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As of this past quarter, Pandora (P) Media, the world's most popular Internet radio, has achieved 200 million users and 25 billion user likes on music and comedy content. Additionally, Pandora commands 70% of the Internet radio market share and 8% of the total radio market in the United States, beating out competitors such as Spotify and Clearchannel. In the background, the company continues to improve its Music Genome project, enhance user interfaces, integrate its product into more devices, and develop the advertisement appeal. Notwithstanding these quantitative and qualitative achievements, the personalized Internet radio company is having trouble achieving profitability. It is clear that Pandora's net loss quarter after quarter is troublesome, but investors nevertheless inflated the stock by 20% even after the previous quarter's net loss report. Are investors chasing a dream or does Pandora have real potential looming?

The Dilemma:

Pandora's business model faces a catch-22, and until it can discover an ingenious method to circumvent this trap, then profitability may be just out of reach. The company makes the majority, 88% in 2012, of its revenue from advertisement that is generated by impressions to the user or user clicks on the ads. Therefore, the more music, sprinkled with advertisements on the side and video/audio ads between content, Pandora plays, the more opportunity to rack in advertisement revenue. However, along with the additional content that Pandora streams to its users, the company incurs royalty and licensing costs to comply with statutory regulations from the CRB (Copyright Royalty Board). To further salt the wound, the royalty rates that Internet radio companies, like Pandora, face are significantly harsher than the fees that satellite or traditional broadcast radios face. Personally, I do not see a logical reason as to why the CRB imposes harsher regulations for Internet radios then broadcast because Internet radio is personalized whereas broadcast radio targets the masses. In other words, for every one song played on Internet radio, usually just one person listens to the content free of charge while every song played on the broadcast radio, an infinite number of listeners are benefiting from the content free of charge. Thus, a more fair regulation would be to ease up on Internet radio royalty fees. For the FY 2012, Pandora paid 55.9% of total revenue to royalties while satellite radio paid on average 9% of revenue and broadcast radio is free of royalties to third party collection organizations such as SoundExchange. Of Pandora's $427.1 million dollars of revenue, $258.7 million went directly to "content acquisition costs."

Potential Solutions:

Lobbying - In July 2009, lobbying efforts by Pandora Radio and other Internet radio providers successfully came to an agreement with the CRB on a lower, more sustainable royalty rate. The agreement reduced royalty rates for the years 2006 to 2010, which were applied retroactively, and established new rates for years 2011 to 2015. The following chart shows the reductions gained from lobbying efforts.

Year

CRB Rate

Pureplay Rate
(non-subscription)

Pureplay Rate
(subscription)

2012

$

0.00210

$

0.00110

$

0.00200

2013

0.00210

0.00120

0.00220

2014

0.00230

0.00130

0.00230

2015

0.00230

0.00140

0.00250

(SEC filing)

What is interesting is the significant increase in royalty fees for content played on subscription or Pandora One in which users pay a monthly fee to remove advertisement interruption during content streaming. These rates, however, expire at the end of 2015, and the future of Pandora depends heavily on further negotiations with copyright holders and the CRB to establish favorable rates. If a more lenient rate is not established, I imagine the confidence in Pandora Media to plummet.

Improve Advertisement Value - Since royalty rates are probably going to be inevitable burdens that Pandora has to carry, the company may find success in improving higher revenue efficiency through advertisement to offset the ever-present content costs.

Advertising Revenue per Thousand Listener Hours

2011

2012

2013

Computer

$61.6

$62.68

$53.73

Mobile and other Devices

$13.7

$21.05

$22.53

Total

$33.65

$32.22

$29.13

(SEC filing)

The numbers are not pleasing in my opinion, but at the same time it shows potential. The decline in total, or weighted average advertising revenue per thousand hours, has declined year over year because of the higher incidence of mobile Pandora usage. Currently, Pandora suffers from lower mobile advertisement revenue efficiency because marketers are not thoroughly convinced yet that mobile advertisement on the Pandora app is effective. Nevertheless, mobile listening hours constituted 5%, 26%, 54%, 69% and 77% of total listener hours for fiscal years 2009, 2010, 2011, 2012 and 2013, respectively. While the higher mobile integration is positive for future growth, that potential is limited by how well Pandora upgrades its mobile advertising venues. If mobile advertising revenues ascended to the efficiency seen in the traditional computer setting, Pandora would be making close to 1 billion dollars of revenue per year. Lastly, the reason that computer advertisement revenue has decreased is due to the elimination of the monthly 40 hour listening cap. The harsh truth is that Pandora is unable to keep up with the Cost of the Goods Sold, in essence, as the raw materials (cost of content acquisition) is rising at a faster rate than revenue from advertisement. Pandora is using analytical data to demonstrate the efficacy of advertisement for marketers, and over the next year or so we will see if these efforts have been successful.

Expand Operations to New Markets - Pandora has developed relationships with major automobile manufacturers and the Internet radio service is currently available on vehicle models sold by Acura, BMW, Buick, Cadillac, Chevrolet, Ford (F), GMC, Honda (HMC), Hyundai, Lexus, Lincoln, Mazda, Mercedes-Benz, MINI, Nissan (OTCPK:NSANF), Scion, Suzuki and Toyota (TM). Additionally, Chrysler, Infiniti and Kia have publicly announced their plans to offer Pandora integration on future vehicles. These developments could be highly beneficial for Pandora because users of the vehicles will be inclined to load the default radio format, which could be Pandora Internet radio. Considering the number of cars and the number of hours driven, Pandora has a sizable goldmine to take advantage of. Marketers and local businesses have already been convinced of the effectiveness of radio ads played through vehicles. The vehicle venue could be an opportunity for Pandora to target local businesses looking to promote their products or services and generate wider profit margins. However, there is plenty of competition in the automotive radio division as traditional broadcast radio, satellite radio, and the auxiliary jack all will take away from the potential listening hours Pandora has access to.

Additionally, Pandora has released a Pandora API that allows for third party developers to integrate Pandora into new software and hardware to further expand into other markets.

Balance Sheet:

Pandora maintains $178 million mostly in cash and equivalents and receivables, as Pandora mostly outsources the cloud and data infrastructure to providers in Virginia and California. This situation is both good and bad in that the liquidity of assets allows for flexibility in operations and resiliency in dire situations, but all operations are dependent on the successful operations of third part data centers. In case of a natural disaster or a power outage, Pandora services will be interrupted indefinitely and the company has no direct ability to intervene. Total liabilities for the company are recorded to be $73.5 million with only $2.6 million in long term debt. This equates to a current ratio of 2.3 and a total asset/total liabilities ratio of 2.4. These ratios are especially important to me as an investor as this shows the financial prudence of management, the ability to finance further operations, and the amount of future revenue that can go to shareholders/reinvestment rather than interest/debt payoff. Albeit these ratios aren't the tarot cards for a company's future, these ratios do show that Pandora is in an advantageous position to succeed in the near and long term future.

Conclusion:

Pandora is another one of those companies that is in a binary position right now. If the company is able to generate wider margins by lowering the royalty rates through lobbying and/or improving the marketability of its advertisement services, then the company will flourish. If the opposite happens, there is no doubt that the stock will drop to single digits. Currently, 22.22% of the public float is betting against Pandora, and upon positive news, a strong short squeeze will propel the stock to even higher levels. I expect that news to come by the latter half of 2014, but realistically updates will come intermittently, and I would buy at the dips and sell at peaks until definitive agreements between Internet radio and regulators are released. I am personally planning on buying in to Pandora once it drops back down a couple dollars. I believe the future is about personalization and interconnectedness among users around the world, and Pandora achieves both through its Genome Project and its integration with social media.

Source: Pandora: Poised For Profit?