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Shares of the leading internet radio company in the United States, Pandora Media Inc. (NYSE:P), have taken a pounding since the start of the year largely due to the doubts surrounding the sustainability of its business model. So far this year, the stock is down approximately 25%. It is down 27% since we last looked at the stock and we reiterate our previous short stance on P based on the reasons discussed in this report.

Pandora is the internet-radio leader in the U.S. As of the end of the second quarter of the current financial year, the company had around 150 million registered users, of which 100 million subscribers used its services through smartphones and other wireless products. It is a $1.3 billion enterprise and its shares are currently trading near $7.5, 5% off the 52-week low of $7.08.

The company derives its revenues mainly from two sources, advertising revenues, which account for almost 90% of its total revenue base; and subscription services providing the rest. The company, apart from advertisement supported music, also provides an ad-free radio listening experience through Pandora one. Pandora has had quite a bit of success in the recent past with staggering growth in its active-listener base largely brought about by the increase in listener hours, which is a key business metric for the company. Listening hours have skyrocketed over the last few years and have also reflected positively in its active-user base that reached 47 million by the end of 2012.

Staggering Growth in Listening hours and Active Users:

Listnening hours

Active Users

2010

1.3 billion

16 million

2011

3.8 billion

29 millin

2012

8.2 billion

47 million

As evident in the chart above, listening hours improved by over 100% in the financial year ended 2012 while the active-user base grew by a staggering 62%. This user growth has also translated into impressive revenue growth for the company. As mentioned previously, the company's advertisement-based revenues account for almost 90% of its total base and have grown rapidly over the years.

2008

2009

2010

2011

2012

Advertisement revenues

$13.3 mn

$18.2 mn

$50.1 mn

$119.3 mn

$239.9 mn

Subscription revenues

$0.9 mn

$1.1 mn

$5 mn

$18.4 mn

$34.4 mn

The chart above shows that its advertisement revenues have grown at a 4-yr CAGR of 106% while the said growth is 149% for its subscription-based revenues. However, the problem the company is currently facing and has been facing for a number of years now is that its revenue growth hasn't trickled down to its bottom line which is continuously contracting. In fact, the company has been posting losses for a while now. In the financial year ended 2011, Pandora posted a loss of over $16 million, an increase in loss of approximately 800% over FY2010.

Rising Royalties:

Looking at the growth in the company's revenue base, any potential investor in the stock would probably jump at the conclusion of putting funds in the company. However, there is a deficiency in the company's business model which is the primary reason behind the company's lack of profitability. This deficiency is Pandora's rising content acquisition costs, which are increasing at a staggering rate, more or less in line with revenue growth. In fact, in the first and second quarter of the year, the company's content-acquisition costs have outgrown the growth in revenues. In Q2 2012, Pandora's content-acquisition costs grew by 80% over the prior year quarter while its revenues jumped up by 51%, which signals why the company is not profitable.

The problem the company is facing is that with a growth in listening hours, its content-acquisition costs are also expanding. Pandora pays royalties to the copyright owners of sound recordings as well as musicians and given the royalty structure currently in place, its content-acquisition costs increase with each additional listening hour, regardless of whether the company generates additional revenue or not. To date, the company has not been successful in generating additional revenue from its advertisements as quickly as the growth in listening hours on various products. Moreover, as Pandora's smartphone listenership rises, the company is facing more challenges in integrating its advertisements on mobile and other wireless devices.

Apple Threat:

Besides the operating challenges the company is currently facing, competitive pressures are also mounting on Pandora. According to a news report, Apple Inc. (NASDAQ:AAPL) is in talks with music labels in the U.S. to initiate an ad-supported radio service that would directly compete with Pandora. Currently, the discussions are centered around revenue sharing and it is widely expected that a deal will be finalized by the end of this year. Apple is already the world's biggest music retailer with iTune accounts in the millions which indicate that the company may be able to keep the content-acquisition costs under control through its already existing relationships with music labels and artists. If Apple is successful in creating an application that is tailored for its iPhones and iPads, then this could prove to be disastrous for Pandora as it derives a significant portion of its revenues from customers that use Apple products.

Financial Review:

As mentioned previously, the company's revenues have grown at a staggering rate. Operating revenues have improved at a 4-year CAGR of 110%. However, the content-acquisition costs have outgrown revenue growth by 900 basis points over the same period. These high-content costs have also led to operating losses as well as a consistent contraction in its bottom line. Pandora had $82 million in cash and cash equivalents by the end of Q2 2012, however, declining operating cash flows are a cause of concern. In the six months ended July, 2012, the company used over $7.7 million in operating cash flows compared to positive operating cash flows of $3.3 million.

Valuation:

Pandora is trading at 108 times its forward earnings which is a significant premium (290%) over the multiple for Sirius XM Radio Inc. (NASDAQ:SIRI). The stock is trading at high valuations despite the deficiencies in its business model, declining margins and operating cash flows. We remain bearish on the company based on uncertainty over mobile monetization and rising royalties.

Source: Why You Should Short Sell Pandora Media