Pandora’s Business Model Woes

According to market reports, broadcast advertising on the radio accounts for 83% of the overall radio advertising market. Broadcast advertising is projected to grow 2.7% annually from 2011 through 2016. Growth will be driven by the online radio advertising market, where analysts project an annual growth rate of 11.5% over the period.

Pandora’s Financials

Pandora’s (NYSE:P) Q3 revenues grew 99% over the year to $75.0 million. Advertising revenues grew 102% to $66.0 million, and subscription revenues grew 80% to $9.0 million. The company reported a breakeven quarter, short of the market’s projections of earnings of $0.01 per share.

During the quarter, active users increased 65% to more than 40 million and Pandora’s premium subscriber base grew to 20 million users. Its app has been downloaded 135 million downloads since launch. Total listener hours grew 104% over the year to 2.1 billion. Pandora now accounts for 66% market share of the Internet radio segment in the U.S. compared with 53% a year ago. According to the company’s research, Internet radio accounts for 4.3% of total radio hours in the country compared with a 2.1% share a year ago.

For the current quarter, Pandora expects revenues of $80 million-$84 million with a loss of $0.04-$0.02 per share. It projects fiscal year revenues of $273 million-$277 million with a loss of $0.05-$0.02 per share.

Pandora’s Content Costs
Internet radio players have been bogged down by the royalty fees on their content. According to the existing federal laws, Internet radio service providers have to pay as much as 55%-60% of their revenues as royalty fees. Royalty charges on other digital media accounts for only 7%-16% of  revenues. Content acquisition costs for Pandora account for nearly 60% of revenues. Although advertising revenue growth is strong, it is still not able to compensate for these content costs.

Pandora, along with other players, has been supporting a bill, the Internet Radio Fairness Act, that proposes to end this royalty rate discrimination. But there are some in the music industry who are not supporting Pandora. Several artists, including names like Rihanna, Maroon 5, Katy Perry, and Ne-Yo have created public Facebook pages to announce their disapproval of Pandora’s fight to reduce royalty payments. The bill is scheduled to be presented to the U.S. House Judiciary Committee this week. If it is passed, Pandora will finally find a way to earn those elusive profits. But if the bill does not get cleared, Pandora will need to seriously rethink its business model.

Pandora’s stock is trading at $8.44 with a market capitalization of $1.43 billion. It touched a high of $15.25 during the past year. But the stock is trading significantly lower than the $26.00 it peaked at after listing in June 2011. Until investors see a better business model emerge, I don’t see how the company surges.