The 'Can't Miss' Trade On Pandora

Jun.11.14 | About: Pandora Media (P)

Summary

There has been takeover activity of music streaming companies in the past month.

Though unprofitable, Pandora could be a potential acquisition candidate.

Put/call options could capture upside of acquisition and downside of future operating losses.

Apple Inc.'s (NASDAQ:AAPL) $3 billion acquisition of Beats underscored music streaming's status as the future of the music industry. The transaction put Google Inc. (NASDAQ:GOOG) and Amazon Inc. (NASDAQ:AMZN) - deep-pocketed music industry players - into the spotlight as potential acquirers of music streaming companies like Pandora Media (NYSE:P) and Spotify. Of the two acquisition candidates, only Pandora is publicly-traded. The problem for Pandora is that there may be a limited number of potential suitors, and consistent operating losses will not drive the price higher sans a sale.

The Situation

Pandora is the leading music streaming service in the country, with 31% market share, well ahead of iHeart Radio (9% share), iTunes (8% share) and Spotify (6% share).

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Known for advertising supported radio (72% of revenue), Pandora has also launched a successful subscriber-based service that has grown to 28% of revenue. Revenue for 1Q 2014 was $194.3 million, a 69% increase over 1Q 2013 revenue of $115.1 million. With run-rate revenue of approximately $780 million, Pandora has economies of scale in addition to a growing revenue base; however, it has never earned a profit in its existence. Below is the company's historical financial performance.

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The article, Will Pandora Ever Turn A Profit? explains the company's lack of operating leverage, despite economies of scale and commanding market share.

Pandora has not turned a profit in its existence. One would think that an impressive growth in revenue, a successful campaign to attract paid subscribers, and declining royalty payouts would generate profits, right? Think again. The company generated an operating loss of $29.0 million and $38.5 million in Q1 2014 and Q1 2013, respectively. As revenue has grown, its operating expenses as a percentage of revenue has crept up, implying that the company has little to no operating leverage.

In the past six months, Pandora's stock peaked $38.87/share on February 26th. Since the Apple/Beats transaction was leaked to the media on May 9th, the stock has traded up from $22.20/share to $25.34 on June 10th. The timing in the stock's uptick can be attributed to the buzz around music streaming's encroachment on the sale of digital downloads. However, with a potential Google / Songza partnership, the number of suitors for Pandora may be dwindling.

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The Play

There is a risk to buying Pandora's stock with the hopes it will be bought out. If a buyout does not occur, the stock could retreat back to its year-to-date lows, or even lower if shareholders cannot stomach more operating losses. However, by shorting the stock or doing nothing, one could lose his/her short position or the potential upside in case the company is indeed acquired at a premium.

Buy "Out Of The Money" Calls

  • To capture the upside, I bought "out of the money" call options on Pandora. The September calls at a strike price of $28/share are above the stock price, yet the strike price is low enough that it should go "into the money" in case Pandora is acquired at a premium.
  • The calls capture the upside of an "event driven" stock like Pandora.

Buy "Out Of The Money" Puts

  • To protect the downside of the company not being acquired or reporting another quarterly loss, buy "out of the money" puts.
  • I bought September puts at a strike price of $20/share.

I made both trades when Pandora was trading at about $24/share; the strike price for the puts/calls were about $4 below/above the share price at the time of the trade. I chose a September 14th expiration date (as opposed to July 14th) because by then, Pandora will have reported earnings. Either way, I expect an "event" - a sale, non-sale or negative earnings report - to drive the stock forcefully higher or lower, and into the money.

Conclusion

Pandora's share price has risen since the leaked announcement of an Apple/Beats transaction. There is no guarantee that the company will be the next music streaming company to be acquired. I recommend that investors i) capture the potential upside from an acquisition by buying out of the money call options and ii) buy out of the money put options to protect the downside risk of Pandora not being acquired and/or reporting a 2Q 2014 operating loss.

Disclosure: The author has a long/short position on Pandora. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.