Pandora: A Must Avoid Situation

| About: Pandora Media (P)

Summary

The bull thesis on P ignores glaring issues.

The business model has not lent itself to profitability.

The pathway to profitability is clouded by slowing RPM growth.

The user base is in decline while competitors' user bases continue to grow.

Investors should stay away.

On trading Friday, 7/22, shares of Pandora (NYSE:P) rallied in response to what was a rather ugly quarter. Revenue missed, Q3 guidance was light, FY16 guidance was weak, and active listeners declined both sequentially and YoY. Some bulls are crediting the rally to strong listener hour growth, but at the end of the day, we think the bullish thesis on P ignores the bigger picture. In P, we have an unprofitable company with a declining user base in a hyper-competitive space.

We don't like the stock at its current valuation and think there are many reasons for investors to stay away from this name. These reasons include:

  1. The business model has not lent itself to profitability. P has netted GAAP profitability only once in the past 10 quarters, and that profit was a mere $0.06 a share in 4Q14 (coincidentally when the listener base peaked). In the other 9 combined quarters since the beginning of 2014, the company has lost $1.86 per share in total. All in all, P has a cumulative net income loss since 2014 of $391.5 million, or about 14% of current market cap. The losses are getting greater this year, as tick up in royalty rates has caused LPM growth this year to dramatically outpace RPM growth.
  2. The pathway to profitability is clouded by slowing RPM growth. LPM growth will ease over the next 4 years, growing at a rate equal to the CPI index, so roughly 0-4% per year into 2019. RPM growth MRQ was only 5%, and this continues a trend of declining RPM growth (26% in Q3 to 18% in Q4 to 14% in Q1 to 5% in Q2). If RPM growth continues this trend, then RPM growth will more or less look like LPM growth over the next 4 years. If RPM growth doesn't dramatically outpace LPM growth, the company will be unable to leverage content costs. Without leveraging its biggest cost, P will have trouble driving net profitability.
  3. The user base is in decline. Compared to the same quarter a year ago, P lost 1.3 million active listeners in Q2. In 2 of the past 3 quarters, the active listener base has declined. The active listener base seems to have peaked in Q4 of 2014 at 81.5 million listeners. Granted, these listeners are listening more, but without user growth, there is an over-reliance on RPM growth to drive profitability.
  4. The streaming music space is more crowded and competitive than ever. The streaming music space is home to a lot more services than just Pandora, Spotify, and Apple (NASDAQ:AAPL) Music. Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) YouTube is making a big push into the space with YouTube Red, Jay-Z has a launched a more exclusive and quite popular streaming service called Tidal, and SoundCloud has really emerged with 175 million unique monthly listeners. And these guys are all growing while P is in decline. Spotify's paying subs continue to tick up at an impressive rate. Meanwhile, Tidal gained 1.2 million users in a week and Apple Music added 2 million subs in 2 months. YouTube Red is doing pretty well and SoundCloud's popularity is soaring. The space is growing, and so are all of the players in it, with exception to P. This should be a red flag to investors.

We think investors should stay away from this name. There are things to be optimistic about (the addition of an on-demand service, growth in engagement through higher listener hours, and slower-than-current LPM growth over the next 4 years), but we do not think these potential catalysts will drive profitability for the reasons listed above. Couple this with the fact that P is the only service in decline in the streaming music space, and we think the stock is a must-avoid for investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.