A Good Short Candidate

Mohsin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Pandora’s (NYSE: P) stock has appreciated by a mammoth 40% in the last three months despite adverse news from the Internet Radio Fairness Act. The analysis below shows that there is no solid fundamental improvement or changes in the industry to justify stock price appreciation. Therefore, I recommend investors take a short position in Pandora.

Pandora

The technology sector has advances in leaps and bounds during the last couple of decades. The advancement has revolutionized even the basic aspects of life and integrated the use of technology into every aspect of everyday life. The growth in Internet dispersion and improvements in Internet speed has allowed the radio industry to evolve. Pandora Media tries to capitalize on this technological evolution and provides an Internet radio service to USA. The registered users can create 100 different personalized channels and listen to ‘unlimited’ free music. The company also runs a premium service which provides advertisement-free access to music. The company pays a royalty on the music content plays and generates revenues from advertisement and premium service subscriptions.

Margins

In a recent article I discussed the high risk that investors of Internet advertisement companies undertake. A major problem that companies such as Groupon (NASDAQ: GRPN) and Pandora face is limited margins. This is because in order to drive traffic and consumer/merchant interest they have to compromise on price, which leads to very thin margins. Groupon has generated a solid revenue growth in the last few quarters, but the bottom line has still been dismal. This is because the company is forced to cut its own ‘take rate’ in order to drive merchant interest in its deals offerings. This is pretty comparable to what is going on with Pandora. The company has shown a phenomenal revenue growth rate but has been unable to transfer this top line performance into bottom line profits.

This inability stems from basic weakness in the business model of Pandora. The company pays very high royalties for the content it plays on its website. These high costs leave very little for the shareholders and severely impact the bottom line of the company. As the chart (below) shows, the growth in the top line is not reflected effectively in the bottom line of Pandora. The company pays as much as 50% of its total revenues as content acquisition cost.

<img src="http://media.ycharts.com/charts/5f266becb2df4a1daf42ef9233fb4bbc.png" />

P Revenue Quarterly data by YCharts

Turnaround

The company is taking drastic measures to improve its business model and improve its margins. Pandora has been pushing for a controversial bill in congress called the Internet Radio Fairness Act.  The aim of this bill is to reduce the royalties that Internet radio companies have to pay and bring them on level with other radio mediums. The shareholders have been hoping for some time now that the act will justify the high valuations of Pandora by bringing down its content acquisition costs. According to recent developments the bill is dead for now.

Yesterday, Pandora announced that it has decreased the amount of music a user can listen to on Pandora. Previously an unlimited amount of music was available to listeners, but now it has been capped at 40 hours. According to reports the per track royalty rates of Pandora have increased by a staggering 25% in the last three years. Tim Westergren has disclosed in a blog that these rates might increase by a further 16% in the next couple of years. Although, this might seem a major cut, according to the company website only 4% of users will be affected by this 40 hour restriction. These 4% can once again get the unlimited access by paying only 99 cents for the rest of the month. 

Bottom line

The company is operating in a very tough macroeconomic environment where businesses are facing advertisement cuts. Pandora faces tough competition from its competitor Sirius XM (NASDAQ: SIRI). Sirius has reported a 5 year average sales growth rate of 30% compared to only 21% for the industry. It has also doubled its EPS y/y and reported an EPS of $0.025 in the quarter ending December 2012. Due to its lower content acquisition costs it has a much more sustainable business model. The company has a pretax margin of 13.9% versus only 7.7% for the industry.  

The analysis shows that there is no justification to the recent 40% rally in Pandora's stock price. The company is operating in a highly competitive market and has the disadvantage of higher content acquisition costs as compared to competitors. The stock is also trading at a 10% premium to the mean sell side target price of $11.21. Therefore, I recommend investors short Pandora as the stock is overpriced at these levels.  


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