Pandora's Box Of Costs
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Pandora Media (NYSE: P) has a fascinating business model and service. Listeners are allowed to listen to up to 100 personalized stations of music and comedy. On a computer or even on an iPad or other tablet with wifi, Pandora is great. The service lets you pick an artist, song, or album and then makes a virtual radio station based on songs or artists that go well with your original choice. Pandora offers all of this at no charge as long as you're willing to accept a few ads. You can also upgrade your experience for $3 a month and eliminate all of the ads. This sounds good and Alyce Lomax of The Motley Fool is impressed enough that she said “I'm thinking the price just may be right for a company that is nearing profitability”.
Respectfully Alyce and I are going to have to disagree on this one. Pandora offers a great service, but I don't see the company as “nearing profitability”. There are several issues with the service as an investment that I can't get past. First, the company is in competition with multiple other innovators that offer similar and in some cases better service. A great example is Spotify, this service allows you to listen to the actual songs or albums you choose without having other songs chosen for you. While it's a little more expensive if you want to port this to a device like an iPad, the service allows you to have as large of a music collection as you want without worrying about storage on your device. Since both services are offered for free online, Spotify would seem to be a better option than Pandora on a traditional computer.
I've heard several people say that they consider Pandora to be a serious competitor to SiriusXM (NASDAQ: SIRI). There is one big hole in this theory. The difference between Pandora and SiriusXM is, in most cases SiriusXM is built into the vehicles' sound system versus Pandora usually has to be connected through a smartphone. Though streaming music through a smartphone isn't a terrible idea, it does require both a strong enough signal for quality sound, and it uses data from the individual's data plan. Since signal strength is unpredictable and data usage is more desired for apps and information, this wouldn't seem to be a great trade-off.
When you compare Pandora and its 125 million registered users to SiriusXM's nearly 22 million paying subscribers, I would rather have 22 million pay to use a service than to have 5 times as many paying little to nothing. Alyce Lomax says in the aforementioned article that, “Pandora's been narrowing its loss and is closer than ever to turning a profit.” The trouble with this statement is some of the company's numbers don't bear out that conclusion. In the company's most recent earnings report, Pandora showed that total revenue grew 58%, however, content acquisition costs increased by 91.43%. The problem with the Pandora model is the more a song is played, the more the company has to pay for royalties. This isn't a model where more users means more profits. Quite simply, more users means more costs. While Alyce points out that these listeners turn into new fans, concertgoers, and merchandise purchases, that is also true of traditional radio which is not compensated for these gains. There are a few other issues that came up in the company's most recent earnings as well.
While the company might want its future growth to be based on subscriptions, this part of the business is not only growing slower, but also is only 20% of total revenues. Advertising is Pandora's main revenue driver and is growing faster so the company needs to stick with what it does best. While the popularity of the service is apparent with 53% active user growth, and 92% growth in listener hours, this does not equate to bigger profits. The company reported a non-GAAP loss per share of $0.09. These results were better than expected, but with nearly 6% of total U.S. Radio listening and the company still showing a loss, you have to wonder, what percentage of listeners does the company need to achieve a profit? In addition, one of the company's comments is good news and yet disconcerting for the future. The company said, "the majority of the top 50 digital advertisers in the U.S. already have bought multiplatform advertising on Pandora." This speaks to the popularity of the service, but begs the question, if most of the top 50 have already signed up, where do the big hits come from going forward.? Last, on a full year basis, Pandora expects an EPS loss of $0.07 to $0.011. This guidance comes in a little above estimates, but again still means the company is expected to lose money this whole year.
The music business is constantly changing, and Pandora does offer a great service. However, until the company can change its licensing costs to a different structure, I don't see big profits in the future. Gaining more listeners, who use the service more often, will result in actually higher costs. A business that grows its costs at least as fast as revenues is not going to be a great investment. Love the service, but I won't be buying the stock anytime soon.
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