Avoid Pandora's Hot IPO

Every week I write a column with a couple simple house rules.

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Today we're throwing out the newest IPO flavor of the week: Come on down, Pandora Media (NYSE: P  ) .

The song remains the same
It's easy to pitch Pandora as a sexy growth stock. Today's IPO debutante is a scorcher, accounting for half of the Internet radio listening market. The appeal of Pandora's music-discovery streams has helped it attract 90 million registered users.

The smartphone explosion has clearly helped, with Pandora's app consistently near the top across all five smartphone platforms that matter. An automaker or home theater component maker wouldn't even dare to attempt raising the tech bar without being Pandora-accessible.

Revenue spiked 150% to $137.8 million last year, with most of that coming in the form of ads that listeners tolerate in order to stream the largely free service. This year is off to another strong start with a 136% top-line boost.

There are holes in the model, though. Pandora can't seem to turn a profit, and after seeing its deficit narrow last year, the tech darling's net loss more than doubled during this year's freshman quarter.

Realizing that there has to be more to this model than obtrusive ads, Pandora began limiting access to 40 free hours a month. More active users -- or those who want to show their support in exchange for unlimited commercial-free streams -- can opt for the Pandora One premium service. Unfortunately, even after the hard Pandora One sell, Pandora is still losing gobs of money, and advertising accounts for 86% of the company's revenue.

Then we get to the valuation. Just a couple of weeks ago, Pandora was set to price its IPO as low as $7, implying a marginally reasonable market cap of $1.1 billion. Despite the fact that we've gone through six straight weeks of cascading stock prices and seen recent online IPOs implode, Pandora has bumped the number of shares it's offering higher, and its offering price has more than doubled.

With as many as 161.9 million shares outstanding if the overallotment is exercised -- and it will, since it's hard to pass up 2 million more shares at $16 apiece -- we're talking about a company that was priced at a whopping valuation of $2.6 billion. Today's feeding frenzy is driving that market cap even higher. The stock traded as high as $26 within minutes of opening, delivering a ridiculous price tag of $4.2 billion!

Today's hungry investors don't seem to mind that more than half of the shares are being offered by insiders, or that a good chunk of the proceeds are going right out the door to pay accrued dividends on convertible preferred shares that are being exchanged for common stock.

I'm guessing that most of today's investors aren't even aware that -- unlike traditional terrestrial radio operators -- Pandora has to shell out a growing percentage of its revenue to the record labels in the form of royalties.

Pandora is an attractive company, but not at today's highly unattractive pop.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

Liberty Capital (Nasdaq: LCAPA  )
Pandora's lofty valuation makes Sirius XM Radio (Nasdaq: SIRI  ) seem cheap in comparison. Sirius XM is profitable and should generate more than $3 billion in revenue this year. Both companies face escalating percentages going out in music royalties in the coming years, but Sirius XM is now built to take on that future profitably. I do like Sirius XM, especially now that it has fallen under $2 with the recent market correction. However, Liberty Capital owns 40% of the satellite radio giant and trades at a discount to its portfolio of properties.

Apple (Nasdaq: AAPL  )
The popularity of Pandora on Apple's iOS platform -- now with 200 million iPads, iPhones, and iPod touch media players in the wild -- may have helped put the music discovery site on the map, but Apple still owns the road. Apple's recent push to the cloud -- with iCloud, iTunes Match, and even last year's uninspired Ping rollout -- will make Apple a bigger threat to Pandora than it thinks.

Google (Nasdaq: GOOG  )
Apple's not the only company crashing Pandora's stream dream. Google and Amazon.com (Nasdaq: AMZN  ) have recently hit the market with cloud-based music storage. Digital lockers offer ear candy on the go wherever wireless carriers or Wi-Fi hot spots can offer up connectivity, which happen to be the same requirements for Pandora. The arrival of Apple, Google, and Amazon in this space so quickly won't spell the end of Pandora, but it will give die-hard music listeners far more options after they've exhausted that 40th monthly free hour on Pandora. I also like Google's valuation here, priced at a mere 15 times this year's earnings and 13 times next year's bottom-line target.

I'm sorry, Pandora. This is one box that I don't want to open at this price.

The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services have recommended buying shares of Google, Apple, and Amazon.com. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Longtime Fool contributor Rick Munarriz doesn't mind taking out the garbage every so often. He does not own any of the stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


Read/Post Comments (9) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 15, 2011, at 4:01 PM, Fool wrote:

    Rick,

    I agree with you that Pandora does seem a bit overvalued at the current prices. But, I think that they are competitively differentiated in a way that Sirius, Google, and Apple just can't touch.

    Pandora is built around the Music Genome Project, where musicians spent countless hours picking apart the suddle nuances of thousands of songs and then developing a digital database to store this information. Pandora then used all of this to create an extremely easy-to-use website that RECOMMENDS NEW MUSIC TO YOU based on what you like.

    This is the code that Apple and Google haven't cracked yet. Yeah, great, you can store your music on the cloud. Apple's 'Genius' recommends songs to me every now and then in iTunes (woohoo?). But Pandora is still the best in class by far. And, the people that are using Apple/Google services are the same ones still using Pandora to expand their musical taste and find new bands.

    Though Pandora is highly dependent on advertising, let's not forget what made Google into the $160 billion company that it is today. I'm still a believer in the long-term future of Pandora.

  • Report this Comment On June 15, 2011, at 5:03 PM, Borbality wrote:

    music is just as easy, if not easier, to steal as it was 5 years ago. I'd rather not invest in a company that has recorded music as its only content.

  • Report this Comment On June 15, 2011, at 5:57 PM, FutureMonkey wrote:

    TX is right on. Pandora is the best music experience available.of array of options available to the consumer. The 20 second ads are not that intrusive, as unlike terrestrial radio, you know that it is only 20 seconds, so no flipping needed.

    Unfortunately monetizing the Music Genome Project has proved harder than I thought, and I don't know if the marginally superior experience is enough of a moat to create a sustainably successful business.

    I'd be cautiously optimistic investing at $2B market cap, especially as Pandora expands into drivers music selection windows -- might actually push my Sirius XM subscription to the curb.

    FM

  • Report this Comment On June 15, 2011, at 7:52 PM, Mega wrote:

    Pandora is winning market share because investors have been willing to throw money at it, not because MGP is a huge competitive advantage.

    Playing songs is not rocket science. I liked Yahoo's Launch radio better for example.

  • Report this Comment On June 15, 2011, at 8:17 PM, jekoslosky wrote:

    As an individual investor, I see no good reason to touch an IPO, even for a product or service I like. Pandora is interesting, being based on the music genome project. But is it really going to be a good business model? One that can grow over years?

    Even if I could answer those questions with a 'Yes,' I think I'd still give it a year.

    stocksnovice.blogspot.com

  • Report this Comment On June 16, 2011, at 9:42 AM, Brent2223 wrote:

    I'll still go with a human recommendation over a computer algorithm any day.

  • Report this Comment On June 16, 2011, at 10:13 AM, bottomfisherman wrote:

    Pandora the company is garbage. Huge operating losses. If you show up there once and never go back you are counted as an active user. They are using an outdated am/fm model that has failed for terrestial radio and it will fail for them. How can one expect people who want something for free, patronizing their advertisers? To make money they are either going to have to start charging for some services which defeats the purpose of they being free and or spamming with commericials which will drive people away. Pandora the stock like the company is garbage too, trading for pennies on the pink sheets in 2 years.

  • Report this Comment On June 16, 2011, at 11:20 AM, Troezen wrote:

    Pandora has a great product, I agree with some of the posters above, but a great product does not always make a good investment.

    A company that cannot turn a profit is not likely to do well on the open market, no matter how popular the service is.

    If they can find a better way to monetize their service, they may become a better investment option.

  • Report this Comment On June 16, 2011, at 4:46 PM, FutureMonkey wrote:

    Currently Pandora is only credit with having only 3% of "radio" listening market, so there is definitely room to grow with greater mind-share and prominence. Capturing a greater percentage of ear-time should translate into higher fee's for advertising. 50 million App downloads can't be bad for a company.

    The major problem I see is not on the revenue side, it is on the cost side. The royalty paid for the music is based on listeners/listening time not a flat fee for the company. As a result Pandora loses the benefits of scale that would flip them to higher profitability with increased user demand. That is as listeners goes up so does the cost of delivering the product.

    Still a huge fan of Pandora and the product, but not an investor at this time. Of course if they do accelerate revenue and become profitable, may be a much higher entry point for new money.

    FM

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