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Just because something is popular with consumers, that doesn't mean it should be popular with investors. I'm a big fan of Pandora Media's (NYSE: P ) well-known service, but there are some pretty glaring holes in its business model, although it has been putting up some lustworthy revenue growth rates.
Is Pandora a buy, sell, or hold?
Buy: lustworthy revenue growth rates
Last quarter, the digital DJ nearly doubled top-line revenue. Sales soared by 99% to $75 million. The quarter before that, which was Pandora's first public earnings release, revenue exploded by 117% to $67 million. Those growth rates are facilitated by strong user growth -- up 65% YOY last quarter -- with active users now sitting at a record 40 million.
Listener hours delivered keeps chugging higher, growing by 104% last quarter to 2.1 billion. That trend is likely set to continue along with the mobile revolution, since more than 70% of Pandora usage is delivered to mobile devices.
Sell: unworthy royalty growth rates
The problem with Pandora's model is that royalty expenses grow faster than revenue and will continue to comprise the bulk of expenses for the foreseeable future. Content acquisition expenses jumped by 107% last quarter, adding up to almost 51% of expenses. Having such a high variable cost structure means that Pandora's business isn't scalable and doesn't have operating leverage.
Pandora has a paying subscriber base, but subscription services as a percentage of total revenue have ticked down from 13.2% to 12%. Last year, the company said it will begin negotiating for better royalty rates in 2014 that it hopes to have implemented in 2016.
As a small-cap-growth investor, I've never had qualms with losses in the early years, provided there are promising growth prospects and hints of inevitable profitability. Unfortunately, Pandora's business model doesn't inspire confidence in long-term sustainable black ink.
Hold: at the bottom of Pandora's Box lies hope (for royalty rates)
There is hope for Pandora's royalty structure, and it has changed in the past. Back in 2009, Pandora cut a deal with SoundExchange, a large licensing negotiator that represents record companies, that slashed minimum per-stream royalty rates for Internet radio providers by as much as 40% to 50%. Companies that fit that description paid the greater of either a per-stream rate or 25% of revenues, and the former is what Pandora pays, which adds up to more than half of revenues. This arrangement goes through 2015.
Meanwhile, a few months ago, the American Society of Composers, Authors, and Publishers, or ASCAP, reached a settlement with the Radio Music License Committee that sets the stage for "a return to a revenue-based fee structure" while acknowledging that distribution for the industry is migrating toward "Internet websites, smartphones, and other wireless devices."
ASCAP is just one of the entities that Pandora pays licensing fees to every time a song is served up, and that settlement at least shows that there may be light at the end of the tunnel with how royalty rates are structured. A percentage-of-revenue model is more sustainable than a per-stream rate, as it could cap Pandora's costs.
On the other hand, SoundExchange President Michael Huppe doesn't think a flat fee is reasonable and adds some figures to the discussion. For Pandora's free service, it pays about 1.65 cents per listener per hour, assuming 15 songs per hour. The free service is capped at 40 hours per month, which amounts to $7.92 per listener per year for 480 hours where Pandora can squeeze in advertising.
Hold: competition is heating up
European rival Spotify recently launched a radio-esque service that takes direct aim at Pandora's music-discovery value proposition. Satellite-radio provider Sirius XM Radio (Nasdaq: SIRI ) is a well-known alternative and also enjoys advantages with its own royalty rates.
Pandora co-founder Tim Westergren recently highlighted the discrepancies among royalty rates for different mediums: "Last year, we paid over half of our gross revenues in royalties just from performance fees. That compares to satellite radio, which pays 7.5% or 8% of gross revenue, and broadcast radio, which is completely exempt from it."
Sirius XM's royalties for last year ended up actually being 15.6% -- higher than Westergren's estimate but far lower than what Pandora pays out.
CBS (NYSE: CBS ) bought music discoverer last.fm years ago, and heavyweights such as Apple (Nasdaq: AAPL ) and Amazon.com (Nasdaq: AMZN ) are making big splashes in cloud music. Apple's iCloud and iTunes Match and Amazon's Cloud Drive player both deliver tunes you already own.
As it stands, Pandora Media is a sell, which is why I've had it next to an underperform CAPScall for quite some time. The current cost structure with royalties means that the bottom line will never catch up with top-line growth at this rate.
Even though Pandora delivers a compelling service with a growing user base, there's little hope that the company will translate that strength into sustainable profitability as content acquisition costs continue to eat up revenue.
There's some hope that royalty negotiations can swing in Pandora's favor as the online music streaming industry continues to mature, but that would also benefit streaming rivals such as last.fm and Spotify. If the royalty structure were to change, I'd reconsider my stance on Pandora.
Any possible change would be years away, until at least 2015. In the meantime, I'm tuning out Pandora as an investment.
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