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These 3 Numbers Explain Why Pandora Has an Uphill Battle Ahead

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Any company with 31% of a growing market would seem to be a potential investment opportunity. Pandora (NYSE: P  ) has been a fantastic investment in the last year, with the stock more than doubling. However, with new competition from Microsoft (NASDAQ: MSFT  ) , Google (NASDAQ: GOOGL  ) , and a host of others, the music streaming field is getting crowded. Pandora has some serious challenges ahead, and this could be a case of what goes up must come down.

Is this enough for investors?
One of the key metrics Pandora uses to measure its growth is listener hours. Unfortunately, this measure is sort of a double-edged sword for the company. The more customers use its service, the more expensive the content. Yet without this growth, Pandora is less valuable to advertisers. The first number that suggests Pandora has an uphill battle is the company's listener-hour growth seems to be slowing.

In the current quarter, Pandora reported a 16% annual growth rate in this metric. In the two prior quarters, annual listener hour growth was 17% and 18%, respectively. Last year, listener-hour growth was 23%. As you can see, Pandora's core business is slowing down.

One area where Pandora doesn't spend enough money
The second number that suggests Pandora has an uphill battle is spending enough on research and development, which is just 4.5% of revenue in the current quarter. Pandora is a technology company, and companies in this field must spend heavily on R&D to fend off competition.

For comparison, Microsoft spent more than 11% of its revenue on R&D in the last three months, and Google spent almost 13%. If you look at the difference between the services being offered by Pandora compared to these two larger competitors, you can see that R&D is a weak spot for the company.

Pandora originally offered customized radio stations based on an artist, song, album, or genre. Today Pandora is largely the same service offering similar capabilities. The company introduced Pandora One at $36 a year or $3.99 per month -- now $4.99 -- to avoid ads in 2009, but not much else has changed.

By contrast, Microsoft is trying to leverage the success of its Xbox franchise to gain a foothold in the music streaming. Xbox Music offers a free version with ads similar to Pandora, but for $9.99 you can upgrade to Music Pass and create personalized playlists, listen offline, and avoid ads.

Google Music offers users the ability to import up to 25,000 of their songs for free. If you upgrade to Google Play All Access for $9.99 per month, users can create playlists, listen without ads, and even reorder the songs in their customized radio station.

While Xbox music doesn't rank in the top 10 domestic streaming services yet, according to a recent survey, Google Play All Access already ranks No. 5, and the service was just launched last year. Considering that Pandora has been publicly available since at least 2005, it seems the company's relatively low R&D spending is allowing competitors to take market share.

Broken since day one
Pandora reportedly has 250 million users, but just 3.3 million have Pandora One. This price increase will not only move annual subscribers from paying effectively $3 a month to $3.99, but also will raise the price for new subscribers to $4.99 per month.

While some might see this as a positive, Pandora risks running off customers at a time when it needs more of them. This is the third number that suggests the company faces an uphill battle. The price increase inches Pandora One closer to its competitors' offerings, which appear far superior in customization.

The core issue has little to do with subscribers, and more to do with the roughly 247 million non-paying customers. Pandora pays every time a song is played, yet has to sell enough ads to offset all of these costs.

As a recurring theme, operating expenses were up 73% in the current quarter compared to a 51% increase in revenue. Unlike companies that can leverage their costs across a larger user base, Pandora's content expenses grow with its audience.

Final thoughts
As we can see, Pandora has multiple challenges, including competitors that appear to offer a superior value. With the stock up more than 100% in the last year, investors would be wise to take profits while they can.

The truth is, Pandora must update its offerings to keep up with its competition. Unless Pandora changes, competitors like Microsoft, Google, Apple's iTunes Radio, and Spotify will eat Pandora for lunch.

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Chad Henage

Chad is a self professed tech nerd and has been investing for over 20 years. He follows nearly everything in the technology and consumer goods sectors, and is a huge fan of the Peter Lynch investing style. He has over 1,000 published articles about stocks and investing. You can follow Chad on Twitter at @chadscards1274.

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