"Time to go to work, work all night.
Search for underpants, hey!
We won't stop until we have underpants.
Lots of yummy pants, hey!"
After a flurry of bad news articles surrounding Pandora (NYSE:P) and its recent disappointing earnings report, investors could probably use a little humor. After all, it's not fun piling in ahead of earnings on a run up, only to have your shares take a 20% haircut within minutes of the closing bell. Hopefully, this was at the very least a wake-up call to investors to dig deeper into Pandora's business model. A wake-up call to consider if they are investing in a company with a solid business plan, or investing in somewhat of a hope or dream that "maybe" something good may happen in the future.
So what in the world does this have to do with underpants gnomes? First, take a minute to watch the clip below (warning, some adult language is included):
The episode aired during the late '90s during the dot com boom, and takes a humorous poke at what was a big problem with many of the companies involved in "the bubble" that burst. They had seemingly great ideas, but a poor business plan that did not have a firm grasp on how to monetize their user base and turn that user base into profit. As many readers will remember, the dot com bubble eventually burst, and many of these start up companies disappeared overnight, taking investors' hopes and dreams with them.
The children in the video take a trip to the underpants gnomes' lair, where the gnomes have gathered an immense pile of underpants. The business plan?
- Collect underpants.
However, profit is not yet there, and "???" certainly doesn't provide a solid plan for getting from step 1 to 3. While nobody can argue that the gnomes have amassed an incredible pile of underpants, it's questionable whether or not there is any value in that huge pile.
I feel the similarities to Pandora here are plain to see. While nobody can argue that Pandora has been extremely successful in acquiring a huge number of listeners -- which most recently came in just shy of 60 million active users per its Q3 report -- it has shown a complete inability to monetize this user base.
The fact is Pandora has grown its user base rapidly, yes, but it has failed to monetize these users faster than those users can gobble up content. This is content that Pandora pays for, yet gives away for free. Obviously buying things and then giving them away for free is not a sound business move unless you have deals on the other end through advertising to at least cover your costs of operation and content acquisition. Pandora is simply unable to secure enough advertising. Period.
Furthermore, rather than attempt to gain additional revenue, Pandora seems to be taking the route of crying to Congress about what it feels are "unfair" royalty rates which it has to pay. But really, when you consider Pandora pays only around $0.27 per user in royalties, and Sirius XM pays nearly $1 per user, it's quite obvious which has the better deal. Pandora would do better focusing its time and energy (and money) on acquiring more revenue, rather than wasting it lobbying and donating to various politicians.
What it boils down to is this, Pandora has a business model which is not working. Nearly 60 million users in a free model equates to 60 million mouths to feed, before you can feed yourself. That's a serious problem, and one which I see Pandora unable to address in reasonable fashion. I believe Pandora will see $5 within the year, and given the sentiment of the insiders who are quietly bailing out of their positions in a sea of red insider sales, I believe they see the same.
Pandora's business plan seems to mirror the gnomes.
- Collect users.
The problem here is obvious. Step two, quite honestly, should be figured out long before step one. Simply amassing a huge number of users and hoping later that monetization will be there is not a sound business plan. In all honesty, I don't think Pandora was started with profit in mind. I feel that profit was an afterthought, and that's supported quite nicely in this article released right after the IPO:
Though Pandora's stock debuted strong at a 40 percent increase the reporters at CNBC were pressing for answers: "How is Pandora going to make money?" CEO Joe Kennedy repeatedly responded that Pandora is building a long-term business and focusing on the listener experience. The reporters would not let up, asking the same question 20 different ways, trying to get an answer. Kennedy continued to talk about how Pandora has 3 percent of all radio listening and that its intent is to grow because radio listening is strong, making up 80 percent of all music listening. But the reporters kept asking Kennedy and other executives to show them the money. Not once did anyone say Pandora plans to make money. It was like a retro repeat of the dot-com boom days, when no one cared about making a profit.
Unfortunately, what should be funny is probably not so funny for some die hard longs of the company. The sad part is that step 2 has now caught up with Pandora to the point that popular sentiment has turned massively bearish, and to the point that what I have been saying since the IPO is now being echoed around the Internet. All one has to do is take a look at the Twitter feed for Pandora's $P ticker to see what I mean.
Rocco Pendola, Pandora's #1 fan, who seems like the only bull left, appears to be having trouble pushing out the usual stream of bullish praises for the company. He even emotionally admits in a recent article, where he was forced to write some bearish commentary on the company:
I've got to be 100% honest here.
I feel awful about writing this article.
I'm sure he does, and I am sure many investors who followed his urges to buy the stock for over a year now feel awful as well.
So what's an investor to do? First, if you are invested in a stock like Pandora, reconsider. Take a look at the business plan, and make sure there is a clear outline that takes the company from step 1, to 2, to 3. In actuality, as long as step 1 and 2 are there, step 3 should take care of itself.
For an example of a plan that works, consider a company like Sirius XM. Sirius XM's simplified business plan?
- Acquire attractive content at the right price.
- Collect users who pay (monetization).
One should notice a striking difference here. Pandora's step 1 is Sirius XM's step 2. One can argue that the pursuit of content nearly drove Sirius XM to bankruptcy in 2009, but that would be oversimplifying, and the fact is that there were a ton of moving parts to the matter. But investors that have come on board for nearly four years now are sitting on a profit themselves.
The key here is having a strong road map to profit, and that starts with having a plan in place to monetize your users, customers, or clients after you initially build out your company. Sirius XM spent years building out infrastructure, and developing a strong business model that would attract users in a profitable fashion. Was it a guarantee that it would work? Certainly not, but for many investors (including yours truly), the writing was on the wall showing the road map to profitability, and those who did their research and invested accordingly have been rewarded year after year. This rock solid plan has worked so well for Sirius XM that it just recently offered a $0.05 per share special dividend, and announced a $2 billion share buyback plan. Very nice.
I want to be fair and honest here. The fact of the matter is that I don't see the end coming quite yet for Pandora. Can Pandora make its business work? Certainly, but with step 1 in full swing, Pandora absolutely must come up with a working step 2, and soon. Sixty million users need to be monetized in some way, shape or form. These users each cost Pandora roughly $0.27 per month in royalties, and are not bringing in income for Pandora to post acceptable margins.
My most simplistic suggestion would be for Pandora to increase advertising to the point that "free" users are monetized appropriately. If a delicate balance is provided, Pandora may see an increase in paying subscribers who wish to listen without advertisements.
For now? No profit, driven by the fact that the road to profit was never really laid out, or quite possibly never even considered at the start. Once Pandora figures out that all-important step 2, it may become investment grade material. Until then, I would highly suggest investors stay away. A crowd of millions of unprofitable listeners may as well be a pile of unprofitable underpants.
Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.