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Pandora (NYSE:P), the online radio service that can magically gauge your music taste based on an algorithm, filed papers to raise as much as $100 million in an IPO. The company has more than 80 million listeners (up 300% from the end of 2009), more than 50% share of listening time of all music listened to on internet radio, and its listeners created more than 1.4 billion stations. Sounds good so far.

Most music listeners I've met love Pandora and have found some awesome music through it, but while there is an attractive upside, its operating profit model is extremely weak and there are lots of substantial risks and unknowns for those looking to invest.

Risks

The company lists the following risks in its prospectus:

Since our inception in 2000, we have incurred significant net operating losses and as of October 31, 2010, we had an accumulated deficit of $83.9 million. A key element of our strategy is to aggressively increase the number of listeners and listener hours to increase our market penetration. However, as our number of listener hours increases, the royalties we pay for content acquisition also increase. We have not in the past generated, and may not in the future generate, sufficient revenue from the sale of advertising and subscriptions to offset such royalty expenses. If we cannot successfully earn revenue at a rate that exceeds the operational costs associated with increased listener hours, we may not be able to achieve or sustain profitability. In addition, we expect to invest heavily in our operations to support anticipated future growth and public company reporting and compliance obligations. As a result of these factors, we expect to continue to incur operating losses on an annual basis through at least the end of fiscal 2012.

Our operation [is] under an evolving music industry licensing structure that may change or cease to exist, which in turn may result in a significant increase in our operating expenses.

Additionally, competitors pose a great threat to Pandora's already weak operating model. According to Pandora, its competitors are terrestrial radio providers such as CBS & Clearchannel, Sirius XM, & Rhapsody. As a result, Pandora plans to improve its algorithm and offer non-music content in the future (they believe 20% of all listeners are talk radio).

Sirius XM

This raises an obvious question - is Pandora a threat to Sirius XM?

It depends. Sirius currently has a very different and much more subscriber-based revenue model - 86% of its revenue comes from subscribers vs. Pandora's 22%. Unless its strategy is significantly altered, Pandora's subscriber revenue would increase only to 25% of total revenue at best by 2012. The remaining portion of revenues comes from advertising.

If Pandora is successful at spreading the concept domestically and abroad, they could enhance the Pandora content and pose a huge threat to the Sirius subscriber base. Would listeners prefer to get free radio subsidized by advertising vs. the relatively high Sirius subscription fees?

The concept is obviously catching on as Pandora is the #1 app downloaded on the iPad, the #2 app downloaded on the iPhone and has contracts with Ford, Mercedes, and the MINI (BMW). If you are a Sirius investor, I would watch operating margins very carefully in the next two years as Pandora continues its entry into the terrestrial radio turf. That doesn't mean that Pandora's stock will sky-rocket either, necessarily, as its strategy is a longer-term solution based on an advertising revenue model and it remains to be seen if Pandora can even become profitable after 2012.

Sirius XM Analyst Sentiment

Analysts expect that Sirius will continue to attract subscribers and could hit as many as 24.8 million subscribers by 2013 with a 12 month forward target price of $2/share. The same analysts propose a bear-case scenario, however, that the Sirius market share of car listeners could erode, while services like Pandora will gain share through internet enabled wireless devices, in which case Sirius could fall to as low as $1.20/share.

Pandora Valuation

It is extremely difficult to come up with a "comparable" valuation for Pandora, however, there is currently a buy order on its stock for $6/share in the private markets, which would give the company an $870 million implied valuation if a seller is found before the IPO. I believe this is an extremely rich valuation given the substantial risks and unknowns. I would value Pandora at around $700 million with a 5x revenue multiple given its rapid sales growth (Sirius XM revenue multiple is about 2.6x). According to my calculations, that would mean the current stock price is not worth more than $4/share.

As the rapid sales growth continues, an argument could be made that the stock price per share will continue to climb. Using a revenue multiplier is extremely dangerous in this case, however, as Pandora has yet to figure out how to generate an operating profit. The majority of Pandora's costs are in marketing & royalties (content acquisition), which together with other costs continue to wipe out revenues. Add that to the fact that the company does not plan on being profitable until after 2012 and you've got yourself a risky offering.

Economies of scale becomes irrelevant with respect to royalties since Pandora's costs increase alongside the user growth. Additionally, the hotter the music, the higher the royalty costs. At the same time, if they do continue to rapidly expand, Pandora can flatten out its marketing & administrative costs and come out with a razor thin operating profit margin by 2013. Still, the fact that they haven't figured out how to generate an operating margin after 10+ years is discouraging.

Because Pandora does not know how to help itself while posing a great threat to rivals, my prediction is that they are a prime buyout target. My model and price/share projections can be found on Alpha Bias.

Source: Pandora Files for IPO: Potential Threat to Sirius XM?