Pandora's Profit Margin Will Remain Under Pressure

Aug.15.13 | About: Pandora Media (P)

In the last few articles that I read on Pandora Media (P), I came across plenty of discussions about its competition. Therefore, in this article I will analyze the effects of increasing competition on its future revenue and earnings. To begin with, we first must understand the different sources of its revenue. The company reported revenue of $125.5 million for the first quarter of the current fiscal year, of which advertisements contributed $105.1 million, and subscription and other revenue contributed $20.4 million. Accordingly, advertising revenue as a percentage of total revenue was 83.74%.

When further analyzing the company's advertising revenue, you will notice that mobile advertising contributed nearly 94% of the total advertising revenue. In the first quarter of the current fiscal year, the company added more than 700,000 Pandora One subscribers in the U.S., which totaled the number of subscribers to 2.5 million. Interestingly, almost half of the subscribers that the company added were through mobile devices, which shows the increasing dependency of Pandora's revenue on mobile advertising.

Before further elaborating on the contribution of mobile advertising to the overall revenue, let's first analyze the cost scenario of the company.

Operating Cost

Despite the fact that Pandora reported revenue of $125.5 million in the first quarter, which was an increase of almost 55% on a yearly basis, its bottom line showed a loss of $28 million. Analyzing the income statement of the last three years, you will notice that although there was an increase in its revenue from $137.77 million in 2011 to $427.15 million in 2013, it consistently reported a negative earnings applicable to equity shareholders. For the fiscal year ended 2011 it reported a loss of $11 million, which increased to a loss of $38.15 million by fiscal year ending 2013.

The primary reasons that led to the continuous loss were the increase in the cost of revenue (content acquisition cost), and the increase in the selling, general, and administrative expenses, or SG&A. For the fiscal year ending 2011 the cost of revenue as a percentage of total revenue was 58.73%, which increased to 62.50% for fiscal ending 2012, and 68.07% for fiscal ending 2013. The expected increase of 18% in the content acquisition cost (royalty payment) in the current year, will further deteriorate the gross margin of the company.

Similarly, if you look at the SG&A expenditure of the last three years, you will notice that there was a consistent increase in its SG&A expenditure. It reported a SG&A expenditure of $50.43 million for fiscal year ending 2011, which increased to $100.44 million for fiscal year ending 2012, and $155.96 million for fiscal year ending 2013. If you compare the rate of increase in the SG&A expenditure with the rate of increase in the total revenue, you will notice that the SG&A expenditure and the revenue increased by almost same percentage -- 210% -- between the fiscal years ending 2011 and 2013.

During the first-quarter earnings call, Pandora's management mentioned that the company increased its headcount by almost 55% in the first quarter on a year-over-year basis. The increase in the number of employees will certainly increase its SG&A expenditure in the current year. The crux of my argument is that if the company is unable to match the rate of increase in its revenue with the rate of increase in its expenditures, I believe there is a high probability that the company's losses will increase in the current year.









Cost of revenue








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All amounts in U.S. dollars ('000). Source: Yahoo Finance.

Mobile Advertising

As I mentioned above, mobile advertising contributed to a major portion of the total advertising revenue. The increasing level of competition in the mobile advertising segment in the U.S. will certainly put downward pressure on the company's current market share in the U.S. Here is an excerpt of what Pandora's management said during the first-quarter earnings conference call:

Our mix of listener hours and ad revenue continues to ship towards mobile. Listening on mobile and other connected devices represented 79% of total listener hours during the first quarter and revenue generated from mobile represented two-thirds of Pandora's total revenue.

So, if mobile devices represent two-third of Pandora's total revenue, I believe any decline in its market share as a result of increasing competition -- such as from Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) -- will reduce its overall revenue.

Stock Price Movement

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Source: Yahoo Finance.

The chart above shows that Pandora's stock price has increased from $9.18 to $20.21 year to date in 2013, which is a price appreciation of almost 120%. During the same period, Sirius XM Radio (NASDAQ:SIRI) -- one of its major competitors -- registered a price appreciation of only 32.52%. Even considering the trailing 12 months price/sales ratio, Pandora's shares have traded at a P/S multiple of 6.91, whereas Sirius has traded at 6.53. This signifies that Pandora's shares have traded at a higher sales-per-share multiple than Sirius.

Bottom Line

Given the increasing competition in the U.S. mobile advertising market, I believe it will be difficult for Pandora to maintain its current market share. Furthermore, the increase in its cost of revenue and SG&A expenditure will put downward pressure on its bottom line. Also, from the stock price movement, I believe there is no upside left for the stock as it is already trading at a higher P/S multiple than its competitors. Thus, I recommend investors not add any new positions in Pandora at the current level.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.