Pandora (P) and Netflix (NFLX) are terrific business ideas that may not be stock market compatible. In other words, both firms have great business ideas and have captured a significant market. However, the problem is that these companies are both more of a service as opposed to a money hungry business, particularly Pandora. More importantly, Pandora faces rising SoundExchange rates and Netflix faces rising subscription costs. These costs will remain a drawback to these stocks. Fortunately for consumers, Netflix and Pandora will bear the brunt of these costs while providing terrific services.
According to Netflix, cost of subscription consists of expenses related to acquisition and licensing of content, as well as content delivery costs related to providing streaming content and shipping DVDs to subscribers. And content acquisition and licensing expenses consist of amortization of streaming content licenses, the DVD content library, and revenue sharing agreements.
Based on Netflix's share price one might think costs have increased exponentially; but this is not the case.
As you can see, the costs of subscriptions as a percentage of revenue has increased since 2002. However since 2008 there has not been a serious change in costs. It is not that important to note that overall costs for subscriptions have increased from $77 million in 2002 to $1.8 billion in 2011 because it is intuitive that as Netflix increases overall subscribers that costs of all the subscriptions will increase. But the percentage of revenue is important to analyze because this indicates whether costs are rising faster than revenue.
It appears that costs are not increasing uncharacteristically compared with revenues. However this story is not finished. After the spike in costs from 2010 to 2011, it will be important to watch this trend. There is another important note to make regarding this increase. Total subscribers only increased 31% from 2010 to 2011, compared to a 63% jump in total subscribers from 2009 to 2010. Despite a larger increase from 2009 to 2010, costs decreased over that period. This indicates that overall costs for DVDs and streaming content increased from 2009 to 2011 in a significant manner.
Turning to Pandora now, Pandora's pain comes from SoundExchange. SoundExchange is in charge of collecting royalties from radio sources and distributing these royalties to the deserved musicians. According to Pandora's fiscal year 2012 10-K, Pandora paid 49.7% of revenues to SoundExchange; which equates to roughly $136.3 million of Pandora's $274.3 million in revenue.
This is quite the significant portion of revenue to be lost. Unfortunately these costs will increase through 2015.
As you can see, Pandora will continue to pay higher fees through 2015. Now, there is some debate as to whether Pandora will pay higher fees after 2015, or negotiate a better contract thereafter. I am one to think SoundExchange will not give Pandora a break. I am expecting to see SoundExchange continue to force Pandora to pay the price.
The good news is that Pandora users that do not sign up for Pandora One cost Pandora less money. On the other hand, these non-subscription users are not contributing to Pandora; unless they are clicking on the ads. Therefore Pandora is simply paying for these listeners without receiving anything in return. This sounds more like a service as opposed to a business to me.
Netflix was once a very strong stock, but has since tumbled due to a slowdown in the new subscribers growth rate. This trend will continue as Redbox (CSTR) offers consumers with a better service. But the key here is that rising subscription expenses will continue to batter the video streaming giant. There will come a time when margins will face severe pressure if prices are not raised.
Pandora faces similar pressure because as song prices increase and users increase we will see Pandora pay SoundExchange exponentially more every year. The key here is the percent of revenue that is paid. If this ratio increases Pandora will have a big problem over the long term.
These reasons are why Netflix and Pandora are great businesses but not such great stocks. There will always be somebody taking advantage of them. Whether it be studios exploiting Netflix or SoundExchange exploiting Pandora; they will continue to have speed bumps. Regulators will also continue to side with the studios and SoundExchange because it would be ridiculous to avoid paying musicians and movie studios for their work. Therefore we will continue to see Pandora and Netflix struggle.
With that said, if a cap is placed on costs then we will see Pandora and Netflix's margins improve. This may be an option in the future as a compromise. But for Pandora this will have to wait until at least 2016. Please note that this does not mean you should avoid these stocks.
I have historically been bearish towards Netflix and this will not change here. But Pandora is a different story. Even though Pandora has stiff competition from Sirius XM (SIRI) and now Spotify, Pandora is expanding very well due to the convenience of carrying the service on a smartphone or tablet. Netflix has this same convenience, but you cannot watch a movie while driving or walking around.
I am not recommending buying Pandora today, but the stock is at a very low level and I consider Pandora to be number two on my list of social media stocks behind Zynga (ZNGA). The key here is patience. For now Netflix and Pandora are merely services that will struggle to produce impressive bottom line numbers. These services are great for consumers, but less so for investors. And as costs continue to rise we will see Netflix and Pandora suffer more pain even as they increase overall subscribers. If, however costs are capped or reduced, these stocks will surge substantially higher.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.