I like Pandora Media (NYSE: P). Wait, scratch that, I love Pandora. It helps me discover new music based on what it knows I like, and it does it for free! Why would I pay to subscribe to Sirius XM Radio instead? Yet, just because I'm a fan of the company's product, that doesn't mean I should become an investor.

The reason I won't invest in Pandora has a little something to do with what I like to call operating leverage (OK, other people call it that, too). Companies with high operating leverage have more fixed costs than variable costs. Generating more sales spreads out these fixed costs and results in lower average total cost per unit produced. This means that as a company's revenue grows, its margins expand. The flipside is that if the business begins declining, the company will also have trouble scaling its operations down to cut costs.

Pandora's primary costs are content-acquisition expenses (royalties and licensing), which are variable and dependent on listener hours delivered. The company's primary source of revenue, advertising, is also linked directly to listener hours. Even though listener hours have been steadily climbing, Pandora's content-acquisition costs have been accelerating while advertising revenue has been decelerating.

G

Source: Pandora prospectus.

This graph compares the growth rates in ad revenue and content-acquisition costs to listener hours delivered over the past eight quarters. I've added in some logarithmic regression lines for illustrative purposes, only to smooth out the overall trend. It's apparent that royalty-expense growth has overtaken ad-revenue growth, which will make it increasingly difficult to turn a profit if this trend continues.

Wait -- there's more!
To be fair, subscription revenue as a percentage of overall revenue has been growing, so it seems that more customers are buying into Pandora's value proposition. I'd like to see the company diversify its revenue stream more in this direction before I'd consider investing. There are more moving parts than this to the overall bottom line, so be mindful that ads and royalties aren't the whole picture.

Even while trying to work out the unprofitable kinks in its business model, Pandora will have to play pretty solid defense against juggernauts Google (Nasdaq: GOOG), Amazon.com (Nasdaq: AMZN), and Apple (Nasdaq: AAPL), all of which are infiltrating the cloud music scene. European music service Spotify also just emigrated from across the Atlantic, looking for a place to settle down as the newest addition to Pandora's list of competitors.

Even though I'm an avid user of Pandora's service, I can't find a compelling reason to buy the shares until I see something at the very least vaguely resembling a path to profitability.