Just because a company is the first and most prominent name in a particular industry doesn't necessarily mean that they will be successful. Pandora Media, (P) just a few months ago, held over 30% of radio listeners over the age of 12 in North America. With such a huge piece of the domestic market, investors might expect big things. However, there are three problems facing Pandora and investors need to listen closely to what is going on.
The new and the old
Pandora faces significant competition in the online music market, and the market just got a little more crowded. The big gorilla in the music market is Apple (AAPL -1.22%), and the company's iTunes business generates billions more in sales than its peers.
For instance, Pandora's full year revenue this year is expected to be below $1 billion. In just the last three months, Apple's iTunes business generated over $4 billion in revenue. While iTunes has been around for a while, a new entrant into Pandora's streaming music market is Amazon.com (AMZN -2.56%).
Apparently Amazon realized that with its Prime service increasing in price from $79 a year to $99 a year, the company needed to add something to sweeten the deal. Amazon Prime Music is the company's offering of unlimited streaming music for Prime members.
While Prime works out to more than $8 a month, compared to $4.99 a month for Pandora One, there is a significant difference between what users receive. Pandora One gives users unlimited streaming without ads, but Amazon does the same with free two day shipping, Prime Video, and more. On the surface it seems like Amazon offers a far superior value.
Another challenger in the field is Spotify, which reported that it has about half the users of Pandora, but also has more than 10 million paid members. Given that Spotify entered the domestic market far after Pandora, and that the company has a less prominent place in vehicles and entertainment systems, this service offers a serious threat to Pandora.
The bottom line is, Pandora is facing serious competition and investors need to listen to this first drumbeat of doom.
Active is a relative term
Though Pandora is still seeing decent active listener growth, the company's listener hour growth is the second drumbeat of doom. Six months ago, Pandora reported the company's listener hours grew by 23% for the year, but in the quarter they increased by 16% annually. In the current quarter, the company's listener hours increased by just 12%.
As we can see, in the last two quarters listener hours showed slowing growth, and compared to last year the growth rate was cut almost in half. It's hard to believe that some of these hours aren't being used on other services like Spotify, Google Play All Access, and iTunes Music. With Amazon Prime Music, it is likely that listener hour growth may be cut even further.
The bottom line
The third drumbeat of doom facing Pandora is the company's margin challenges seem to be getting worse. What is particularly troubling is, Pandora's gross margin is being compressed, and the company is also hurting itself by growing its spending significantly.
Relative to Pandora's peers, Apple's gross margin benefits from the popularity of the iPhone in particular. With a gross margin of nearly 40%, Apple sits atop the peer group we've mentioned. Amazon has managed to improve its gross margin significantly in the last few years, and in the company's last quarter managed a margin of nearly 29%.
By comparison, Pandora's gross margin looks OK at 36.6%, but there is much more to the story. First, the company's gross margin was nearly 47% last quarter. Second, even more than 12 months ago Pandora's margin was nearly 39%.
Beyond the fact that the company's margin is being compressed, is the problem that Pandora is growing its spending at a faster rate than its sales. In the current quarter, sales & marketing expenses grew by more than 60% annually. In addition, general & administrative expenses nearly doubled.
The significant increase in costs caused Pandora's operating margin to come in negative. Even worse for investors, the company's capital expenditures jumped by over 170%. While Apple generates billions in free cash flow, and Amazon breaks roughly even, Pandora is spending more than it makes.
With more competition, slowing listener hours, and negative trends in spending, Pandora investors should realize the drumbeat of doom is getting louder with each quarter. The company needs to make some changes and quick if it hopes to reverse these issues. Until then, investors should probably avoid the stock.
