Huge Growth in the Wrong Places
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I've written before about this company, and I'm not sure that investors got the point the last time. There really is no nice way to say this, so I'll just tell you that Pandora's (NYSE: P) business model doesn't work. Soon after the company released its most recent earnings results, I noticed on Twitter several people questioning whether the business model was sustainable. The answer to that question is very simple, any company that has to pay more the more frequently its service is used has a major problem. That's the crux of the argument against investing in Pandora; the more the service is used the higher the cost to the company. Let's take a look at the company's earnings report and I'll show you where the problems are, and give you an idea of a better alternative to invest in.
The number that primarily caught investors' attention was that Pandora reported earnings per share of $0.00. Normally when a company makes no money this would not be news, but with analysts calling for a loss of $.03, the company's results were better than expected. There's just one huge problem and that is earnings per share do not necessarily equal cash generation. With the company increasing revenue by 51%, novice investors probably think that this is a huge growth opportunity given the popularity of the service. In fact, if the company were measured solely based on listening hours, growth was massive with an 80% increase on a year-over-year basis. However, unlike with other services, the more Pandora is used the more expensive the content is for the company.
Investors need to understand that Pandora is a different animal than a company like Sirius XM (NASDAQ: SIRI). Sirius has multiple advantages over Pandora. The first of which is the company has significant subscriber growth which drives better free cash flow. Second, Sirius is integrated into many vehicle entertainment systems, and the company converts roughly 45% of new vehicle owners. In this company's most recent quarter they added over 600,000 new subscribers and reported relatively low churn of 1.9%.
I've mentioned in the past that the best way for investors to play Sirius would be to consider purchasing shares in their majority owner Liberty Media (NASDAQ: STRZA). Liberty not only owns 48% of Sirius, but the company has other investments worth about $1.5 billion, owns the Atlanta Braves, and has a net cash balance. The end result is investors can buy Liberty Media and get the growth of Sirius for a cheaper multiple. Given the fact that Sirius expects to generate about $700 million in free cash flow during the current year, this is the one company in non-traditional radio that is significantly free cash flow positive. When it comes to Internet-based radio, the privately owned Spotify seems to be a better option.
For those who aren't aware, Spotify offers both Internet radio and an iTunes-like experience. By comparison, Pandora operates primarily as an Internet-based radio company. Considering that users can choose not only individual artists or records, but can also listen to specific tracks on Spotify, there's no question that this service is more customizable than Pandora. Pandora's radio service may be superior to Spotify at the current time, but nothing trumps the ability to listen to what you want when you want. While both Spotify and Pandora will struggle with the same challenges of content costs mirroring growth, Pandora is the only public company of the two.
The primary reason investors should avoid Pandora can be summed up in two statistics. While the company's overall revenue grew 51%, Pandora's content acquisition costs grew 79.47%. This is the simple problem with the company's business model: Pandora must pay each time a track is listened to. In short, this means no matter how fast revenue grows, content acquisition costs are likely to grow faster. Since the primary service that Pandora offers is advertising supported, the only way for the company to outgrow its content acquisition costs is to sell advertising at a rate faster than listener hour growth. The bottom line is that, though Pandora reported EPS of $.00, free cash flow came in at just $188,000. Considering the company had to generate over $100 million in revenue to produce less than $200,000 in free cash flow, you can see that even with large-scale revenue growth, free cash flow will likely not be significant.
What's worse, the company-projected revenue for the year of more than $400 million would still produce a non-GAAP loss per share of at least $0.04. At the current stock price of nearly $12, shares sell for a P/E ratio of 240 based on next year's EPS estimates. With the company expected to grow EPS by about 40%, this means the stock sells for roughly six times its growth rate. While it's true that services like Pandora and Spotify may change the way people listen to music, this doesn't mean that Pandora will necessarily be a good investment. The real irony is the more popular the service gets, the harder it will be for Pandora to make money. Unless the company can somehow change its content acquisition cost structure, real earnings growth and cash flow growth will be fleeting.
MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.