Great Product, Poor Business: The Pandora Story

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

Most investors are familiar with the saying: “Great companies aren’t necessarily great stocks.”  That being said, poor companies almost never prove to be quality long-term investments.  Accordingly, finding a solid business model with excellent growth potential or a sustainable competitive advantage ought to be the basis of any investment thesis.  Of course, discovering companies that fit this description is no small task.  Pandora (NYSE: P) has demonstrated a fundamental lesson for investors in 2012: a great product doesn’t always equate to a great business.

Needless to say, it has been a volatile year for the internet radio provider as Pandora has commanded headlines left and right.  The company’s stock has traded as high as $14 back in March as well as below $8 in November.  Earnings per share has varied from -$0.09 after the first quarter to $0.05 after the third.  Pandora’s stock price, however, has not traded in correlation with its ability to beat analysts’ estimates—which it has for three straight quarters—and has been dictated by the forward-looking statements offered by management as well as extrinsic developments such as rumors that Apple (NASDAQ: AAPL) will soon roll out a similar service. 

A lot of the confusion with Pandora’s stock stems from the dichotomy that such a great product could yield such poor business.  First things first, what makes Pandora’s internet radio service so great?  Clearly, it is an innovative product that allows users to listen to music for free on the internet.  While it is true that users must put up with commercials, most would prefer the commercial interruption to subscription fees. 

Furthermore, Pandora utilizes its patented “Music Genome Project” to code songs according to approximately 400 genes and return similar tracks on a user’s given station.  Ultimately this yields customized radio stations tailored to the preferences and tastes of each individual listener.  To put it simply, Pandora takes traditional radio, personalizes it, and puts it on the internet.

How could this translate to bad business, one might ask?  The answer lies in the costs associated with acquiring content.  Investors who follow Pandora are well aware that the company must expend roughly 50%-65% of its revenue on content acquisition, depending upon the quarter.  These expenses are particularly salient for Pandora—as opposed to, say, Sirius XM Radio (NASDAQ: SIRI)—because the Copyright Royalty Board applies a different standard to internet radio than it does to traditional broadcast or satellite radio.  According to Ben Sisario of The New York Times, Sirius XM Radio only spends about 8% of its revenue to acquire content. 

Obviously, internet radio providers such as Pandora must endure significantly reduced margins as a result.  Of course, low margins are not necessarily a death sentence for a company’s bottom line.  Many companies, in fact, pursue price-cutting, margin-reducing strategies in order to attract more customers and compensate via high volumes.  The problem for Pandora is that this strategy is not a viable option for internet radio providers.  Why?  Content acquisition costs for internet radio actually increase with each additional user hour.  Accordingly, Pandora’s profit margin diminishes with each additional user hour, thereby removing the plausibility of pursuing a high-volume strategy.  If you are a Pandora user, I’m sure that you are familiar with the question: “Are you still listening?”  Well, this explains why the service stops your music to ask you this after a designated amount of time.

In conclusion, I will admit that I am an avid Pandora user.  As a college student, I spend countless hours each and every day on my laptop and truly appreciate the quality and variety of music that Pandora enables me to enjoy.  The “Music Genome Project,” in my opinion, has yielded a phenomenal product and the commercial interruptions are only a minor nuisance. 

That being said, Pandora is not built upon a great business model for the reasons mentioned previously.  If the Internet Radio Fairness Act were to pass through Congress, effectively moving internet radio providers from their current standard to that of satellite and cable radio providers with regards to content acquisition rates, Pandora’s business would improve tremendously.  Unfortunately, that is not looking likely as popular musicians from Katy Perry to KISS have recently banded together in opposition. 

As of right now, Pandora is a prime example of a great product that does not equate to a great business.

FatNDSquirrels has no positions in the stocks mentioned above. 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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