in the Nasdaq. During the six weeks since Apple introduced iTunes Radio, its stock has flattened as investors wait to see how Pandora will fare with its new rival.
Apple is an especially dangerous competitor since many people already have accounts with iTunes Radio because of using Apple's iTunes software. Last week, Apple CEO Tim Cook said the service had 20 million listeners, or more than a quarter of the listeners Pandora reported in September.
Whether those new listeners will remain active remains to be seen, but it's a daunting start. Some observers believe that it's too early to call iTunes Radio a Pandora killer (its listeners stream an average 2.6 hours of music per month, according to Billboard, compared with Pandora's 15.8 hours).
Even so, Pandora isn't sitting still. Speaking about Apple, Pandora CFO Mike Herring told CNET, "We take them very seriously and do see them as a credible threat." But the company sees its focus on the market as an edge, and it recently hired Brian McAndrews as CEO, a move seen as shifting Pandora's focus onto advertising, especially in mobile where many of its listeners engage with its service.
To support its ad plans and to manage a growing customer base, Pandora last month staged a secondary stock offering that ended up raising nearly $400 million for the company but also boosting its share count by 9%. That dilution hasn't dampened interest in Pandora shares, but it could affect future rallies in the stock.
In general, investors seem willing to stick with Pandora for now, hoping it fulfills its potential to become the Netflix of online music. Large hedge funds like Orbis, Eminence Capital, and Lone Pine Capital have taken significant stakes in Pandora. Last Friday, rumors emerged that Carl Icahn, fresh off his $800 million profit in Netflix shares, took a stake in Pandora. Pandora may be farming on dry soil these days, but there are still plenty who believe it's still king of that arid land.
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