Pandora Media Inc (NYSE:P)’s stock has appreciated by a mammoth 40% in the last three months despite adverse news from the Internet Radio Fairness Act. The analysis below shows that there is no solid fundamental improvement or changes in the industry to justify stock price appreciation. Therefore, I recommend investors take a short position in Pandora.
The technology sector has advances in leaps and bounds during the last couple of decades. The advancement has revolutionized even the basic aspects of life and integrated the use of technology into every aspect of everyday life. The growth in Internet dispersion and improvements in Internet speed has allowed the radio industry to evolve. Pandora Media Inc (NYSE:P) tries to capitalize on this technological evolution and provides an Internet radio service to USA. The registered users can create 100 different personalized channels and listen to ‘unlimited’ free music. The company also runs a premium service which provides advertisement-free access to music. The company pays a royalty on the music content plays and generates revenues from advertisement and premium service subscriptions.
In a recent article I discussed the high risk that investors of Internet advertisement companies undertake. A major problem that companies such as Groupon Inc (NASDAQ:GRPN) and Pandora face is limited margins. This is because in order to drive traffic and consumer/merchant interest they have to compromise on price, which leads to very thin margins. Groupon has generated a solid revenue growth in the last few quarters, but the bottom line has still been dismal. This is because the company is forced to cut its own ‘take rate’ in order to drive merchant interest in its deals offerings. This is pretty comparable to what is going on with Pandora Media Inc (NYSE:P). The company has shown a phenomenal revenue growth rate but has been unable to transfer this top line performance into bottom line profits.
This inability stems from basic weakness in the business model of Pandora. The company pays very high royalties for the content it plays on its website. These high costs leave very little for the shareholders and severely impact the bottom line of the company. As the chart (below) shows, the growth in the top line is not reflected effectively in the bottom line of Pandora. The company pays as much as 50% of its total revenues as content acquisition cost.
The company is taking drastic measures to improve its business model and improve its margins. Pandora has been pushing for a controversial bill in congress called the Internet Radio Fairness Act. The aim of this bill is to reduce the royalties that Internet radio companies have to pay and bring them on level with other radio mediums. The shareholders have been hoping for some time now that the act will justify the high valuations of Pandora by bringing down its content acquisition costs. According to recent developments the bill is dead for now.