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Pandora: Uninvestable?

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Pandora (NYSE: P) exceeded Wall Street's expectations on both earnings and revenue on Dec. 4. But shares plunged 15%. Why? Pandora slashed their guidance, estimating a loss of 9 to 12 cents per share in fiscal 2013. Analysts were expecting guidance for a loss of just 6 cents per share. Disappointing investors is nothing new for Pandora. It's down over 40% from its IPO price last year. Does this sell-off represent a buying opportunity? Or is it yet another warning of an unfortunate future?

Long-Term Investing
Some investors like to say that there is a price for everything. I, however, stick with Warren Buffett's tried and true approach to investing in wonderful companies at fair prices with an intention to hold them for the long haul. This means that there are some businesses I won't even consider.
Investing in only wonderful companies means that there are less opportunities for investment, and when I do find an opportunity I will typically hold the stock for a very long time. There is empirical evidence that low-turnover portfolios generally outperform high-turnover portfolios. Buffett's long-term approach, therefore, will work generously in your favor. As Warren Buffett says: "Time is the friend of the wonderful company, the enemy of the mediocre."
Does Pandora fit Buffett's definition of a "wonderful" company for the long-term investor? Let's take a look. In 2007, Buffett outlined a filtering process for investments that Bud Labitan has coined as "The Four Filters:"
"Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag"
Buffett's investment partner, Charlie Munger, likes to say that they are in the business of "getting into high quality businesses." This filtering process helps them do this. It's no magic formula; It is the same process anyone would use when buying a business as a whole (and that's what a stock is after all, isn't it?) Best of all, this simple filter has helped them earn market crushing returns for Berkshire Hathaway shareholders for decades.
Pandora Fails Buffett's Four Filters Test
It can be argued that Pandora has an understandable business model, solid management, and maybe even a decent price tag. But Pandora utterly fails Buffett's "favorable long-term economics" filter. For a business to possess favorable long-term economics it must possess a durable competitive advantage, or an economic moat.
Due to the low barriers to entry in the streaming music business, companies with much larger balance sheets are able to introduce competing services and tap into their existing resources and users. Many of these competitors have much more experience in the music business. Consider Comcast's (NASDAQ: CMCSA) Rhapsody. In Comcast's most recent quarter it reported free cash flow of $1.5 billion, an amount that is greater than Pandora's entire market capitalization of $1.35 billion.
Sirius XM Radio (NASDAQ: SIRI) has not only performed better as a stock than Pandora, but also as a business. Though Sirius XM may earn the majority of its revenues from satellite radio instead of internet radio, it still offers a service that competes for listeners' time. While 90% of Pandora's revenue comes from advertising and is, therefore, very unpredictable, Sirius XM is based on a subscription model with consistent and predictable cash flows. The business model allows Sirius to generate sufficiently more revenue per subscriber than internet radio offerings:
<img src="/media/images/user_13783/sirius-revenue-per-subscriber_large.png" />
(image source: Sirius XM Radio earnings presentation slides)
Then of course there is always a possibility of larger and better equipped companies to launch an internet radio service that competes directly with Pandora. Pandora outlines the threat clearly in the risks section of its 10-K:
"We believe that companies with a combination of financial resources, technical expertise and digital media experience also pose a significant threat of developing competing internet radio and digital audio entertainment technologies in the future. In particular, if known incumbents in the digital media space such as Amazon, Apple, Facebook or Google choose to offer competing services, they may devote greater resources than we have available, have a more accelerated time frame for deployment and leverage their existing user base and proprietary technologies to provide products and services that our listeners and advertisers may view as superior. Our current and future competitors may have more well-established brand recognition, more established relationships with consumer product manufacturers, greater financial, technical, and other resources, more sophisticated technologies or more experience in the markets in which we compete."
Indeed, there are numerous rumors that Apple (NASDAQ: AAPL) is working on its own Pandora-like music service. Apple's TTM free cash flow of $40.5 billion alone is equal to thirty times Pandora's market capitalization. With millions of iTunes customers across the world, Apple already has access to the largest digital music customer base in the world. A competitive offering from Apple could very well represent the beginning of the end for the much smaller Pandora that is already forecasting a loss for the next twelve months.
The Bottom Line
Pandora has no economic moat. Barriers to entry are nearly nonexistent for well-capitalized competitors. Its cash flows that are primarily derived from advertising are not predictable, making the business impossible to value. According to Buffett's four filters, the business is uninvestable.

DanielSparks owns shares of Apple. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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