Pandora Is Getting Desperate

The first thing that an investor should look for when researching a company is a business model that makes sense. This is more important than brand awareness or active users or whatever other metric is touted by the company in question.

Internet-radio company Pandora Media (NYSE: P  ) is a great example of a company with wonderful-looking metrics but a fatally flawed business model, and the most recent quarter has shown that the company is getting desperate.

Growth is a double-edged sword
It's relatively easy to spin Pandora's earnings results into a positive. Revenue rose by 55% year over year as advertising revenue grew by 44% and subscription revenue grew by 153%. Non-GAAP mobile revenue jumped 92% year over year as the company has made great progress targeting mobile users. Listener hours rose by 18% year over year to about 3.9 billion and active users grew by 30% to 71.2 million.

All of this sounds wonderful, but there's another number that's growing as well: costs. Total costs rose by 55%, matching the revenue growth and causing the company to record a slightly larger loss than in the same period last year. Sales and marketing costs nearly doubled, general and administrative costs rose by 73%, and product development costs jumped by 77%.

Another thing that's growing is the share count. The weighted-average diluted share count grew by nearly 5% year over year, meaning that a share of the company bought one year ago now represents a reduced ownership stake in the company.

Volume doesn't solve the problem
The vast majority of Pandora's users don't pay the company a dime, and Pandora monetizes that user base via advertisements. Advertising revenue made up 81% of revenue in the quarter, with subscription revenue accounting for the rest.

The problem that Pandora seems to have is that the company is losing money every time a user streams a song. Costs are rising just as fast as revenue, and in fact faster than advertising revenue, so simply adding more users doesn't help profitability.

In Pandora's latest earnings call, the company announced that it was lifting its 40-hour limit on non-subscribing mobile users, a policy which was only in place for six months. This policy was originally put in place because increasing royalty rates made free unlimited listening untenable. Although the company states that strong advertising revenue is the reason for the policy being scrapped, I suspect that there is another reason: Player Two has entered the game.

The growth story may be over
There are plenty of competitors in the market already, such as Spotify, Slacker Radio, and a slew of start-ups. But Pandora has remained a popular choice for Internet-radio streaming even as other services gain traction. This could very well end with tech juggernaut Apple (NASDAQ: AAPL  ) getting into the game: Apple is set to launch iTunes Radio in September.

Looking at Apple's website detailing the service, it becomes clear that it will be very similar to Pandora. One positive for Pandora is that iTunes Radio will not be available on Android devices, although it will be available on PCs. iTunes Radio does have some unique features, such as Siri integration and the ability to buy songs and add them to an iTunes collection with ease. But the concept is essentially the same as Pandora.

iTunes Radio will have an ad-supported free version, but a subscription to iTunes Match will allow users to listen ad-free. iTunes match is Apple's cloud-based music-syncing service, which allows you to access your music collection, whether bought on iTunes or ripped from CDs, on any device.

iTunes Match costs $24.99 per year, less expensive than Pandora's $36 per year ad-free subscription. I doubt Apple will make much money directly from the service, but its tight integration with iOS 7 is a selling point for Apple devices. And the record labels which own the content are likely thrilled with the ability to buy songs directly from the app.

The bottom line
My opinion for quite some time has been that a business based on paying royalties for content which is then streamed doesn't make much sense as a stand-alone company. If these streaming companies began to make a considerable profit, the owners of the content would likely demand more money, reducing profits back to piddling levels. Royalty rates are currently statutory, but could potentially change in the future.

As part of a broader ecosystem like Apple's, an Internet-streaming service makes sense, but I don't think a stand-alone company like Pandora will ever consistently earn meaningful profits. I'm not sure what investors see in Pandora, but I see a failed company waiting to happen.

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Read/Post Comments (8) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On September 04, 2013, at 2:39 AM, EightBucks wrote:

    “If these streaming companies began to make a considerable profit, the owners of the content would likely demand more money, reducing profits back to piddling levels.”

    You didn’t do your homework, the royalty rates are not set by the “owners of the content” but by the CRB (Copywrite Royalty Board) which sits under the Library of Congress and the current rates are locked in until the very end of 2015.

    Very sloppy journalism, if you can that journalism.

  • Report this Comment On September 04, 2013, at 8:04 AM, patruns wrote:

    You also left out Google's music streaming that while not free, has no limits on skipping songs, allows you to stream an entire album, choose specific songs to listen to and also make an immediate purchase. I used the paid version of Pandora for a year, but once I tried the Google service I dropped the Pandora subscription.

  • Report this Comment On September 04, 2013, at 8:18 AM, bugnuts wrote:

    The 40-hour listening limit caused me to cancel my Pandora account months ago.

    The limit never made sense. Most companies would delighted to have listeners keep consuming content and hearing more ads.

  • Report this Comment On September 04, 2013, at 9:47 AM, EightBucks wrote:

    Wow bugnuts, why didn’t you just buy a sub, was one dollar a week for unlimited music out of your budget?

    You could have asked your mommy to increase your weekly allowance.

  • Report this Comment On September 04, 2013, at 11:31 AM, WhyStopNow wrote:

    "My opinion for quite some time has been that a business based on paying royalties for content which is then streamed doesn't make much sense as a stand-alone company."

    Netflix.

    I don't know about anyone else, but I for one would find my pandora and netlix being compatible with one another convenient.

  • Report this Comment On September 04, 2013, at 8:36 PM, newjerseynets444 wrote:

    If you go a bit deeper into Pandora's outlook for streaming costs, you'll realize it's not as simple as "owners demanding more money" if Pandora becomes more profitable. On the publishing rights side, the two major players ASCAP and BMI have lost case after case for higher royalty rates in NY district Judge Cote's court since 2009. It's reasonable to expect Pandora to secure lower rates as well. Meanwhile, politicians have stirred up a debate regarding the fact that Internet radio pays ~50% of revenue in streaming costs while its competitors satellite radio and Internet radio pay 7.5% and 0% respectively. Throw in three completely new arbitrating judges deciding performance rates for 2016 forward on the heels of precedents set in Cote's court, and one can bet that Internet radio no longer has to deal with 10% annual increases in unit streaming costs as was set in 2009 (when a significantly smaller Internet radio industry was at the whim of huge record labels upset that Apple had gotten the best of them in the iTunes deal).

    As for marketing and sales costs, Pandora barely had a sales force in 2012, with a small presence in only 8 of the top 40 markets. Now its sales force has increased by 60-70%, poaching top reps from the likes of clear channel and CBS radio, and is present in 28 of the top 40 markets. Any advertiser will tell you that selling advertising is a relationship driven business, making Pandora's hiring spree a logical and necessary business move. Its results thus far speak for themselves, with mobile RPM growing 46% Y/Y in Q2.

    At the end of the day, Pandora is competing in a $14B radio advertising market, where it has a competitive advantage both in attracting listeners and advertiser dollars. AM/FM radio listening in terms of hours listened per week has been decreasing over the past decade, while Internet radio listening has exploded. Advertisers are finally wising to the fact that no one listens to am/fm radio ads that last 4 minutes at the time, people immediately change stations upon ads coming on. Pandora's ads are much more infrequent, usually 30 seconds at a time, and are on personalized stations. This is a not a short term investment by any means, but as the market leader in the disruptive Internet radio industry, I wouldn't shoot it down just yet.

  • Report this Comment On September 05, 2013, at 12:56 AM, bbsatx wrote:

    I'm a Pandora user. Their business model may suck now, but they really don't advertize much when you listen through your home receiver or listen thru your bluray, or phone. They could double those sound ads and rake in bud.

  • Report this Comment On September 06, 2013, at 12:20 PM, pwright99 wrote:

    Sounds like Mr green is getting desperate. As the stock continues to climb, the only negative articles (with pejorative headlines) seem to come from Motley Fool "analysts", even though, apparently, MF recommends Pandora!

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