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Founded in 2000, Pandora (NYSE:P) is the king of internet radio. Following its IPO in June 2011, the shares have fallen nearly 50%. That, however, might not be enough. With the recent news that Apple (NASDAQ:AAPL) may be getting into the radio business, we find that Pandora's valuation is too high, with or without a competitor like Apple.

Its current valuation is based on negative earnings, negative cash from operations, and negative free-cash-flow -- much like the valuation of Yelp (NYSE:YELP). And unfortunately, besides Pandora's quality and status quo bias, there does not seem to be much barrier to entry.

For those interested in Yelp, I've written about it here.

But The Service Is Awesome…?

I use and enjoy Pandora. Nevertheless, it is pretty obvious that the stock will need to correct further. For this article, we assume Pandora will indeed grow and continue to exist and therefore we don't focus on user or usage statistics, but on monetization -- since it is the latter which affects share price, even while the former may hint at some distant future profitability. The problem Pandora currently faces is stated clearly in their most recent 10-Q:

"Given the royalty structures in effect with respect to the public performance of sound recordings in the United States, our content acquisition costs increase with each additional listener hour, regardless of whether we are able to generate more revenue." (Emphasis added; Pandora July 2012 10-Q, p. 16)

You will see the financial expression of this in their income statement below. But wait, there is more:

"As such, our ability to achieve and sustain profitability and operating leverage depends on our ability to increase our revenue per hour of streaming through increased advertising sales across all of our delivery platforms. To date, we have not been able to generate additional revenue from our advertising products as rapidly as we have been able to grow our listener hours on mobile and other connected devices, which have experienced significant growth." (Emphasis added; Pandora July 2012 10-Q, p. 16)

Very well Pandora, is there anything which justifies your share price?

Basic Operating Statistics

Pandora's more recent figures show positive operating cash flow; however, as one can see below, it precariously straddles the positive and negative cash flow line:

P Cash Operations Chart

P Cash Operations data by YCharts

Indeed, if we take a look at its recent income statement for the six month period ending July 31st, 2012, we see that the growth in "content acquisition costs" has outstripped the growth in revenue by some 30%:

(Source: July 10-Q, p. 4)

Note the 54% year-over-year growth rate because we will use it below.

Given the high price of Pandora shares and because they are not generating positive operating cash flow, Pandora is still issuing stock to pay the bills -- about 3.5 million in the first six months of 2012. During the same period they had negative operating cash flow of $7.7 million.

Stock Based Compensation

Similarly with other high priced companies not making money, Pandora has been paying employee compensation with stock. Pandora's case is not as bad as Yelp, but its stock based compensation expense for the six month period ending July 31st, 2012 is nearly 3 times its capital expenditures.

(Source: July 10-Q, p. 6)

This large figure relative to the capital expenditures -- which are investments necessary to run the business -- suggests that either the stock, at grant date, was way overvalued; or that the company is using stock based compensation in lieu of cash payments to employees, since the latter would put further pressure on Pandora's cash flow position.

Current Valuation

Currently with greater than 167,429,000 shares outstanding and a market price of $9.91, Pandora has a market capitalization of approximately $1.659 billion. The trailing twelve month sales figure of $338 million puts their TTM P/S at about 4.9. If 15% of the revenue instantly became profit (a nearly inconceivable scenario) the stock would then have a P/E of 32.7. If only 5% instantly became profit (again, pretty unlikely in the near term), their P/E would be 98.1.

Of course, the P/E ratio and the P/FCF ratio are inapplicable since the company is not making any money -- let us stress those last seven words again, hopefully with the result of protecting someone's savings: "the company is not making any money."

Does the growth rate justify the share price?

Considering they had a six month revenue figure of about $182,051,000 and that they will probably increase that figure over the next six months, let us assume they are on track to receive $370 million in revenue in 2012 -- a figure about substantially higher than what they achieved last year. Assuming 10% of those future revenues become free-cash-flow [1] (unlikely), and assuming they continue to grow revenues at the 54% rate noted above, and, lastly, assuming no change in share price, then the hypothetical future would look as follows (in millions):

FCFRevenuePriceP/FCF
2011-5034137.71,640N/A
201237.00370.001640.0044.32
201356.98569.801640.0028.78
201487.75877.491640.0018.69
2015135.131351.341640.0012.14
2016208.112081.061640.007.88

This is to say that if they can continue at their recent growth rate and if they can achieve 10% free-cash-flow margin, they still wouldn't be "fair valued" [2] until half-way through 2014. Even if they achieve the growth rate, they would still need to achieve earnings and free-cash-flow.

Can Listener Growth Save Pandora?

When we see revenue growth, we ought to see growth in their other operating statistics, and we do:

(Source: July 10-Q, p. 17)

But the catch, of course, is that revenue per listening hour does not keep pace:

(Source: July 10-Q, p. 17)

Perhaps, net losses as a percent of revenue have been falling?

Loss as a percent of revenue
Six months ended July 20117.25%
Six months ended July 201214.08%

Unfortunately, the net losses as a percent of revenue have been increasing. The loss tripled from a negative $8,566,000 for the six months ended July 2011 to a negative $25,643,000 for the six month period ended July 2012. This negative number is partially due to their reliance on stock based compensation, which is expensed in the income statement at the overvalued market price.

Can Mobile Save Pandora Media?

"While historically our revenue growth was principally attributable to selling display advertising through our traditional computer-based platform, the rapid adoption of our service on mobile and other connected devices is changing this mix…As our mobile listenership increases, we face new challenges in optimizing our advertising products for delivery on mobile and other connected device platforms and monetizing inventory generated by listeners using these platforms." (Emphasis added; 2011 10-Q, p. 16 - 17)

Probably not in the near term.

Conclusion

There is no margin-of-safety in this stock. Pandora is an excellent service, but its present financial operating statistics do no suggest that the current valuation will last. Further, it does not appear that there are barriers to entry -- hence why the news about Apple struck fear into the heart of the Pandora investors. Just because something is a good service, doesn't make it a good stock.

When we haven't changed the music, Pandora asks if we are listening because each song costs them money -- an investment which has, as yet, yielded a negative return.

I leave you with the following quotes from Pandora's S1:

"On each of July 22, 2009 and September 10, 2009, our board of directors determined that the fair value of our common stock was $0.16 per share." (Pandora Media S1, p. II-3)

"As part of this determination, the board considered a third party valuation analysis that concluded that the fair value of our common stock was $0.71 per share as of February 28, 2010." (Pandora Media S1, p. 67)

"On June 2, 2010, the board of directors determined that the fair value of our common stock was $0.94 per share." (Pandora Media S1, p. 68)

"In anticipation of granting options during the fourth quarter of the year ending January 31, 2011, we initiated a third party valuation of common stock as of October 31, 2010. The valuation analysis estimated that the fair value of our common stock was $3.14 per share." (Pandora S1, p. 69)

  1. Free-cash-flow = FCF = Operating Cash Flow - Capital Expenditures
  2. Fair valued is defined as the average P/FCF of the DJIA. As of today: 13.789.
Source: Pandora Is Not Worth $1.6 Billion