Shares of Pandora Media (NYSE: P), an internet-based provider of radio services, have been on a tear lately. Currently, shares of the company trade for $27.10, about 3% off of their 52-week high of $27.93 and 282.8% above their 52-week low of $7.08. As a result of this strong share price appreciation, the company's market capitalization now stands at $5.13 billion.
Admittedly, this is an impressive figure for a company with roots going back to 2004, and which has only been publicly traded since 2011. However, it's a far cry from the $24.77 billion market capitalization of another giant in the radio industry: Sirius XM Radio (NASDAQ: SIRI).
Before we go on, I should clarify that comparing Pandora to Sirius is a bit of a stretch in and of itself. Though both companies provide radio services, Sirius does so through a satellite-based system, while Pandora operates via the internet. Seeing as how both compete for the same customers in the same industry, it's not impossible to make a comparison between the two. Rather, it makes things a bit more interesting as it affords us the ability to ask if Pandora has what it takes to catch up with Sirius in terms of size and profitability.
Exploding growth but margin divergence
Looking at the revenue for both companies, we can see that each has demonstrated their ability to grow phenomenally fast:
Over the past five years, Pandora has been able to significantly outpace Sirius in terms of growth, seeing its revenue grow from $19.3 million in 2008 to $427.1 million by the end of 2012. This represents a more than 2,100% increase in revenue over time. In juxtaposition, Sirius has seen its revenue increase significantly as well, rising by more than 104% from $1.66 billion to $3.4 billion.
In all fairness, judging an investment by its revenue alone would be a disservice to both companies, as they are both in very different stages in their life cycles. Pandora is still in what investors might deem to be the early stage of its development, where revenue is capable of growing rapidly even at the cost of foregoing a profit. Sirius, however, has long since passed that stage and is dividing its efforts between generating revenue and showing profitability.
In another article, I provided a discussion of the difference in each company's margins. I essentially arrived at the conclusion that Sirius' improving gross profit and operating margins are the result of it achieving economies of scale in its business, thereby increasing its buying and supplying power among content providers and customers, respectively. On the other hand, Pandora's margins have seen a general decline, primarily as a result of increased expenditures on content (impacting its gross profit margins) and employee-related expenditures (impacting its operating margins). In the event that the worsening trend continues into perpetuity, it is inevitable that shareholders invested in Pandora will feel the pain. If these investments in content and increased workforce can yield higher future returns, however, then the company can flourish and provide the same kind of valuation that Sirius has.
Free cash flow woes
In addition to revenue growth and margin improvement, another area of interest for the Foolish investor is free cash flow. Any company ultimately derives value from its ability to generate positive free cash flow over time.
As we can clearly see with Sirius, it has been able to generate positive (and continually improve) free cash flow for four of the past five years. Such cash flow generation has enabled management to continue its growth through acquisitions, while allowing the company to engage in significant share buybacks. Pandora, on the other hand, appears to fall short in the free cash flow test. To make matters worse, its cash flow from operations (free cash flow minus capital expenditures) has been negative in three of the past five years, suggesting that the company isn't even capable of being cash flow positive without instituting growth initiatives.
Move over, boys! The Big Man's coming through!
As if competition between these two players doesn't present a large enough threat for the companies, they both suddenly have to worry about an even larger company coming to town: Apple (NASDAQ: AAPL). According to this article, Apple unveiled its own streaming platform for radio listeners, logically dubbed iTunes Radio. Based on the terms of iTunes Radio, listeners have the ability to access the entire iTunes catalog of songs, something that could prove threatening to Sirius but will more likely impact Pandora. Sirius has a heavy lineup of programs that attract listeners, whereas Apple has not released any plans to do the same (at least not yet, though I suspect it will eventually).
Perhaps the most concerning detail behind this news is that in its first month of operation, Apple saw its number of unique visitors grow to 11 million. This is dwarfed by the 25.3 million subscribers that Sirius hopes to have by the end of the year and the 71.2 million active users and 200 million registered users held by Pandora. However, such a rapid accumulation of visitors in such a short amount of time could spell trouble in the future (especially when considering that Apple has more cash and cash equivalents with which it can make investments than Sirius and Pandora have in market capitalization).
It is hard, if not downright impossible, to see what lies ahead for Pandora. If the company is able to generate higher revenue over time from its larger customer base than Sirius has, however, then it too may end up being a fast-growing business that can yield profitable returns instead of the annual losses that investors have had to contend with. With a big company like Apple coming into the fray, though, I don't believe that it's unreasonable to imagine a scenario where both Sirius and Pandora are beaten at their own game.