Pandora's (Nasdaq:P) September 12 hiring of Brian McAndrews to replace long-time CEO Joe Kennedy put its stock into overdrive gaining 12% on the news. Is McAndrew's hiring enough to keep its stock moving higher? Investors seem to think so.
I've long been skeptical of its business model. In June I recommended investors pass on Pandora's stock because the risks were too great. It's gained 67% ever since. With a royalty battle looming in January, Pandora shareholders ought to consider taking some profits off the table.
At $15 I wasn't a fan. At $24, I'm downright pessimistic. McAndrew's hiring does little to change the fact the company can't make money. Read on I'll make a case why you should get out while the getting's good.
The Elephant in the Room
Pandora doesn't have a revenue problem; it has an expense problem. Specifically, its content acquisition costs rise regardless of whether you listen to its ad-supported service or pay for Pandora One, its subscription service. Either way the artists have to get paid. In the second quarter ended July 31, its listener hours increased 18% year-over-year to 3.88 billion. Meanwhile its content acquisition costs went up 35% or almost double. Furthermore, the content acquisition cost per listening hour went from 1.8 cents in Q2 2012 to 2.1 cents in the second quarter this year—an increase of 16.7%.
What's the significance?
Although revenues grew by 55% year-over-year, its operating loss kept pace up 44%. Normally that doesn't happen. Economies of scale kick in boosting margins—but not in Pandora's case. And herein lies the problem with its business model. In Q2 2012, after paying 1.8 cents per listener hour in content acquisition costs, it had 1.2 cents per listener hour left over to pay its remaining expenses. In this year's second quarter it had almost two cents left over thanks to the 55% jump in revenue. Unfortunately, its sales and marketing costs per listener hour increased 66% year-over-year leaving it with about the same amount to pay its remaining expenses despite $56 million in additional revenue. Once you subtract those expenses you are left with a much bigger operating loss.
Pandora loses big time if it can't successfully renegotiate its royalty rates. Without some kind of break in its content acquisition costs, it won't matter how much ad revenue it generates in the future—it will continue to lose money. Investopedia contributor Stephen Simpson pointed out in June that Pandora acquired an FM radio station in Rapid City, South Dakota as part of its battle plan with The American Society of Composers, Authors, and Publishers (ASCAP) over royalty rates.
Psndora feels this gives them the right to pay the same (lower) rates as CBS (NYSE:CBS), Cumulus Media (Nasdaq:CMLS) and other radio station operators. In a nutshell, the company feels ASCAP is discriminating against internet radio. It's an interesting move that will certainly make January's meetings much livelier. It's questionable, however, whether this tactic will work. And even if it does, in the short-term it's not expected to save Pandora much in the way of costs. Therefore, it might end up doing more harm than good. I guess we'll see in January.
You really have to question Pandora's approach when Pink Floyd, one of the most revered bands of all time, writes an op-ed in USA Today berating the company for intentionally trying to trick artists into accepting an 85% pay cut. The highlight of the op-ed—the band remarks, "…a business that exists to deliver music can't really complain that its biggest cost is music. You don't hear grocery stores complain they have to pay for the food they sell. Netflix (Nasdaq:NFLX) pays more for movies than Pandora pays for music, but they aren't running to congress for a bailout…" This pretty much sums up what intelligent artists think of Pandora.
The company can argue all it wants that it should pay less in royalties but the reality is that regular terrestrial radio (AM/FM) should pay more. Currently these stations pay songwriters royalties per play but not the actual artist who performed it. The argument being that AM/FM radio provided performing artists with a promotion vehicle to sell albums and concert tickets and therefore it was considered advertising, no different from any other cost of doing business.
However, with internet and satellite radio currently already paying performers for each listen, it only seems fair that terrestrial radio do likewise. As both sides make their arguments in January before the federal government I would hope that the powers that be do anything but lower the rates that Pandora pays. The creative types who make music cannot afford to give up any more than they already have.
Terrestrial radio must pay the piper.
Hiring Brian McAndrews as CEO does little in my opinion to change the big negative hanging over its head. You remember, the part about not being able to make money. If the federal Copyright Royalty Board doesn't lower its rates come January Pandora faces a grim future—one where it continues to spin its wheels despite selling gobs of advertising. If I were the type to short stocks, which I'm not, Pandora would be an awfully enticing target.
I just don't see this ending well—with or without a new CEO.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.