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Pandora Finally Gets It Right -- Time to Sell

Chad Henage
March 13, 2014

For anyone who thinks this is going to be an article bashing Pandora Media (NYSE: P), you've got it all wrong. The truth is, Pandora's business model is actually starting to make sense and that is exactly why it's time to sell... the company.

Doomed to fail but defying the critics
Many analysts and observers have been skeptical about Pandora's future from the very beginning. When Pandora plays a song it has to pay the artist a royalty. In this way, the more the service is being used, the more expensive the royalties.

While Pandora's overall operating expenses are still growing faster than revenue, it's not the company's content expenses that are to blame. Content costs increased by about 30% in the current quarter, but SG&A and other expenses grew much faster.

By contrast, Pandora reported overall advertising revenue grew 39%, and its subscription revenue increased by 132%. With subscription revenue now making up 19% of total revenue, and this revenue stream growing much faster, the company could generate more stable revenues in the future.

The bottom line is, Pandora is beginning to look like a business that will stick around. The challenge, of course is, all of a sudden every large company seems to want a part of the streaming music business. So where does Pandora go from here?

The best course of action for Pandora might be to make itself available for purchase at the right price. The company currently carries a market cap of about $7 billion, which is easily within the budgets of several of the largest players in the technology field.

Customers of Pandora, Apple's (NASDAQ: AAPL) iTunes Radio, Google's (NASDAQ: GOOG) All Play Access, or even Microsoft's (NASDAQ: MSFT) Xbox Music Pass all have one thing in common. These listeners have found a reason to prefer the one service over the other.

With streaming video, it's not unusual for subscribers to have more than one service because there is significantly different content available. However, if a subscriber is paying $9.99 a month for Google's Play All Access package, are they likely to pay $9.99 to have Xbox Music Pass as well? Probably not.

Why should Pandora sell? Pandora has been around and widely publicized since about 2005. According to recent research, the company carries about 31% domestic market share. However, iTunes Radio didn't launch until September 2013 and already commands 8% of the market. Google's Play All Access is almost never mentioned or publicized, started in May 2013, and yet has managed a 2% market share.

Xbox Music didn't rank in the top 10, but the company sold more than 7 million Xbox consoles last quarter alone. If Microsoft hopes the new Xbox One will be the center of customers' entertainment systems, Xbox Music has to be part of that push.

Apple could have bought Pandora twice last quarter
Apple's $140 billion in net cash makes Pandora's $7 billion market cap look like peanuts. In fact, Apple generated enough core free cash flow in the last three months to buy Pandora almost two times over.

Apple could provide the resources to cut Pandora's SG&A expense growth and make the service more profitable. Apple would also benefit from tighter integration with iTunes in Pandora. Considering iTunes generated almost 8% of Apple's revenue last quarter, this wouldn't be insignificant.

No one does advertising like Google
Where Google is concerned, the company's Play All Access could be the top-tier offering at $9.99, Pandora One at $3.99 could be the mid-tier option, and Pandora's free radio would be for everyone else. With millions of Android devices bein