by Rocco Pendola
Consider several sets of numbers. Then you'll see why it's hardly crazy to use the words "buy" and "explode" in association with Pandora (P) stock.
For the fiscal quarter ended July 31, 2012, Pandora generated $101,267,000 in revenue. During the same period, it paid $60,522,000 in content acquisition costs, or royalty fees. That comes just shy of a whopping 60% of revenue.
Those numbers contributed to a net loss of ($5,415,000) or ($0.03) per share. Take away about $6,000,000 in stock compensation and, on a Non-GAAP basis, Pandora broke even for the quarter.
If Pandora had a domestic royalty deal closer to the one it cut to return to New Zealand and Australia (certainly less than 25% and likely less than 20%), we've got a whole 'nother story.
At a royalty rate of 25% of revenue, Pandora would have shelled out just $25,316,000 for content acquisition. All else equal, that would have turned the net loss of ($5,415,000) into a net gain of $29,791,000.
Without taking tax expenses into account and again, holding all else constant, Pandora would have reported a profit of about $0.18 per share during the quarter in question.
That changes everything.
Last week, as first reported by radio publication, FMQB, Pandora took a key step towards putting up those types of numbers:
New bipartisan legislation was introduced to Congress today, which could lower Internet radio royalty rates for music. The Internet Radio Fairness Act (HR 6480) was introduced by Rep. Jason Chaffetz (R-UT) and Rep. Jared Polis (D-CO). A companion bill will be introduced in the Senate by Senator Ron Wyden (D-OR). The legislation would categorize Internet radio under the same standards used to set royalty rates for other digital services such as satellite radio or cable.
... Chaffetz said ... "Congress enacted the royalty rate standard for Internet radio 14 years ago, when Internet radio was barely a concept. This bipartisan legislation levels the playing field for Internet radio services by putting them under the same market-based standard used to establish rates for other digital services, including cable and satellite radio. It's well past time to stop discriminating against Internet radio."
Clear Channel (CCMO.PK), which promotes IP-delivered iHeart Radio more than its broadcast stations, supports the legislation. While I'm not certain about Sirius XM's (SIRI) position on the matter, it's not necessarily happy with the existing royalty structure and it only pays roughly 7.5% of revenue. Cable comes in at 15%.
Whether your bullish or bearish Pandora and Internet radio in general, it's tough to disagree - we have an antiquated and inequitable system in place. It's only sane and logical for it to change. I can't see it not changing, even in a place as seemingly illogical as Washington, D.C.
Pandora released an official statement on the introduction of the bill on Friday. I exchanged several emails with Pandora co-founder Tim Westergren, who echoed the press release's content, adding that "while our case is hard to argue with ... this is really just the beginning."
Westergren also explained that if the bill becomes law, the new standard would not be used until the next hearing come 2014-15. That means Pandora would likely be stuck with its current deal until it expires.
If Congress comes through, I expect considerable upside no matter how much time we have until 2014-15. Not only will this give investors more confidence in Pandora's future cost structure, but even with the disproportionate amount of money the company pays to play music, it continues to report increasingly impressive numbers.
With or without a new royalty scheme, these numbers should continue to improve.
As growth in listener hours moderates, even the unfair cost structure becomes more predictable. As it steadies, the bottom line should benefit from surging revenues. I have done the math. That's already taking shape. Sequentially, content costs rose just 8.4% between the two most recent completed quarters versus 15.9%, 27.9%, 11.7% and 15.7% over the previous four quarters.
At a projected $226.4 million in mobile ad revenue for 2012, Pandora ranks second to only Google (GOOG). eMarketer anticipates Pandora's share of the pie to grow to nearly $350 million in 2013 and just shy of half a billion dollars in 2014. And that's just mobile revenue.
Ratchet down content costs with that type of revenue and an EPS of $0.18 looks incredibly conservative.
This stock has lofty (and well-deserved) multiple as well as pending explosion written all over it.
I am long the stock, writing occasional covered calls against my position. For a little less exposure, consider LEAPS options. They're available on P to January 2014.
From a speculative standpoint, the $10, $12 and $15 strikes look attractive, however, I would set limit orders and try to secure the current bid price in each case.
Disclosure: I am long P.