Recently, S&P quietly downgraded Pandora (NYSE:P) to "Strong Sell" with a price target of $17, which is much lower than the company's current price of $25. Considering that only about 20% of the stocks covered by the rating agency get designated as "Strong Sell" this can't be too good for the investors of the company.
In its report, S&P acknowledges that Pandora enjoys a market share of 7% within all radios and a market share of 70% within internet radios with more than 70 million registered listeners. On the other hand, the rating agency also mentions that Pandora is currently priced for perfection and there might not be enough room for growth, especially a growth rate large enough to justify today's share price.
S&P's qualitative risk assessment puts Pandora in the "high risk" zone as the company is still having trouble with monetizing its content, gaining paid members fast enough and keeping content costs low enough to allow healthy margins. At the current rate, Pandora is barely breaking even and the company will have to either cut its costs considerably or increase its revenues significantly while holding its costs constant. Every time Pandora increases its sales, it seems to increase its costs at the same rate, if not at a higher rate.
S&P's analysts see Pandora growing at a double-digit rate for the next few years. Pandora is expected to generate $650 million in this fiscal year and $877 million in the next fiscal year in revenues, which indicate a growth rate of 52% for this year and 35% for the next year. As Pandora gets better at monetizing its mobile content, while adding members at the PC space, its revenue growth should continue, but there are still a lot of risks in front of the company. Apart from the emerging competition such as Apple's (NASDAQ:AAPL) iTunes Radio, the biggest threat in front of Pandora will be the company's margins. Royalty and marketing costs will continue to eat Pandora's lunch for the foreseeable future, as S&P expects Pandora to report a loss of 22 cents per share this year, followed by 18 cents per share next year.
Furthermore, the company's stock based compensations will continue to dilute the existing shares. Compared to the 161 million outstanding shares at the company's IPO a couple years ago, Pandora currently enjoys 190 million outstanding shares.
Earlier this year, Pandora capped free weekly listening hours to 40 per user in order to improve its margins; however, this resulted in decreased total listening hours, which is one of the important metrics Pandora tracks every month. As of last month, the cap was cancelled and the users will be able to listen to unlimited amount of music per week at the website. Currently, Pandora is still testing the waters and experimenting with different things in order to find the right balance between maximizing its listening hours without making it too costly for the company and this struggle will probably continue on for a while.
Because Pandora doesn't have positive earnings (and it isn't expected to have positive earnings anytime soon), it is difficult to value the company using this metric. Many analysts use sales multiples rather than earnings multiples in order to value this company accurately. Given Pandora's growth rate and peers, the right price-to-sales ratio seems to be around 4-5. Given that the company is expected to generate about $870 million in the next fiscal year, it can be valued at $3.8 or 3.9 billion. Currently, this corresponds to $20 per share; however, further dilution will probably bring the number closer to $17-18. In this sense, I agree with S&P's valuation of the company.
Does that mean I suggest shorting the company? I don't like the idea of short selling stocks because no matter how overvalued a stock is, it can always get more overvalued. The very dynamics that make a stock overvalued can keep it up for a long time and as the famous saying goes, the market can stay irrational longer than most investors can stay afloat. If anyone were to short this company, I would suggest them to hedge their short position with a long position in order to limit their risk exposure. For example, I currently own both puts and calls of this company, which means I am in both sides of the trade and waiting for the stock to go strongly in either direction in order to make a profit from my position. In this case, I am betting on volatility rather than a direction the stock may move towards.
Will Apple's iTunes Radio kill Pandora? It is too early to tell. In its first week, iTunes Radio captured 11 million users as opposed to Pandora's 72 million users that were accumulated in a decade. At this rate, the number if iTunes Radio users will be similar to the number of Pandora users by the end of the year. While a lot of people could be users of both applications rather than limiting themselves to either, iTunes Radio will probably slowdown the growth of Pandora. Of course, some would say that statement is rather optimistic, because iTunes Radio could potentially do much more than slowing down Pandora's growth, such as completely reversing the growth and putting the company into shrinking mode. Regardless, Pandora is priced for a lot of future growth and if a massive growth doesn't follow, the investors of the company will not be very happy.
This is the first month where iTunes Radio and Pandora will be on air for the full-month. It will be interesting to see how Pandora's monthly numbers stack up by the end of this month. This month's numbers will be able to give investors a lot of insight about the next 3-4 years of Pandora.
Additional disclosure: I also own both calls and puts of P.