Pandora's IPO: Wait and See

| About: Pandora Media (P)

Pandora (NYSE:P), which launches its IPO today, is anticipated to hit the market at a price of $16 per share. That price certainly will not set the tone for the stock though, as demand for Pandora stock seems to be quite high. In the last month, Pandora went from an anticipated offering as low as $7 per share to more than double that amount at $16 per share.

Up for grabs are about 6 million shares that the company is offering, 8.7 million shares put up by the venture capitalists and another 2.2 million shares of "over-allotment" that the company could choose to sell as well. This means that nearly 17 million shares of Pandora out of about 160 million outstanding will be part of the IPO. This now translates into a market cap of about $2.6 billion.

There is a lot of hype around Pandora, and a lot of discussion. The company has not yet made a profit, so what justifies a market cap of $2.5 billion? Certainly early investors in Sirius XM (NASDAQ:SIRI) can understand this dynamic. It was a little over five years ago that investors in satellite radio were betting on the potential of a company that had not yet made any money. It is the potential of Pandora that people are betting on. Ironically, both boast about the same number of active users: Pandora says it has between 34 and 35 million active users, while Sirius XM says that it has 35.5 million listeners.

So what exactly makes an investment in Pandora compelling? People are quite familiar with the company. They see Pandora on their televisions, on Blu-ray players, on their smart phones, and now even in their cars. Pandora has become one of America's most recognized brands. Some will invest on the hype, while others will invest with the thinking that the company can grow and find a way to become profitable.

Satellite radio was a money loser for years. Sirius and XM competed stiffly with each other as they also tried to convince consumers that paying for radio was a good idea. It was a long and tough road to profits that also required a merger; even with that, the company still almost went bankrupt prior to Liberty Media (LCAPA) stepping in and bailing out the satellite radio provider. It was not until there was serious penetration into cars that Sirius XM was able to make the jump from a wanna-be audio entertainment service to a real player.

Pandora could well be on a similar path. The company has been around for quite some time and never has been able to make a dime. It was not until the advent of the smart phone that the company began to see substantial inroads. Over the past two years, smart phone ownership has tripled. The next real step, and what could be the determination of ultimate success or failure, is smart phone integration into car dashboards. Remember, it is their existence in cars that made satellite radio compelling. That same dynamic could also hold true for Pandora.

Using satellite radio as a template for Pandora's future path may be exactly what those who wish to invest in Pandora should do. I am not saying that Pandora will follow the same path as Sirius XM, but I think that in many ways the things that led to satellite radio's success give Pandora a decent road-map to reference. Satellite radio blazed the trail, and it is always a bit easier to be the second down the path. Pandora can see what has worked and what has not.

What we know is that Pandora is not making money yet. It relies on a "free to consumer" advertising-supported model that puts it in direct competition with all forms of traditional media. It's also now offering a subscription tier to its service which most recently accounted for 14.5% of its revenue (page 9 of its most recent filing). The company had $51 million revenue in the three months ended April 30. Of that revenue, over $29 went to paying royalties. This is a ratio that presents various challenges to the business model.

So how does Pandora rectify this situation? First, it needs to bump up the advertising a bit. Not to the level of terrestrial radio, but something more than what it does now. It could actually double the audio advertising and still be at less than half of the 20 minutes per hour AM and FM listeners are exposed to. This dynamic will likely get more and more people to actually subscribe. The key is finding the right mix that makes the business model work. The company cannot thrive on the costs it currently has, but a little reported dynamic in P's royalty deal could be the "aha" moment that helps Pandora make the next step.

Year

CRB Rate

Pureplay Rate

(non-subscription)*

Pureplay Rate

(subscription)

2011

$0.00190 $0.00102 $0.00170

2012

0.00210 0.00110 0.00200

2013

0.00210 0.00120 0.00220

2014

0.00230 0.00130 0.00230

2015

0.00230 0.00140 0.00250
Click to enlarge

* The rate applicable to its non-subscription service is the greater of the per performance rates set forth in this column and 25% of its U.S. gross revenue.

As you can see, the royalty rates will increase between now and 2015. Compounding the issue is that the more time people spend listening, the more costs the company incurs. However, if the company can get revenue higher, it can limit outlay for royalties to 25% instead of the nearly 60% we saw in the latest three months. That is a substantial shift in the business model. What it requires the company to do is find an appropriate mix of advertising revenue and subscription revenue. Over time, Pandora can accomplish this by doing a little more advertising and getting the subscription rate increased. Another tactic P could use on the subscription side is to follow Sirius XM's lead and charge a royalty fee pass-through. The genius in what Sirius XM did was that it effectively added revenue by charging more to consumers while maintaining the advertised price of $12.95 per month.

What I believe is that people will bet on the excitement of Pandora driving the stock price upward over the initial day. The equity will then begin to settle down and the number crunching will begin. As quarters pass, the company, now public, will be compelled to institute changes in its business model. Let's face it, Pandora accounted for over 25% of the revenues Sound Exchange collected last year. The record industry does not want to see Pandora fail. It does, however, want its proverbial pound of flesh.

Is Pandora worth investing in? It depends on your tolerance for risk. Look at the history of satellite radio and you will see how long and hard the road to profits was. My opinion is that Pandora will be around for quite some time, and may be worth your consideration. However, I would wait for a few quarters to seek out a better buy-in position with more information in hand.

Step back from the IPO hype and give the company a serious look a bit down the road.

Disclosure: I am long SIRI.