Pandora Media Inc (P): Don’t Buy the Dips!

Shares of Pandora Media Inc (NYSE:P) are down sharply as investors run for cover after rumors of a competing product from Apple Inc. (NASDAQ:AAPL). While a number of media outlets are worried that Apple Inc. (NASDAQ:AAPL)’s decision to enter the Internet radio business will cause irrevocable harm to Pandora, the truth is that Pandora Media Inc (NYSE:P) was already a poor investment well before the Apple rumor surfaced.

Pandora offers a wonderful product–I am actually listening to background music from Pandora as I pen this article. But despite my appreciation of the company’s primary product, I have serious reservations when it comes to owning the stock.

If you currently own the stock, I would suggest you cut your losses and exit the position right away. And if you’re considering “buying the dip” while Pandora Media Inc (NYSE:P)’s stock is on sale, I would strongly suggest that you reconsider.

Inability to profitably scale the business

The biggest challenge for Pandora is not new competition from Apple Inc. (NASDAQ:AAPL). Instead, it is an inability to truly scale the company’s business model towards significant profits.

For a content business like Pandora Media Inc (NYSE:P), the typical business model revolves around buying the rights or license for content and then increasing profits by distributing that product to a growing audience.

The larger your base of customers is, the higher your revenues should be. And since content costs are typically fixed (or have a significant fixed component), healthier revenues translate into growing profits.

Pandora, on the other hand, has built its model with significant variable costs as the company must negotiate deals with each record label whose music it plays. To this end, Pandora has become a victim of its own success. As loyal users stream hours and hours of music, Pandora faces higher content costs because they pay for each individual song played.

In Pandora’s most recent quarterly report, the company announced revenues of $125.5 million. This was a 55% increase over last year, and evidence of the company’s growing popularity.

Unfortunately, the company’s content acquisition costs also rose dramatically, up 49% to $82.2 million. On top of the content acquisition costs, product development costs and marketing costs also rose roughly 75% each.

Financially speaking, Pandora Media Inc (NYSE:P) is falling into the same trap that took out so many of the “dot com” companies when the Internet bubble burst. Growth companies should not be measured by the amount of revenue, the number of eyeballs, or in this case the number of earbuds that are actively streaming music.

At the end of the day, profitability is what drives long-term stock prices. Pandora has yet to prove its ability to consistently generate (not to mention grow) attractive profits.

Marketing and development costs should continue to grow

Now that we know the Apple rumors are true, Pandora Media Inc (NYSE:P) will have to be even more aggressive with its marketing in order to keep from losing market share.

This is a particularly challenging task given Apple’s media reach and their $137 billion dollars in cash. Not that Apple would spend anything close to that amount on marketing, but suffice it to say that the company’s promotion strategy is not in any way affected by budgetary constraints.

In addition to Apple’s potential offering, Google Inc (NASDAQ:GOOG) has its own streaming music platform that is slowly building popularity.

To be sure, Google Play doesn’t have the same patented features that Pandora offers. But the company should be able to effectively grow its platform as users consolidate mail, social media, maps, calendars, spreadsheets, documents, and all of the other services Google Inc (NASDAQ:GOOG) offers – all under one username and password.

The “ease of use” benefit may ultimately give Google Play the upper hand in the battle for streaming music listeners.

As Google Inc (NASDAQ:GOOG), Apple and other offerings such as Spotify begin to compete for listeners ears, potential profit margins will be squeezed and it will become all the more difficult for Pandora to substantially grow profits.

Unreasonable valuation even based on optimistic expectations

The primary argument for owning Pandora Media Inc (NYSE:P) is that the company will eventually grow profits to a level where its current stock price makes sense. But even given analysts’ optimistic profit expectations for $0.27 per share next year, the stock’s valuation still looks incredibly rich.

By this measure, investors are willing to pay roughly 50 times the earnings that may or may not be generated in the year ending Jan. 31, 2015. This is a tremendous premium for any growth stock, much less one with the competitive pressures and profit margin issues that are plaguing Pandora.

At this point, it appears that the best-case scenario would be for Pandora’s stock price to tread water for several years while the company struggles to build enough mass to overcome the variable cost challenges of its business model.

On the other hand, a more disappointing outcome for investors would be a continued drop in the stock as investors realize that although the company has a tremendous product, it is very risky as an investment.

Whether Pandora treads water for a few years or declines rapidly, there are plenty of better growth opportunities with significantly less risk. I would urge investors to liquidate positions in Pandora Media Inc (NYSE:P) and resist the urge to buy the dips until the stock price more appropriately matches the earnings potential of the underlying company.