When you're a natural bear like me, you take a look at the valuations of the high-flying tech cohort and you can't help but shudder.
Source: Yahoo Finance.
Facebook (FB) even looks like a bargain at 42x earnings! Normally, such insane valuations cannot be justified, thus warranting a short position. However, I do not believe that logic applies to Pandora (P).
The Short Case Is Excellent
The short case for Pandora is obvious and logical. The company currently pays more for its content than its competitors like terrestrial radio, Sirius XM (SIRI), and Apple's(AAPL) iTunes Radio pay. With sky-high content costs, Pandora has been unable to generate net income for a full year, or -- my favorite metric -- free cash flow. Additionally, the company is facing an onslaught of new competition from web services like Spotify, SongZa, and iTunes Radio. In just a month and a half of competition from Apple's new streaming radio service, Pandora's monthly active users declined sequentially by 1.8 million 70.9 million users. That's a strong number, in my view, considering the amount of time it takes for any new service to ramp.
Total U.S. radio market share notched over 8%, an increase of 30 basis points, and total hours listened were 8% higher than September at 1.47 billion hours. Ultimately, October was a mixed bag, but Pandora should be concerned that competition will intensify going forward. Plus, Apple can afford to engage in any tactic necessary to steal market share from Pandora due to its endless mountain of cash and the overall small impact on Apple's financial performance.
But I'm Not Shorting Pandora
After iTunes Radio launched, my first instinct was to short Pandora -- and I did. The stock fell slightly, but ultimately, the trade was marginally profitable. The short continues to look incredibly attractive on the basis of valuation. I think Pandora is worth somewhere between $12 and $15, a decline of roughly 50% from its current price. However, lurking from beyond lies the destroyer of all shorts -- a potential acquirer with compelling reasons to acquire the company.
Microsoft (MSFT) looms as the most likely bidder, in my view. CEO Steve Ballmer has used the last years of his reign to establish the company in consumer electronics. Ballmer paid $8.5 billion to acquire Skype in 2011, and the company recently added Nokia's handset business into the fold. These two acquisitions, coupled with the upcoming release of Xbox One, make Pandora a perfect fit for Microsoft.
Since the days of the Zune, Microsoft has struggled to gain any presence in music. Each attempt has fallen flat on its face. The current iteration, Xbox Music, won't even be available for free streaming on the Xbox One. Pandora brings an established brand name with an enormous installed user base. It would be a wonderful compliment for Xbox One. Microsoft hopes the system will be an all-in-one living room entertainment device, and that hope moves closer to reality if Microsoft acquires Pandora and its established music service.
It could also make an interesting addition to the Windows phone product. If sales of the latest Lumia struggle, Microsoft could package a free subscription to Pandora or even make it a Windows exclusive (exclusivity isn't likely, in my view). Xbox Music might not draw customers in, but smartphone integration with Pandora would provide a compelling offering.
Pandora could also fetch a hefty price tag. For comparison, Microsoft purchased Skype for $8.5 billion in 2011 after it had generated a small loss in 2010 on revenue of $860 million. Though this is just a rough valuation, 10x Pandora's FY 2014 revenue would value the company at roughly $6.4 billion -- a 28% premium from its current share price. Yet, Pandora has a much more obvious path to monetization than Skype does, so Microsoft could justify paying 10x FY 2015's revenue estimate of $890 million -- roughly $9 billion. That figure represents roughly 80% upside from current levels.
The Detroit Bear would never pay that much for Pandora, but a departing Steve Ballmer certainly might. Plus, his $80 billion war chest would hardly notice the difference between $6.4 billion and $9 billion, assuming that's what it takes to get a deal done. Microsoft also might hold superior negotiating leverage that could help lower content costs. To top it off, newly appointed CEO Brian McAndrews previously oversaw aQuantive before selling the company to none other than Microsoft. I assume he would be comfortable dealing with Microsoft relative to other companies.
The Bottom Line
Unfortunately, finding shorts in a bull market can be an exercise in torture, and the fact that Pandora could be such a strong strategic investment for Microsoft makes Pandora look even more unattractive from the short side. Famed investor Ricky Sandler of Eminence Capital loathes shorting individual stocks because he thinks the risk of acquisitions is too great. In the case of Pandora, I could not agree more.
Disclaimer: The Detroit Bear is not a registered investment advisor, so the contents of this article may not fit your personal investment goals or philosophy.