The explosive rise in shares of Pandora Media (NYSE:P) over the past 18 months has been somewhat perplexing. Pandora has yet to turn a profit, its expenses have routinely grown faster than revenue, and competition has only gotten fiercer. Since hitting a high of $40 per share in March, the stock has collapsed to the low $20s, in part due to the most recent earnings report. While rapid growth in users and revenue has been the driver of Pandora's stock in the past, slowing growth and stagnation in active users seems to have convinced the market that profits may matter after all.

A shift in spending
One good piece of news that came out of Pandora's first-quarter earnings report is that content acquisition costs grew more slowly than revenue. Advertising revenue grew by 45% year-over-year, with total revenue jumping by 69% thanks to a near-tripling of subscription revenue, compared to just 26% growth in content acquisition costs. This shows that Pandora is doing a better job of monetizing its users, and that's certainly a good thing.

The problem with this story is that operating expenses rose by 72%, with sales and marketing spend increasing by 63% and general and administrative costs nearly doubling. So while gross profit rose considerably, the massive increase in spending led to a $29 million loss during the quarter. This is slightly better than the $38 million loss during the same period last year, but Pandora was still squarely in the red.

It seems that this increase in sales and marketing was the main revenue driver, because the number of active users actually declined compared to the previous quarter, and it's only up 8% year-over-year. At the end of the fourth quarter of 2013, Pandora had 76.2 million active users. This number declined to 75.3 million at the end of the first quarter of 2014, a bad sign for a company that has relied on rapid growth to quell concerns about lack of profitability.

Without new users, better monetization of existing users is the only way to grow revenue, and that has a limit. Of course, Pandora may be able to reverse this active user trend in the following quarters, possibly by expanding to new markets, but with all of the alternatives that consumers have, it's very possible that the company has hit its peak, at least in the markets that it currently serves.

What, exactly, makes Pandora different?
There are a litany of options facing the consumer when it comes to music streaming services, and while Pandora has the largest user base, the company still has yet to prove that it can stream music profitably. Pandora was the first Internet radio service to go mainstream, and that first-mover advantage helped the company get to where it is today. But when a company that's valued at nearly $5 billion can't seem to turn a dime of profit, even with more than 75 million active users, investors should be wary.

What does Pandora do differently than every other music streaming company out there? That's the most important question that investors should be asking themselves, because without a clear differentiating factor, Pandora will never turn a serious profit. What does Pandora do differently than Spotify, a company that is rumored to be planning an IPO for later this year? What does Pandora do differently than Apple (NASDAQ:AAPL), which launched its iTunes Radio service last year?

iTunes Radio has the advantage of being tightly integrated with iOS, and along with Siri integration and compatibility with music purchased from iTunes, iTunes Radio is a very serious competitor on Apple devices. 11 million users tried iTunes Radio during its first week of availability, and while it still is nowhere close to the size of Pandora, more competition is not a good thing for the company.

All of these services work the same way. Royalties are paid per song played, and revenue is generated from both advertising and subscriptions. All of them offer a large number of songs, although Pandora has a fairly small selection, and all of them try to create personalized playlists based on user preferences.

This is one area where Pandora has the chance to be better than all the rest. Being able to play songs that users want to listen to, based on the billions of user interactions that the company has been analyzing since its launch in 2000, is the one thing that Pandora can really do differently. And based on Pandora's huge Internet radio market share, the company seems to know what it's doing.

But is this advantage sustainable? A competitive advantage is nice, but a sustainable competitive advantage is what every company is striving for, and what very few achieve. The fact that Pandora hasn't been able to turn a profit even though it is the dominate Internet radio company is not a good sign. The problem is that Pandora doesn't have any power over the royalties that it pays. This is the same problem that every Internet radio company faces, and without the ability to control the largest expense, I'm not sure how any of them expect to turn a meaningful profit.

The bottom line
Pandora's is facing a stagnating user base, and while revenue rose considerably in the quarter, it was on the back of an enormous increase in spending. Pandora's biggest problem is not the competition, but its business model, and unless the royalty rates that Pandora pays are reduced, there doesn't seem to be a path to profitability. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.