Shares of Internet radio company Pandora (P +0.00%) got slammed after it reported its fourth-quarter earnings, falling short of revenue estimates and guiding for a weaker-than-expected first quarter. Pandora's stock price is now down nearly two-thirds from its 52-week high, and the company has continued its annual tradition of reporting a net loss.
I wrote about the unrealistic expectations surrounding Pandora about a year ago, when the stock was trading at more than twice its current level. Pandora has made some progress in monetizing its platform since then, consistently increasing the amount of advertising revenue taken in per hour of music. But costs are rising as well, and the net result has been continued and growing losses. Pandora has a spending problem, and it's not clear that there's a solution.
Bringing in more advertising dollars
Pandora's business model is simple: The company makes a royalty payment for each song it plays, and it attempts to bring in enough advertising dollars per song to pay for both these royalties and its operating expenses. Pandora also offers ad-free subscriptions, but advertising revenue makes up the bulk of Pandora's revenue.
Pandora has made a lot of progress in terms of monetization over the past couple of years. During the fourth quarter of 2014, the company brought in $48.19 in advertising revenue for every thousand hours of music. This is up from $40.95 in the fourth quarter of 2013, and $32.33 in the fourth quarter of 2013.
The main driver has been mobile. Mobile revenue made up 78% of Pandora's revenue during the fourth quarter, and over two years, Pandora has increased the advertising dollars per thousand hours on mobile by nearly 75%, compared to a 16% increase on the PC.
This improved monetization, combined with 15% growth in listener hours during the fourth quarter, led to a 33% year-over-year jump in revenue during the fourth quarter. These are all good developments, as royalties now make up a smaller percentage of revenue. During 2014, royalties accounted for about 48.5% of revenue, down from 53.8% in 2013 and 60.6% in 2012.
This hasn't led to profitability for Pandora, though, because this improved monetization came with a cost.
Pandora's rising costs
Ads don't sell themselves, and Pandora has had to increase its sales and marketing spending in order to drive this improved monetization. This spending has increased at a rate faster than revenue growth, cancelling out any gains.
During 2014, Pandora increased its sales and marketing spending by 52.2%, faster than the 44% increase in revenue in 2014. Total operating expenses also rose faster than revenue, jumping nearly 53%.
One driver of this increase in spending has been Pandora's local advertising push. Pandora has opened offices and stationed sales representatives in cities across the country in an effort to compete for local advertising dollars directly with radio stations. This gives Pandora the ability to sell ads to not only large, nationwide advertisers, but small, local ones as well.
Source: Pandora.
During 2014, Pandora derived about 16.6% of its revenue from local advertising, with local advertising revenue jumping 155% compared to 2013.
One could argue that these higher costs are the result of these early investments in local advertising, and that over time, the picture should improve. But guidance for 2015 leaves a lot to be desired.
Things aren't quite getting better
Revenue is expected to increase by 27% in 2015, a sharp deceleration compared to revenue growth in 2014. Adjusted EBITDA, or earnings before interest, taxes, depreciation, and amortization, is expected to be between $70 million and $80 million in 2015, a bit higher than the $58.2 million of adjusted EBITDA in 2014.
This number excludes Pandora's sizable stock-based compensation expense, and using this guidance to come up with an estimated operating loss for 2015 yields pretty dire results. Pandora is implicitly guiding for an operating loss of $65 million, assuming the high-end of the EBITDA estimate, more than double the $30 million operating loss of 2014.
It turns out Pandora's operating loss in 2014 would have actually been closer to $45 million, but the company recognized a $14.2 million gain related to its subscription return reserve. Adjusting for this, Pandora's losses have been growing in each of the past two years, and this deterioration will accelerate in 2015 based on the company's guidance.
The only conclusion is that costs are going to continue to rise faster than revenue, and that obviously isn't sustainable in the long run. At some point, Pandora needs to figure out how to make money. With its business held hostage by royalty payments that are largely out of its control, and with heavy spending more than canceling out the effects of improved monetization, the situation at the leading Internet radio company is only getting worse.
