Markets

This Controversial Company's Future May Get A Whole Lot Brighter

Over the past decade, several national radio station operators have declared bankruptcy, and those that remain are on the ropes.

Shares of Cumulus Media (Nasdaq: CMLS ) , for example, traded for $20 a decade ago, but now fetch less than $5. These radio firms have been hit by the double-barreled assault of satellite radio and audio streaming services. Indeed, the next generation of car stereos is more likely to feature buttons for Pandora (NYSE: P ), Sirius XM (Nasdaq: SIRI ) or Spotify. The number of listeners inclined to peruse the AM and FM dials will dwindle.

Still, it's an industry in flux and even Sirius XM and Pandora have had their share of controversy. My longer-term concerns around Sirius XM have not gone away. The company's satellite radio service is popular now, but with firms like Apple, Google and Microsoft aiming to control in-car entertainment systems, Sirius can no longer count on strong direct relationships with auto makers to pre-install its platform. The balance is already titling towards streaming audio services such as Pandora, Spotify and others.

Pandora, for its part, has had plenty of detractors. As I noted back in May, Pandora's Q1 results raised concerns about growth and margins . Second-quarter results were slightly better, but shares remained in the mid-20's, well below the 52-week high of $40. Yet this past week, shares of Pandora broke out to the upside, perhaps in belated response to an announcement that took place earlier this month.

In one fell swoop, Pandora quashed the biggest risk to its business model: legal threats from unhappy musicians over royalty rates.

On August 6, Pandora announced that it will work with a consortium of 20,000 global independent record labels (known as Merlin) to establish more suitable royalty rates, and more importantly, create a platform for the bands on those indie labels to have a marketing partner. Pandora will create great exposure for up-and-coming bands that traditionally would have a hard time cracking traditional radio stations. As Dave Hansen, CEO of Epitaph Records told the technology publication CNET, the deal "is a great opportunity for Merlin's coalition of independent labels, along with the artists we are proud to represent, to gain additional exposure, increase revenue and communicate directly to fans." Epitath has artists like Tom Waits and Wilco.

Two key questions have emerged out of the deal.

First, will such a move pave the way for a long-awaited aggressive push into global markets? And second, will this pave the way for a similar relationship with Universal, Sony and Warner -- the three major record labels?

On the first question, Pandora hasn't addressed the issue but management is expected to spell out international expansion plans during their third quarter conference call. The truce with indie labels establishes a framework for Pandora to work with labels in other parts of the world.

The dynamic between Pandora and the major record labels is harder to handicap. Pandora's support of independent artists might be seen as a threat to the major labels, which would prefer to quash the exposure of artists that aren't on their labels.

Then again, if moves like this strengthen the hand of indie labels, then the major labels may have no choice but to play ball. Otherwise, they run the risk of their artists getting less exposure on Pandora, which in some markets, is already more popular than the leading radio station. Any agreements with the major labels would be a huge endorsement for Pandora's business model and would provide an immediate boost to the stock.

Yet that isn't needed to get this stock moving back toward its 52-week high. Instead, it's the heavy investments in a sales force that should help Pandora to much better monetize its platform. Up until now, Pandora has been more focused on building a registered user base, which now exceeds 250 million users. Just as we've seen with companies like Facebook (Nasdaq: FB) and Twitter (Nasdaq: TWTR) , once a sizable base has been established, the stage is set to generate a strong advertising model. Pandora's sales force will be heavily focused on local markets, where car dealers and other big spenders are typically focused.

To help the sales force, Pandora "will start spending marketing dollars for the first time in 2014 to drive usage," said a Merrill Lynch analyst. Such spending on the sales and marketing are seen as a negative by some investors, as it crimps near-term profitability. But that view is myopic. Pandora is in the midst of a land grab for market share and this is not the time to focus solely on the bottom line. To be sure, the company has yet to reach positive free cash flow, thanks to heavy spending. But after this year's big spending push, free cash flow should soar. Analysts expect that figure to hit $100 million next year and exceed $800 million in 2016, according to Factset Research. For context, Pandora has a market value of almost $6 billion. Trading at less than eight times projected 2016 free cash flow is a relative bargain.

Action to Take --> Speculation is rising that Pandora may be an acquisition target for a large tech or entertainment firm. You should never buy a stock based on buyout hopes. But the buyout chatter underscores the notion that Pandora is building a dominant and defensible business model, positioned for a large audience and considerable free cash flow. Shares still haven't fully recovered from a sharp plunge in March, but with news flow now turning positive, a move back to recent highs appears to be in the cards for Pandora.

Risks to Consider: Pandora needs to execute its business model without a hitch, as it faces considerable competition from Spotify and other audio outlets.

Pandora is a market disrupter -- a stock that comes along, challenges conventional wisdom and recreates the industry in its own image . At StreetAuthority, we like to call these stocks "Game-Changing Stocks." My colleague Andy Obermeuller spent months researching the best game-changing stocks and he just published his findings in "The Hottest Investment Opportunities Of 2015." To find out more, click here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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