Pandora Earnings Preview: What to Look For

Matthew 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) has had quite a rally over the past couple weeks, popping almost 20% since reaching its all-time low of $7.08 on November 16.  In this relatively slow time in earnings season, more attention can focus on smaller companies. And when Pandora reports this coming Tuesday, that’s exactly what will happen.  Investors have many questions about Pandora, from whether the recent rally is justified to whether or not the business model is viable in the long term.

There is no question that Pandora is the internet radio leader in the U.S.  As of the most recent available report, they had about 150 million registered users.  More impressive, in my opinion, was that 100 million of those subscribers listened primarily on smartphones.  Not bad for such a young industry.

So, how does Pandora make money?  Users have the option of subscribing (for a fee) to a service that provides advertiser-free music, similar to Sirius XM.

First, here are a few strengths of the company.  Pandora has grown listening hours 530% since 2010, and has grown their number of active users by 193%.  This implies that not only are there more users, but those users are each spending more time listening to Pandora than before.  Also, Pandora’s platform is unique in that users can create custom radio stations, a feature Sirius does not offer.

The major weakness in the company is the profitability of its business model.  The company has been losing money for some time now, and most of that is due to the rising royalties the company is forced to pay.  These royalties must be paid regardless of whether the company generates additional revenue from the listening hours or not.  On this note, the company is having a very tough time integrating ads into their mobile services, making it difficult to capitalize on their staggering number of smartphone listeners.

Despite these weaknesses, there are tremendous opportunities for growth here.  A recent study by Strategy Analytics found that over 1 billion (that’s billion) smartphones were now in use worldwide, and this number is growing fast.  The exact statistics are 1.038 billion smartphones as of Q3 of 2012, up from 708 million the year before, a 46.6% gain in only one year!  The study also notes the tremendous growth potential in China, India, and Africa.  If even half of the current users download the best “free music” app available, that is a fivefold increase in the number of smartphone users potentially looking at and hearing Pandora’s ads.

The biggest threat to the company is competition, especially from giants like Apple (NASDAQ: AAPL).  Apple is reportedly in the early stages of creating a nearly identical free radio service.  Apple has the advantage of pre-existing relationships with recording artists and music labels that may allow it to keep costs low.  In fact, this is such a threat that Pandora sold off to the point of tripping market circuit breakers and halting shares after the news broke.

However, not all is going well for Apple’s plan to go live in 2013.  Some record labels reportedly don’t like the terms Apple is offering, which supposedly offer lower royalties than Pandora in exchange for a portion of advertising revenue earned.  It is also speculated that Apple is planning on charging significantly higher advertising rates than Pandora.

When Pandora reports earnings Tuesday, I would look for the company to address the Apple threat and smartphone business model.  In my opinion, the increase (or lack thereof) in the paid subscriber base is not too relevant due to ad sales being the company’s bread and butter.  Analysts expect the company to post earnings of 1 cent per share, and although a beat would be nice, it would be nothing compared to the most important things investors want to hear about: sustained and sustainable growth in both users and revenues.

KWMatt82 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!

blog comments powered by Disqus