Buying Pandora is a Big Mistake

By Timothy Green - September 14, 2012 | Tickers: AAPL, NFLX, P | 0 Comments

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It's strange writing a negative article on a company who's product I use almost every day (and am currently using as I write this). But unfortunately, a good product doesn't always equal a good company. I'm talking about Pandora (NYSE: P), a very popular internet radio service. Services like Pandora revolutionized the way people listen to music, but will this equate to large profits for shareholders.  

The alternative to internet radio is purchasing music through Apple's (NASDAQ: AAPL) iTunes or through Amazon, both options allowing you to play your purchased music from the cloud. Pandora, in addition to ad-supported music, also offers a paid subscription service, called Pandora One, which costs $36 per year and is ad-free. Pandora's popularity has exploded over the last few years, as is evidenced by the trend in listener hours and active users:

* Data from 10K

Listener hours increased by 115% in fiscal 2012, while the number of active users increased by an equally impressive 62%. More and more people are using Pandora every day, and that translates into increasing revenue. Most of Pandora's revenue comes from advertising, while a much smaller portion comes from the subscription service.

* All amounts in thousands

Pandora's revenue increased by 99% in fiscal 2012, and in the second quarter of this year revenue came in at $89.4 million compared to $58.3 million one year ago, an increase of 53%. Of course, revenue doesn't mean anything if it doesn't translate into profit. And therein lies the problem with Pandora.

The Cost of Doing Business

Pandora's business model is as follows: each time a song plays Pandora must pay a royalty for that song. They offset this cost with advertising revenue and by charging for a subscription service. How has the cost of content increased over the years?

Pandora pays more than half of their revenue for content. And even more unsettling, the percentage has increased from the same time last year. Including other expenses Pandora has been losing money quarter after quarter, year after year. What good is adding more users if each one loses the company money? There's no reason to expect content costs to decrease in the future, so a question arises: Will Pandora ever be profitable? If every time the company doubles revenue, content costs go up by the same percentage or more, so I don't see a clear path to profitability. Pandora's problems are similar to those of Netflix (NASDAQ: NFLX), which also faces ever-rising content costs. The difference is that Netflix turns a profit because it doesn't rely on advertising revenue.   

The stock currently trades around $10 per share, putting the market capitalization at roughly $1.6 billion. Let me get this straight. A company which has never turned a profit and whose revenue growth appears to be unable to outpace the growth of expenses is worth $1.6 billion? If I buy a shredder and destroy $10 million a year in cash am I worth $1.6 billion? This is a case of not only overpaying for growth but overpaying for the wrong kind of growth. Revenue could double every year but if the company has to spend $1.05 for every dollar of that revenue it doesn't much matter how fast it grows. And then, of course, there's the matter of Apple.

Competition   

This week Apple announced that it would launch its own internet radio service as part of iTunes. In response, Pandora stock plummeted. This raises another issue with Pandora's business: there's no discernible barrier to entry. Anyone can pay royalties and stream music. What makes Pandora special? Nothing at all. And with Apple set to offer internet radio on its devices, Pandora is in for a world of hurt. The worst part of all of this for Pandora is that Apple doesn't even need to make money off of its new service. It could simply be a feature meant to sell more iPhones and iPads. And with Apple's resources there's no reason to believe that they can't do what Pandora does just as well, perhaps even better.

Conclusion

Pandora has a big problem. With 50+ million users the company can't seem to turn a profit, and there's no reason to expect more users will change that. Couple this with the entry of Apple into the market and I really don't see any way for Pandora to live up to its valuation. The company may survive, and may someday even turn a profit, but at this point it is pure speculation, plain and simple. The secret to successful investing is not trying to find the next big thing but instead avoiding big mistakes. And Pandora is a big mistake.

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