Will There Be Profits in Pandora's Box?

| About: Pandora Media (P)

By Justin Dove

With more than 90 million registered users in the United States, chances are you or someone you know uses Pandora (NYSE: P) as a music service or smartphone application.

Pandora’s opening on June 15 resembled a roller coaster ride. The stock surged to nearly a 50 percent gain just after the markets opened… Then, when it looked like it might follow in LinkedIn’s (NYSE: LNKD) path, it leveled off. By closing, Pandora fell back to earth for a gain closer to 9 percent of its $16 starting price.

There are varying opinions on how good of an investment Pandora is… so let’s look under the hood…

NYSE: P – The Undisputed Market Leader in Online Radio

Pandora has shown strong growth over the past three years, according to its income statement. Revenues went from $19 million through 2008 to $55 million after 2009 and last year exploded to $137 million. The net loss from operations shrunk from more than $28 million through 2008 to just above $1.5 million last year. This is the type of pattern you want to see in a growing technology market such as internet radio. Whether that pattern continues into the black is anyone’s guess…

Sure, there will be plenty of competition in the online media market with streaming online radio such as Slacker Radio, Yahoo! Music, and so on. There are also the new cloud computing options such as the iCloud from Apple (Nasdaq: AAPL), due out in the fall, and Cloud Drive from Amazon (Nasdaq: AMZN). The cloud will let users save music files and playlists to a personal online “hard drive” which they can access from any internet-connected device.

But despite the competition, The Music Genome Project and a polished user interface have made Pandora the undisputed market leader in online radio.

So what’s the concern?

Pandora claims to contain a library of more than 800,000 songs. Each time a user plays a song, Pandora must pay royalties. With an ever-growing base of listeners, the expenses increase with the expansion of the user base. The current deal in place, which expires in 2015, is generous for Pandora. However, a subsequent deal may end up increasing long-term royalty expenses.

The Gift and the Curse of The Mobile App Market

One of the biggest developments in the life of Pandora was the introduction of the iPhone App Store in 2008. As the web version of Pandora seemed to be stalling, the mobile app market version quickly became the most downloaded application by iPhone users in late 2008.

In 2011, mobile device users comprised 60 percent of Pandora’s total usage. But the company still hasn’t figured out how to fully capitalize on this customer base. According to the Risk Factors section of Pandora’s latest SEC filing states, the company acknowledged that “To date, we have not been able to generate revenue from our advertising products delivered to mobile devices as effectively as we have for our advertising products served on traditional computers.”

Mobile expansion has been a double-edged sword for Pandora. While its mobile application certainly catapulted the usage and convenience of the service, it also brings up new difficulties in the business model.

As Mark Walsh of MoBlog states, “Pandora is caught between the more established world of Web advertising and the mobile ad frontier, where advertising hasn’t caught up to usage.”

A Wait-And-See Approach

There’s obviously a hype surrounding the potential of these internet companies. It’s also easy to love a company that you like as a consumer. That doesn’t mean it’s a sound investment though. There are questions with the business model and if the model is overhauled, there will be risk of losing user base.

Pandora, valued at more than $2.6 billion on the day of the IPO, is now awash in cash. This infusion of money may be just what it needs to buy time and find a way to become profitable. But it could also be a temporary flotation device for a ship taking on water.

As my colleague Alex Green pointed out on Monday, the technology sector, outside of social networking, is on the upswing for the long term. Pandora is kind of stuck in the middle though. It isn’t a social network and it earns substantial revenues with an attachment to the smartphone boom. But many experts are claiming the company is being overvalued considering a lack of profits and the current technology stock frenzy. It should be an interesting story to follow throughout the rest of the year.

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