In November, Pandora Media Inc (NYSE: P ) played its investors an ugly tune. The company reported a significant downtrend in advertising revenues. Pandora stock plummeted from the 7s to below 5. And Pandora stock has failed to recover - it remains stuck in the $4-$5.50 range recently.
This latest earnings report didn't do much to help. Shares initially bumped up on stronger subscription revenue news. But more weak advertising results and soft guidance capped the stock's rally. And with good reason. The company's advertising model hasn't been working, and the pivot to subscription revenue is likely too little to late. Here's why:
Content Costs Too Much for Pandora Stock
Pandora has never turned an annual operating profit since going public. And it's simple to understand why. Consider that Pandora is essentially an online software business. It delivers a service to consumers digitally, and gets paid via advertising and subscriptions.
Most software businesses of this model have minimal costs to sell another unit of their goods. Once Microsoft Corporation (NASDAQ: MSFT ) codes the newest versions of Windows, Office, or whatever, it can redistribute it millions of times at minimal additional cost.
Pandora, on the other hand, gets next-to-no benefit from operating scale. That's because its product, music, is not the property of Pandora. In fact, the company is obligated to pay a cripplingly high royalty rate on every song it queues up for listeners. Because it's an online service, Pandora is stuck with much higher music royalty rates than peers such as terrestrial radio and Sirius XM Holdings Inc. (NASDAQ: SIRI ).
So, Pandora is basically a software company. But it only earns 35% gross margin on its sales - compared to the usual 80% or so for software companies - since the music labels consume a large chunk of the revenue.
And gross margin isn't the end of the story. That's Pandora's profit before paying employees, doing research and development, dealing with taxes, and so on. Put it all together, and even after two years of meaningful cost-cutting, Pandora is still nowhere near turning a profit. Hence Pandora stock's ever-lower lows.
How Pandora Stock Could Improve
Pandora stock-owners have to be hoping the company finds a new way forward. The current business model hasn't made money dating back to 2012. It's unlikely to improve now.
One strategy is to try to grow so large that the music labels will have to back down. This is the approach that Spotify appears to be following. Spotify has garnered such a huge user base that it is now integral to the music industry's ongoing prospects. Spotify has pretty much eliminated physical CDs as a relevant medium. Even the once-burgeoning iTunes music market is now in severe decline. Spotify has attracted critical mass, and can now go to music labels with a compelling threat: "Reduce our music royalty rates to levels where we both profit, or we go bust and you do too."
Pandora doesn't really have this option though. Its user base has been stagnant for years and is nowhere near a critical mass that determines the music industry's fate. There's also the option of developing ancillary revenue streams, such as ticket sales and data mining. To date, Pandora's efforts here do not appear to have delivered much. Finally, Pandora has the option of trying to go the subscription model - which it is now in fact doing.
Subscriptions No Panacea for Pandora Stock
Pandora stock bulls point to the company's subscription business as the company's saving grace. This is unlikely to be true, however. Sure, the company's most recent earnings report showed 25% year-over-year growth in the company's subscriber count. But that is off a small base.
Look at outright usage and revenue stats, and both Spotify and Apple Music are growing more quickly. Music streaming, like video streaming, has network effects. The site with the best catalog and snappiest user interface is going to win. Netflix, Inc. (NASDAQ: NFLX ) has crushed the other streaming sites because it has both the content and easy-to-use apps.
Unfortunately, Pandora is way late to the music subscription game. That's not to say that Pandora can't achieve moderate success here. There are niche consumers who love Pandora and will happily subscribe. That's in the same way Amazon, Inc. (NASDAQ: AMZN ) has its small but passionate fanbase for Kindle readers. Kindles will never be a major player in the tablet space, but Amazon can do decent business dominating that corner of the market.
In Pandora's case, though, achieving a modest share of the subscription market does little for the company. That's because it is still burdened with its massive music royalty costs. Spotify hasn't figured out how to make money, and it is significantly more exciting and growing faster than Pandora. Yet the labels are simply charging too much for Spotify to turn a profit. So how can Pandora hope to compete?
Does Pandora Stock Have a Path Forward?
It's not all bad news for Pandora stock. There are many potential suitors for the company. Sirius, for example, made its near half-billion dollar investment in Pandora last year. If there's one company that could convince the labels to cut Pandora's royalties and make their business model work, it might be a combined Sirius/Pandora entity.
Mobile carriers are getting interested in music as well. Sprint Corp (NYSE: S ) has partnered with Jay-Z's struggling Tidal streaming music service. And T-Mobile US (NASDAQ: TMUS ) has been increasingly using music for promotional purposes. It wouldn't be surprising to see them make a move for a company like Pandora.
Furthermore, there's the chance that P stock could turn around if the company posts stronger subscription numbers going forward. While the company can't make meaningful profits in its current business model, it has enough cash and consumer interest to keep the lights on for awhile.
And as long as that is the case, Pandora stock remains an exciting trading vehicle. My call though, despite short-term pops, is the long-term direction is going to be downward.
At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.
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