Pandora is one of the Web's most popular and beloved music services, and smart investors shouldn't go anywhere near the company's stock.
Shares of the profitless radio service began trading today on the New York Stock Exchange as part of an initial public offering, the latest technology play with a questionable business model to test the public equity markets.
In early morning trading, Pandora, which trades under the ticker symbol P, was up 28 percent to $20.37 a share but then began to level off. Investors began pulling back not long after and the stock closed the day at $17.42, up 8 percent. According to Bloomberg, Pandora sold 14.7 million shares yesterday at a price of $16 a share, giving the company a valuation of $2.6 billion. Pandora isn't worth $2 billion and here's why:
Where are the ads?
The way Pandora works is that the company's 80 million users choose their favorite artists and musical genres and the Oakland, Calif.-based company delivers songs over the Internet based on those choices. Pandora offers an ad-supported service that is free of charge to users but limits them to 40 hours of free listening per month. Another service, called Pandora One, costs $36 annually and offers unlimited commercial-free listening.
Since most of the users choose the free-of-charge service, advertising is vital to Pandora. Up to now, however, the company doesn't appear to to be very effective at drawing ad dollars. In documents Pandora filed with the Securities and Exchange Commission, the company saw $119 million in ad revenue for fiscal year 2011, or 87 percent of total revenue. That's more than twice the ad revenue Pandora saw the previous year, but not enough to cover costs, which are also growing. (We'll get to those later.)
The Wall Street Journal pointed out yesterday that one likely indication that Pandora is struggling to sell ads is that users frequently hear the same ads. Another is that only 1 percent of listener hours are devoted to ads, compared to traditional radio, which generates about 20 percent. The Journal noted that mobile ads are less lucrative and the percentage of music Pandora delivers to portable devices rose from 1 percent in 2009 to 60 percent last quarter.
Another stumbling block is that Pandora has failed to tap into local advertising effectively. According to music industry sources, Pandora executives have complained that the company has not been able sell the kind of ads to, say, regional car dealerships, department stores, and other local businesses that are the bread and butter of traditional radio broadcasting.
For Pandora to slice off a piece of this market, it would have to snatch away share from hundreds of local radio stations across the country and their individual ad sales teams, who have established relationships with local advertisers over decades.
Music expenses to grow
When you talk about fixed costs, that's when Pandora's stock really begins to look dicey.
Every time someone listens to a song on Pandora's ad-supported service, the company must pay about a tenth of a penny to copyright owners. Actually, Pandora pays SoundExchange, the performance rights group that collects music royalties from Internet radio and satellite services.
"For our fiscal year ended January 31, 2011, we incurred SoundExchange related content acquisition costs representing 45 percent of our total revenue," Pandora said in SEC filings. That's not all. The statutory rate, which is set by Congress, is scheduled to go up almost every year until 2015. There are estimates that Pandora will pay half of total revenue to SoundExchange for fiscal 2012.
"If we are unable to reach a new agreement with SoundExchange," Pandora wrote, "our operating costs may significantly increase, which could harm our financial condition and inhibit the implementation of our business plan."
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So what does a tenth of a penny per play cost Pandora over a year? Laurie Anderson, a SoundExchange spokeswoman, broke it down this way: Pandora allows users of the ad-supported service 480 hours per year of free play (40 hours x 12 months). She said that if a user listens to 15 songs an hour, this is the equivalent of 7,200 songs per year. She said the 2011 rate Pandora pays is a "PurePlay Webcaster rate" of $0.00102 per spin. Assuming all these users max out their 40 hours of free listening each month, this means each of them costs Pandora $7.35 per year.
As Pandora bulls on Wall Street wax on about how the company should be able turn its large audience into gold, Anderson painted a picture of what Pandora has to overcome just to break even.
"Everyone will be watching to see if they can figure out how to monetize their users in other ways," she told CNET today. "Because the rate they pay is based on per-spin, more listeners doesn't make them more profitable. It doesn't solve their problems. They have to make each listener more profitable."
One high-profile critic of Pandora's business model for the past several years has been Michael Robertson, the founder of pioneering music service MP3.com. This is what he told me in 2009 about Pandora and pay-per-stream business models:
"It's just simple math that you can't make enough with ad banners and click-through keywords to pay a penny per song," Robertson said. "Simple math, ask anybody who knows Internet advertising. Somebody sits there, listens to 20 songs, the royalties pile up with each tick of the clock. Those songs may or may not have ads at any given time and even if they do you can't charge enough for those ads to cover the royalty payments, much less all the other engineering fees and bandwidth, sales and all of the other costs. There's no question that today, Webcasting is not a business."
And what about digital music overall? Surely, this is an area where lots of companies are raking in big bucks, right? On the contrary, this is a sector that over the past five years has seen most of the top players shut their doors, satisfy themselves with niche markets and small profit margins or, in Apple's case, use music to sell phones and digital music players. What's one of the worst performing areas? You guessed it, ad-supported music services. They have taught us that music remains popular and you can attract large audiences by offering free music. But it doesn't equal a profitable business.
There are indications that the situation may have bottomed out. Instead of a free fall, overall music sales appear to be flat. Online music piracy appears to be under siege thanks to some recent court victories and government action.
For Pandora, it's hard to believe that SoundExchange will try to drive the company's costs higher. It wants Pandora to stick around and generate cash for artists, which could mean a break on the royalty rates. Other things Pandora has going for it are an excellent brand and an experienced management team. I have written that Pandora could make a nice acquisition for Google and others.
But as a standalone investment, Pandora is too dependent on its music suppliers. The company faces too much competition for listeners from other Web music services, such as Google's YouTube, which also is a popular ad-supported music discovery service. Pandora must also fight for regional ad dollars with terrestrial radio stations. And any investor should remember Pandora isn't a start-up. The company has been unprofitable at this for 10 years, and there's little reason to think it will suddenly turn into a great business.