Straddling the Fence on Pandora

Spencer 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) continues to grow at a rapid rate in the competitive internet radio segment.  The company's listener growth has been phenomenal, and Pandora now boasts over 7% of the total U.S. radio listening market, which amounts to 67 million listeners.  These users tuned into Pandora for nearly 14 billion hours in 2012, up from 8 billion hours in 2011.  With numbers like these, one might assume Pandora's financial future is also bright.  But the company has posted a net loss in 2011 and 2012, and analysts expect this trend to continue in 2013 and 2014.  Which raises questions: if Pandora cannot turn a profit, why is the company valued at nearly $2 billion?  And if Pandora cannot survive as a standalone business, who might benefit from acquiring Pandora?  The public is on the fence about Pandora's prospects, as some see a potential acquisition premium bidding up shares in the future, while others are sure that years of negative cash flow will eventually wash out shareholder value.

Pandora is often described as a "social media" company and is lumped into the same category as Facebook (NASDAQ: FB) and Twitter.  Since listeners only access Pandora through either desktop or mobile applications, it makes sense to value Pandora as a company that could potentially be acquired to enhance another brand's social media presence.  Besides the intangible customer loyalty that is intrinsic to Pandora's brand value, the company also creates value by getting to know their customers through the use of tracking "cookies."  So not only is Pandora literally in 67 million people's ears, but they also have a good idea of what advertising will be most effective and relevant to their listeners.  This targeted advertising capability along with Pandora's growing customer base are the major assets that would attract potential buyers. 

In April 2012, Facebook paid $1 billion for Instagram and its 33 million users.  At the time of the acquisition, it was well known that Instagram was not only unprofitable, but they barely had any sales at all.  The Facebook-Instagram deal amounted to an acquisition cost of about $30 per user.  Applying the same logic to Pandora's listener base, Pandora is worth just north of $2 billion, right around where it trades today.  But Pandora has significantly higher revenue than Instagram per user, so it could be argued that the Pandora listener is worth significantly more than the Instagram user.  While difficult to measure, this premium would push Pandora's share price much higher in the event of an acquisition.  For example, if Pandora's users were valued by another entity at $40 apiece, the company value would be $2.7 billion, a 25% premium to today's value.

Could Pandora fit as a Facebook acquisition target?  With nearly 200 million U.S. users, a Pandora-Facebook deal would make the Facebook experience better while further engaging the user base.  At a cost of $10 per Facebook user, the ROI may be reasonably achieved.  But Facebook already has a strategic partnership with Pandora rival Spotify, and Spotify is integrated into Facebook's platform.  However, any change in this partnership may open the door to a deal with Pandora.  

Apple (NASDAQ: AAPL) continues to develop an app that streams radio on the iPhone, iPad, and iPod.  Many analysts conclude that Pandora's business model will be crushed when Apple's streaming service begins.  While some Pandora mobile users may migrate to Apple's streaming app, the existing Pandora desktop users should remain intact.  Additionally, with Apple's recent map application failures, along with the lackluster Apple TV, an Apple streaming service is far from a sure success.  If Apple cannot develop a radio app that gains traction, a logical next step would be to acquire a strong brand that would create value to their existing users.  With $137 billion in cash, along with hundreds of millions of iPhone, iPad, and iPod users in their ecosystem, a $2-$3 billion price on Pandora could be a cheap way to leverage Apple's customer base.

News Corp (NASDAQ: NWS) is a cash-rich traditional media company looking for growth.  With businesses in newspaper and cable TV, News Corp's user base and offerings are stagnant, and revenue growth last quarter was just 5%.  While the world moves toward media alternatives like Pandora, investors in News Corp wonder about future growth.  Traditional media companies like News Corp may prefer to grow the business through acquisitions like Pandora, but these types of deals have not performed well in the past.  Time Warner's merger with AOL in 2001 is still regarded as one of the worst in history.  News Corp's purchases of Myspace and Friendster did not go well, as both hot social media companies lost brand value after being acquired, and are now irrelevant.  Given this history, traditional media companies would likely take a long look to ensure synergies with Pandora before making a move.

Pandora's clock is ticking.  Management is leading a charge to decrease their royalty expenses, which currently costs Pandora $0.50 of every dollar of revenue.  Fierce lobbying in Washington is set to take place over the coming two years as Pandora's royalty contract renews in 2015.  With the company expected to be unprofitable until 2015, it is becoming uncertain that Pandora can survive even after 2015 as a standalone business with half of revenue going out the door immediately.  If acquired by any of the companies above, Pandora would have more muscle to fight the royalty battle.

Traders are increasing their wagers on Pandora, both short and long.  Sophisticated investors could play Pandora using options straddle trades.  This type of position will benefit traders in the event of extreme volatility, which looks likely to occur.  The company appears to be an all-or-nothing wager, as the 2015 deadline approaches.  Assuming the right set of circumstances, Pandora could be significantly undervalued in today's marketplace.  Or assuming another set of circumstances, the value is next to zero. 

houlijr8 has a position in Facebook. The Motley Fool recommends Apple and Facebook. The Motley Fool owns shares of Apple and Facebook. 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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