Pandora's Hidden Upside

| About: Pandora Media (P)

Summary

Consumers biggest Internet Radio cost is not the music itself, but the bandwidth to transmit it.

Pandora is unfairly harmed by government subsidies for terrestrial radio bandwidth.

This is in addition to other obstacles like unequal royalties and advertising revenue.

The spectrum subsidies alone account for most or all of Pandora's losses.

These policies are unlikely to continue forever. When they end Pandora may bounce quickly.

Pandora's Bumpy Ride

After Pandora Media (NYSE:P) reported its quarterly earnings in July, I wrote an article arguing that the results, disappointing at first glance, were actually more positive than they appeared. For a little while the market appeared to agree with me. From $12 even on July 21st, the day before my article was published, Pandora rose exactly $1 to $13 on July 25th and peaked at almost $15 two months later before starting to decline. It is now trading back below $13. Right where it was three months ago.

My core thesis around Pandora is built around the idea that no one else seems to really want the local radio advertising market, a $17 billion powerhouse that will need a new home as terrestrial radio declines. Sirius XM (NASDAQ:SIRI) doesn't want it nor apparently do any of the big tech powerhouses like Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN). Even Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), the ad powerhouse, seems disinclined to make room for non-visual ads on its YouTube Music service. Spotify (Private:MUSIC) does have a free, ad-supported tier, but it brings in only one-fourth the revenue of Pandora.

The single biggest disincentive to a Pandora investment is the simple fact that more than a decade after launch it remains unprofitable. But a closer look reveals that may not be the market's choice at all. Rather, the US government is keeping terrestrial radio's costs artificially low, and that is forcing Pandora to set artificially low prices and lose money despite being the most efficient radio operator.

Radio's Hidden, Biggest Cost

While radio music does impose a lot of different costs - and for some companies like Pandora that includes paying the actual musicians, while for others it doesn't - the single biggest cost of music broadcasting is actually spectrum. Spectrum is what everyone uses to transmit information to mobile devices, everything from cell phones to satellite radios to FM radios in cars to Internet dongles.

Spectrum is incredibly expensive, which is part of the reason why our cellular data is incredibly expensive. With most adults consuming upwards of 30 hours a month of music on the go, and a GB of mobile data costing around $2 per GB, high-quality audio streams can cost upwards of $10 a month, more than what even Apple and Amazon charge for the actual music subscription itself.

As a mobile service, Pandora users pay full price for this spectrum consumption, which in turn diminishes what Pandora can charge for the actual product it provides since in consumers' eyes the price of the two combined has to stay below a certain level. Multiplied by 80 million users that comes to billions of dollars in spectrum costs every year, at least some of which indirectly comes out of Pandora's bottom line.

But commercial radio stations are given free spectrum by the federal government. Commercial radio stations pay application fees to the FCC, but those fees come to only a few thousand dollars each. Even multiplied by all the stations in the country, that is a mere pittance of what Pandora pays.

Spectrum Giveaway

The FCC reports that 20 MHz are allocated to FM radio broadcasting from 88 MHz to 108 MHz. There is also the AM band which is even lower, but that is too low to make an effective music broadcasting service, which is why you usually find news broadcasts there. Plus that spectrum is somewhat hobbled by nighttime fluctuations from the ionosphere. You can check out the full explanation of the interaction of terrestrial radio waves and atmospheric EM interference here.

So, Pandora is competing against FM broadcasters who are being given sweetheart deals on spectrum which would otherwise substantially raise their operating costs and increase the appeal of alternative services like Pandora. How much is this subsidy worth?

The simplest way of answering that question is simply to do what I've done before, and multiply the size of the spectrum licenses by the going rate for spectrum in the most recent FCC auctions, which has been conservatively calculated around $2.50 per MHz-POP. Multiplied by a conservative 320 million population in the United States and 20 MHz yields a total of $16 billion for a 10-year license, or $1.6 billion a year.

Pandora's Fair Share

In the world of radio, that is a substantial sum. Pandora's "crushing" losses that have so many convinced it will never be a viable business come to about $300 million over the last 12 months and it accounts for over 10% of total radio listening. At that rate over half of its losses, $160 million of $300 million, are attributable to being unfairly denied its share of government radio subsidies.

But that assigns all other 90% to terrestrial, which isn't right since satellite also takes a large share. The real ratio is Pandora to terrestrial radio's actual share, which is a little harder to measure since Nielsen isn't the most accurate. At one-sixth, though, which doesn't seem wildly unrealistic, almost all of Pandora's losses are attributable to being denied its fair share of the subsidy.

Royalties are another sore spot for Pandora, but also another potential salvation. Pandora pays out a lot of its revenues in royalties while terrestrial radio is exempt from any royalty payments. Any changes to that system would also substantially ease Pandora's troubles. A lot of articles have already been written about the royalty imbalance so I won't rehash all of that here. But you can check out these articles by fellow Seeking Alpha contributors, or this article by Fortune. Suffice to say, as with spectrum, Pandora gets shafted and terrestrial gets subsidized.

It is true of course that some cellular providers, most notably T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S), do not charge their customers for music streaming, which makes those customers more willing to consider their services. But combined those companies only amount to about one-third of the US cellular market. The big cell companies, AT&T (NYSE:T) and Verizon (NYSE:VZ), do not exempt music from data caps. And even T-Mobile and Sprint are not so much offering free music as bundling the cost into their basic plan, while radio broadcasts are truly free.

Investment Implications

Pandora can almost be likened to the poker player who is waiting for the River card in Texas Hold 'Em. The opposing player is winning with a pair of Kings, but Pandora has an ace, a pair of Queens, and an 8-9-10 in its hand. It has a ton of outs. An Ace, a Jack, another Queen, an 8, a 9, a 10, they all put them in the win column. Oh, and four of the cards are clubs so any club wins the match too.

If the government stops giving spectrum away terrestrial loses and Pandora gains. If royalties become rational terrestrial loses. If advertisers continue to migrate to digital, terrestrial loses. If more cell carriers offer free music streaming at a lower price, if more listeners embrace ad-free listening like Pandora now offers, terrestrial loses. Yes, if none of these things happen Pandora is in trouble. But on the flip side, it only takes one for Pandora to pull ahead. And if, quickly or over time, they all happen, Pandora could return a very sizable gain to its shareholders, potentially multiplying several times over.

Conclusion

Pandora is not free and clear by any means, but there is a lot of potential in the company. They are a far more efficient user of a very scarce resource, spectrum, and they pay actual royalties. Terrestrial radio is essentially being propped up entirely by the government at this point. When and if Uncle Sam ever gets tired of wasting the money, things could change for Pandora in a hurry.

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.