Pandora (NYSE:P) Investing

Brian Hicks

Written By Brian Hicks

Posted October 21, 2013

It’s been more than eight years since Pandora Radio (NYSE:P) launched, and the Internet radio pureplay service has made very little in the way of profit during that time. But with steadily rising audience engagement, a steadily falling outflow of cash to music licensees, and a brand new CEO heading the company, Pandora hopes to fight its way to profitability.

Unfortunately, the cards don’t seem to be stacking up in Pandora’s favor.

A leadership change

Pandora’s CEO Joe Kennedy stepped down from his position last March. Kennedy had been with Pandora since 2004 – before it was a public company – and long before the smartphone revolution put the service in everyone’s pockets. The motivation for Kennedy’s departure was unclear at the time of its announcement, since the company had just enjoyed a great quarter.

Last September, Pandora’s board elected Brian McAndrews as the company’s new CEO, President and Chairman. With McAndrews’ escalation, the motivation became clear: ad monetization.

McAndrews served as the head of aQuantive, one of the most promising digital marketing companies of its time. In 2007, Microsoft (NASDAQ: MSFT) threw down $6.4 billion dollars to acquire aQuantive in the hopes that it would be a powerful display ad vehicle to compete with Google

At the time, it was Microsoft’s largest acquisition ever, and it remains the third largest in its history – behind only Nokia and Skype.

But just two years later, Microsoft took a $6.3 billion writedown on aQuantive – it was a catastrophic failure.

According to former employees, Microsoft established too much control over aQuantive, and pushed it into search advertising despite the fact that its strength was in display advertising. This triggered a company wide brain drain that eventually took McAndrews with it.

Though McAndrews was part of one of the biggest online ad firms in history, his experiences at aQuantive don’t exactly fit the conventional advertising model. Pandora’s advertisements are a mixture of audio, video, and graphic, and they’re chosen based upon user behavior. Today, the relevance of display advertisement is in debate, and McAndrews’ expertise in the field was shown off before mobile apps took over.

What’s more, he has no experience in the music industry.

Pandora’s lasting value

Pandora, aka the Music Genome Project, is the epitome of big data. The songs that Pandora suggests are based upon proprietary algorithms that analyze user data such as, musical preference, age, gender, and geographic region. Suggesting music seems simple on its face, but it takes an immense amount of data to cultivate a single Pandora radio station.

This is what makes Pandora so valuable as an advertising platform. It doesn’t simply play music, it learns about its audience as it’s playing. As Pandora’s ability to learn grows, both users and advertisers benefit.

In March 2013, Pandora announced it would be instituting a listening cap of 40 hours per free mobile user. In September, just five months later, that limit was abolished because the company had learned how to better monetize mobile listening hours.

“Although we are removing the broad 40 hour per month mobile listening limit, we have implemented other more precise measures that we believe will allow us to moderate the growth of mobile content acquisition costs while minimizing adverse effects on the listener experience, ” according to a statement from the company.

So can it even make money?

Pandora (NYSE%3A P) Earnings from FY 2009-2013

Pandora can surely do business. It has increased its revenue, grown its audience every quarter, and even managed to increase the amount of time users engage with the service.

But at the same time, it has also grown its selling, general, and administrative expenses. These include the hefty licensing fees Pandora pays for the music it plays. As a result, Pandora is consistently in the red.

In the first half of FY 2014, Pandora suffered an increase in its content acquisition costs that has continued the downward trend.

For the last three years, Pandora has steadily decreased its ratio of income to expense. In 2011, the company almost broke even, earning 99.4 cents for every dollar spent. In 2012, that dropped to 90 cents of income per dollar spent, and in 2013 it dropped to 78 cents of income for every dollar spent.

With big data about its users at its disposal, Pandora could be more effective in its advertising. This would involve striking a tenuous balance between music playing and advertisements playing. If it plays too much music, it has to pay a greater amount of royalties to music rights holders, if it plays too many advertisements, it could decrease user engagement.

Apple (NASDAQ: AAPL) Poses an Existential Threat

Apple’s iOS-based devices have contributed immensely to Pandora’s revenue, but Apple has integrated iTunes Radio, its own Pandora competitor, into iOS7. Pandora’s Chief Financial Officer Mike Herring recently recognized this service as a “credible threat” to Pandora moving forward.

Pandora’s big data value seems like a weak weapon against Apple’s unfettered access to all parts of iOS, both existent and still in development. There is also the fact that iTunes Radio is installed in new iOS devices by default and Pandora is not.

Apple has already integrated iTunes Radio into key iOS features. For example, users can activate the application by voice through Siri. This feature alone is a killer for users behind the wheel of a car. It’s also integrated into iCloud, which means user preferences and stations can be shared across all of their Apple products.

As of today, iOS7 has only been available for one month, and iTunes Radio usage hasn’t yet tipped the scales out of Pandora’s favor. Unfortunately, this will remain a tremendous threat to Pandora as long as the biggest revenue drivers remain iOS users. If Pandora unveils Android-exclusive features that appeal to the massive pool of Android users, some of the iTunes Radio threat could be mitigated. 

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