In our social media industry review from last month, we recommended a bearish stance on Pandora Media (P) owing to doubts about the sustainability of the business model. Today, we are reiterating our bearish outlook with the help of some more supportive analysis.
Pandora is the most widely known Internet radio service in the U.S. It makes revenues via online advertisement on the Pandora Network and premium subscription services. The most significant operating expense for the company is the content acquisition costs to music companies for the user-played radio content. These content acquisition costs are a form of royalties, and are directly proportional to the usage of Pandora services. In other words, a growth in revenues will transform into a similar growth in content acquisition costs.
Cost of Revenue
Total Op. Costs
Content acquisition costs, as a percentage of revenues, have risen in the past one year from 57% in Q1 2011 to 59% in Q4 2011 and 69% in Q1 2012. The rise in content acquisition costs should be a matter of grave concern for investors.
Content Acquisition Costs
% of Revenues
Over the last one year, the company experienced a faster growth in content acquisition costs than revenues. In Q1 2012, revenues grew by 58% year over year, while content acquisition costs grew by more than 91%. Even though Pandora is experiencing rapid active user growth and growth in number of listening hours, the company has been unable to monetize the said growth. Plus, the higher growth in content acquisition costs compared to revenues will decrease margins. Pandora needs to devise a way to control content acquisition costs in order to improve margins. However, at the moment we have a bearish outlook for Pandora because we believe that the company's business model is not sustainable, given the hefty content acquisition costs it pays to music companies.
Forward P/E (fye Jan 31, 2014)
Forward P/S (2012E)
Operating Margin (TTM)
Pandora is trading at 207 times' forward earnings, which we believe is too high given the declining margin prospects for Pandora. Therefore, we suggest selling Pandora.The stock has risen 3% since the start of the current year. A review of the sell side outlook suggests that the sell side is not giving much importance to rising content acquisition costs, but we believe that content acquisition costs and declining margins should be a matter of concern for any prudent investor.