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Pandora (P) is a company with a flawed business model and increasing competition.

The company, which I personally believe has the best internet radio technology in the market, continues to attract active users and increase listening hours at an impressive pace. According to the latest 10-Q: From January 31st 2012 until July 31st 2012, the company increased active users from 47.6 million to 54.9 million, approximately 15%. Listening hours have also increased by about 85% year /year.

The problem with the company's business model though is that royalty rates to record companies are stifling the chances for the company to ever become robustly profitable.

Cost of revenue (content acquisition costs/royalties) were 60% of revenue for the latest quarter while they were 51% of revenue in the same quarter the previous year. As the company states in their 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. 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.

The company also mentions that they "do not expect to be profitable on an annual basis in the near term" and that they expect "to invest heavily in our operations to support anticipated future growth".

The company has developed a flawed business plan which will have a difficult time ever becoming profitable unless the company is able to change its royalty structure. It is simply not scalable.

The NY Times reported over the weekend though that,

...a new Congressional bill, the Internet Radio Fairness Act. Introduced in the House by Jason Chaffetz, Republican of Utah, and Jared Polis, Democrat of Colorado, the bill would move so-called noninteractive online radio services like Pandora and Clear Channel Communications' iHeartRadio app from the "willing buyer, willing seller" standard to the one used to determine rates for Sirius XM Radio. That model would let the panel of federal judges that set the rates consider evidence both on the value of the music and on the effect the royalty rate would have on the industry over all. Pandora and its supporters believe that standard would yield lower rates.

If this bill passes it would be a huge boon for Pandora but the chances of it passing is still unclear. The NY Times mentions that "the issue is expected to be deliberated after the national elections in November, and probably into the spring."

The only other option for Pandora to start earning profits is to increase advertising / subscription revenues at a faster pace without annoying its listener base. Considering the company faces stiff competition from others such as Sirius XM (SIRI), Clear Channel and new competitors are expected to enter the fray soon such as Apple (AAPL) and Microsoft (MSFT) the chances Pandora will successfully be able to do so is very unlikely.

In summary, Pandora under the current business model is a terrible investment but there is significant upside if the Internet Radio Fairness Act is passed.

As it is impossible to gauge what the chances of the Internet Radio Fairness Act passing, one way to play this would be through a straddle option position with expiration in June 2013. If the act is passed the stock could easily double, while if it doesn't pass the stock price could crater. Two major risks with this strategy would be if the deliberations on the act are delayed further than June 2013 and if the stock price movement is not large enough to either direction to make up the price of the option contracts.

Alternatively, one could go long the stock while buying protective puts in order to prevent the downside or short the stock and buy protective calls in case the bill is passed.

(As with all investing, especially out of the money call options, there is significant risk to principal. Please do not rely solely on articles on this but do your own research and make your own decision whether this the right investment for you.)

Source: Pandora: Everything Is Riding On The Internet Radio Fairness Act