What is Pandora's Problem?
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Pandora (NYSE: P) rose over 20% last week thanks to a second quarter report with a revenue growth of 51%, year-over year, to $101.3 million. Advertising accounted for $89.4 million of that revenue with mobile ads at $59.2 million, an 86% year-over-year growth in an area many web companies are finding difficult to monetize. Yet for all its triumphs, Pandora still put up a net loss of $5.4 million.
The problem is that Pandora loses money with every user it gains.
Pandora agreed to a content acquisition license in 2009 that charges the company a per song, per user flat rate. This puts the company in the odd position of losing more money for every user it gains – and it is gaining users. There was a 48% year-over-year growth in active users in the second quarter and the amount of hours users spent listening rose 80% on the year to 3.3 billion hours.
Granted, Pandora has lost less revenue to content acquisitions with this license than it did prior to the summer of 2009. But a correlation user increases and cost increases means that the costs have continued to grow since the signing and could continue to do so until the license is up in 2015.
What will happen at that point? In Pandora’s dreams, its Capitol Hill lobbying will pay off in the form of lowered license costs. It wouldn’t be the first time that Washington’s stepped in to lower content costs. Failing that, there’s the chance that the license-granting bodies will decide receiving Pandora’s revenues is worth cutting the company a bit of a break. Or the bodies could decide the revenues aren’t worth it and charge a higher per song fee.
There’s also the possibility of Pandora stealing from its competitor’s playbook. Spotify strikes license agreements with music labels on an individual basis, theoretically allowing for more negotiation wiggle room. In that respect, Spotify has more in common with Netflix (NASDAQ: NFLX) than it does Pandora. But Netflix has discovered that individual license deals can fall apart, potentially raising prices or creating a large content gap. On a revenue/loss comparison, Spotify’s not faring much better than Pandora.
Balancing the Costs
It’s going to be extremely difficult for Pandora to offset these levels of content costs with advertising. Advertising currently accounts for 88% of revenues, with the breakdown of 30% desktop and 58% mobile. Mobile has been doing extremely well but that’s still not enough to cover the costs. Competition in the mobile streaming arena, from Spotify’s newly free mobile Radio app in particular, may curb the future growth rate of mobile revenues.
The revenues acquired from subscriptions aren’t a growth option, either. Pandora’s free version offers a comprehensive enough experience for most users. Users who are willing to pay for a music service would be better off investing in a Spotify subscription because that service has a more interactive music experience for users than Pandora.
Pandora’s future will be decided in 2015 when the new license is signed. If the company has continued to grow its advertising revenues in the interim, and the new license is more favorable than the current agreement, Pandora might have a shot at profitability. There’s a very large risk, however, that the new license will be equal to or worse than the one currently in place. If that’s the case, Pandora might revert to the shaky ground it stood upon prior to the 2009 license, when it faced a potential doubling of its per song fees. In that period, founder Tim Westergren said: “We're approaching a pull-the-plug kind of decision.”
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