This article presents a bear case for Pandora Media (NYSE:P). I'm a big believer in long-short investing and wanted to do a follow-up to my last article, which presented a bull case for Research In Motion (RIM), with an article on a short idea.
Pandora is currently at a very interesting time in its growth story. Top line growth has been impressive over the last few years, but has yet to translate into a positive bottom line. The current valuation is rich at 5.4 times sales, and seems to imply that investors are expecting: (1) the growth to continue, and (2) significant improvement to the bottom line within the next few quarters. The motivation for this article stems from the fact that I believe the valuation is headed for a correction because the top line growth is not sustainable and the business model, as currently structured, will prevent material profits. The rest of this article explains the rationale for my below-market expectations.
The Bear Case
Pandora is facing difficulties with its business model. The problem is that the royalties that Pandora must pay to the music industry for the rights to stream music are very high compared to the revenue generated from ad sales. What's more disturbing is that as the company has grown - the costs are increasing faster than the revenues. The company can not simply grow to fix this problem because the problem is due to high variable costs. Below is an analysis of the cost trends.
Cost to Revenue Analysis
A close look at the most recent income statement reveals some disturbing information. In the first quarter of 2011, content costs ($29,158K) were 57% of revenue ($51,040K). Just one year later, the situation has deteriorated strongly.
In the most recent quarter reported, Q1 2012, content costs ($55,818K) were 69% of revenue ($80,784K). The trend is not good. Despite growth, margins are not improving. Despite quick growth in listeners, Pandora is having trouble turning these users into new ad sales.
Low barriers to entry
There are a growing number of streaming music services out there competing for listeners. Spotify, AOL radio, grooveshark.com, Jango.com, and playlist.com are just a few. Google "streaming music" and you'll have lots of options at your fingertips. Pandora is one of many competitors in a space where it is not very hard for new entrants to start a service. In the long run, is there really anything truly special about Pandora from the perspective of the consumer? I doubt it. Switching costs are low as well. Despite having a large customer base at present, it's conceivable that competitors will present many attractive alternatives for music listeners in the next few years.
Mobile Users vs. PC Users
Another problem is highlighted by the shift in how Pandora users are accessing the service. More and more users are using Pandora via their phones instead of PCs. This is bad for Pandora because there is less advertising potential through mobile compared to traditional PCs. Mobile users can't see their phone's screens when the phone is in their pocket! Pandora sells both audio ads and banner ads. This shift in how users are using the service is hurting overall ad revenue, and as a result, gross margins.
The opposing view is that Pandora's costs will eventually go down due to economies of scale resulting from better negotiating power as size increases. It can also be argued that the cost/revenue structure will become more favorable as Pandora becomes increasingly adept at selling ads at better prices. Make sure you consider the likelihood of these scenarios when doing your own analysis.
If the revenue growth slows down or investors become inpatient about the lack of profitability, the stock is likely to come under pressure (make sure to follow the earnings on August 24th). You can't take an unprofitable business model and make it profitable by increasing the volume of sales. Unfortunately, this is what the management of Pandora has been doing. The company has not turned a profit in any of the last three fiscal years, despite increasing sales five-fold between 2010 and 2012.
Disclosure: I am short P and long RIMM.