Pandora: Gaining Audience, Losing Value?

| About: Pandora Media (P)
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A growing audience does not automatically lead to increasing share values for digital radio stocks. At least that's been the experience of Pandora Media (NYSE:P). Estimates from the ratings service Triton Digital indicate that Pandora's audience has grown by 6% in the last quarter, yet the company's share value has been falling in recent weeks.

These estimates indicate an increased leveraged value for Pandora because the biggest increase in listenership came in the 18 to 49-year-old demographic that advertisers like best. Pandora has been trying to increase its cash flow by selling advertising. Such a change in advertising should lead to increased revenues and leveraged profits in the long run, right?

Not according to the market, which seems to be ignoring Pandora's reports of growth. By August 1st, 2012, Pandora had fallen to a price of $9.48 a share at the close of business. The stock lost 3.95% of its value or 39¢ on Friday, July 27 alone. This fall took place a full two weeks after Pandora tried to spread the good news about its increasing appeal to the advertisers' favorite demographic.

It is not hard to blame the market for not taking Pandora's claims about being able to make money seriously. Bloomberg Businessweek reported that the company lost $20 million during the first quarter of 2012 alone.

Music Royalties Payments Eating up Pandora's Revenue

The reason Pandora is losing money is a simple one: its costs simply exceed its revenue. The company has to pay royalties to musicians and music companies every time it runs a song. Pandora's founder, Tim Westergren, has even admitted that his company spent $136 million on music royalties payments in the last year. In the same period, Pandora had revenues of $274 million. That means royalty payments are eating up about half of Pandora's cash flow. To make money, Pandora would presumably have to increase its revenues by around $100 million or reduce the payments of royalties.

Westergren's solution to this dilemma is a simple one: he is lobbying Congress to change the rules that govern music royalties. A blog post he wrote for the Huffington Post indicates that Westergren would like to go to a system where Pandora would pay performers directly instead of making royalties payments. The most likely situation here would be for Pandora to give musicians a cut of its gross profits. That's the way many movie stars get paid.

Yet Westergren himself admits that there is a way to make money in internet radio. Pandora's major competitor, Sirius XM (NASDAQ:SIRI), has revenues of about $2.7 billion a year, even though it makes $205 million a year in music royalties payments. Sirius, of course, has other sources of revenue it can tap, including subscriptions for car systems and advertising on sports programming.

Terrestrial Radio's Big Advantage Over Digital

The current royalties system also puts Pandora and Sirius at a real disadvantage when competing with terrestrial radio operators such as Cumulus Media (NASDAQ:CMLS) and CBS Radio (NYSE:CBS). These companies don't have to pay royalties to musicians and the record companies they work for under current federal law.

That means radio station operators are free to work out other payment plans with musicians. Clear Channel Communications has a deal to pay Tyler Swift performance royalties (a cut of the gross) when her songs play on its stations. That means Swift gets a cut of advertising and other revenues Clear Channel makes, rather than a flat royalties payment, so her pay is tied to performance and the number of listeners her music can attract.

That saves Clear Channel money because it doesn't have to pay Swift if her music doesn't attract any listeners. Digital radio providers such as Pandora and Sirius have to pay royalties every time they play a song, even if the song generates no revenue. That system makes digital music a black hole into which cash disappears, rather than a revenue generator.

Pandora's Future Share Value Could Depend on Congress

Westergren wants to change the law so that his company can make similar deals with musicians. If Westergren were successful in lobbying Congress, Pandora would be able to pay the owners of music a percentage of whatever profits it made from the songs rather than a royalty. That means it would only have to pay for music that actually made money.

It is not clear if Westergren will be successful in his efforts to get the law changed. If he cannot, there is a good chance that Pandora will never make money. It will have to go on handing most of the cash it makes to musicians, music companies, and agents. Even if it starts making money by selling ads, most of that money will go straight out the door in the form of royalties payments.

If the law could get changed, Pandora might actually making a profit and even pay dividends because it would be able to keep a lot more of its cash. There is no indication that Congress is even considering such changes or when it will make them. That means Capitol Hill might not bail out Pandora anytime soon.

Pandora needs to find some means of keeping the cash it generates if it wants to survive. Right now, it seems the only way for the company to do that is to go begging to Washington and hope the politicians listen to it. That does not seem like a very good business plan.

Judging by Pandora's share value, Mr. Market is not buying this business plan either. Instead, he's rightly not buying shares of company that seems to have no means of holding onto the cash it generates.

At the moment, Pandora is a company with a lot of potential, but very little cash. It has proven that it can attract a huge audience, but it has not figured out how to keep the money that it makes. This reveals a deeply flawed business model that the company seems to have no way to fix. Its future revenues seem to be tied up in circumstances that are probably beyond its control, namely an act of Congress.

That makes Pandora more of a speculative stock than a value stock. Any profits it hopes to make are in the future. Any cash it's making right now it has to pay out to keep the content that attracts customers namely music coming, so it's easy to see why this stock is losing value fast.

It looks as if Pandora is actually overvalued at this time. The company's losses and high operating costs don't justify the current price of $9.48 a share. The $16 a share Pandora was selling for after its IPO in June 2011 seems to confirm Benjamin Graham's belief that the market is insane.

Value investors would be well advised to stay away from Pandora right now. This company is bleeding cash, and unless Mr. Westergren gets the law changed, that situation probably is not going to change.

Expect Pandora's share value to keep falling unless Congress steps in and changes the law so it can stop making those huge royalties payments. If that does not happen, look for Pandora at less than $5 a share in the near future. Pandora shows us that trying to get Congress to take action is not a good way to increase your share value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.