Pandora Embarking On A Long, Strange Trip

By Ryan C. Fuhrmann | March 13, 2012 AAA

Internet radio firm Pandora (NYSE:P) is seeing a huge jump in popularity, as consumers increasingly embrace its music streaming services. With its service, users are able to enter an artist name, such as the Grateful Dead, and have its Music Genome Project create a customized channel of similar music. The service is great for music lovers, but investors may not make out as well.

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Full-Year Recap
Revenue growth was impressive at 99% to bring total revenue to $274.3 million. Advertising revenue more than doubled and made up the bulk of the top line at $240 million, or roughly 87.5% of the total. Subscription revenue advanced 86.5% and is where users pay an annual fee of roughly $30 to avoid commercials. This and other revenue brought in the remaining $34.4 million.

The advance in content acquisition costs outpaced the top line, growing 114% to $148.7 million. The overall growth isn't surprising, as these are the royalty payments that Pandora must make to "the copyright owners of both sound recordings and the underlying musical works themselves." This includes Sony's (NYSE:SNE) music division and is a similar arrangement that Apple's (Nasdaq:AAPL) iTunes and other resellers of music, including Amazon (Nasdaq:AMZN) in paying royalties for music.

The fact that royalty expense growth outpaced sales is somewhat disturbing for Pandora because it accelerated the operating loss from $321 million last fiscal year to $11 million this year. Marketing and sales costs also rose rapidly, though it was smaller than sales growth at 80%. Including other expenses, the total bottom line loss was close to $20 million for the year, or 19 cents per diluted share. (To know more about income statements, read Understanding The Income Statement.)

For the coming year, analysts project continued rapid sales growth in excess of 50% and total sales of about $414 million. However, they still expect a loss of 12 cents per share, though for 2013 they expect modest profitability of four cents per share on sales north of $599 million.

The Bottom Line
Pandora currently sports a market capitalization of $1.81 billion, or more than four times sales projections for the coming year. This looks somewhat reasonable given Pandora's rapid growth and the fact that Facebook could IPO with a price to sales multiple above 30. However, it can't currently be valued based off earnings, because there aren't any. Additionally, its profit potential is incredibly uncertain and likely to remain so for several years.

It's also difficult to see Pandora successfully competing in the music space over the long haul. Its streaming model is proving popular, but relies on an ever-increasing number of subscribers in an industry that is ultracompetitive and fast-changing. Spotify has already been rolled out in the U.S. that offers the ability for users to customize and catalog song selection, in exchange for a low monthly fee. Sirius XM (Nasdaq:SIRI) also already exists and offers a wider selection of streaming content.

As basically a reseller of music content, it's hard to see the firm surviving without a wider selection of products and more control over its own destiny. The recent launch of comedy content could help, but other major innovations are going to be needed to increase the appeal of Pandora's competitive edge. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

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