According to Renaissance Capital, the leading source for IPO analysis, U.S. public offerings in 2011 are averaging a total return of 1.6% with a first-day pop of 12%. This tells me bad things are happening to these stocks after their first day of trading.
Pandora (NYSE:P), the leading Internet radio site with more than 90 million registered users, saw its stock jump 8.9% on June 15, its first day of trading, only to decline 22.4% since then. As of its Aug. 5 close, it’s down almost $2.50 from its $16 IPO pricing. Pandora subscribers might look at this as an opportunity to buy its stock cheap. You’d be wrong. This company’s business model is broken, and I’ll tell you why.
How it Makes Money
Pandora provides music to its listeners in two ways: 1) through an advertising-based service where you receive 40 free hours per month and then pay 99 cents for the remainder of the month once you’ve hit your maximum number of hours, and 2) through a paid subscription for $36 per year. As of the first quarter, ended April 30, 2011, advertising accounted for 85.5% of its $51 million in total revenue. In addition, subscription revenue increased 139% year-over-year to $7.4 million. It’s a great double threat and — you’d think — a validation of their business model. Actually, all it means is Pandora knows how to sell advertising well. Making money is an entirely different matter.
As you look down the five expense lines from its prospectus, there’s a serious flaw. It’s the music royalties. It’s an unavoidable cost. It can trim the all its other expenses; however, if it wants to stay in business, it has to pay the artists. Therefore, as more listeners actively listen, whether through the free model or paid subscription, its costs go up either way.
The advertising model currently generates about 3.1 cents in revenue per listener hour, the subscription service another half-cent while it pays 1.8 cents per listener hour for the content, leaving 1.8 cents to cover the remaining expenses. Advertising clearly is the road to take here, with subscriptions acting as gravy. However, I’m skeptical it can sell enough advertising, especially if we go into another recession. That would be the kiss of death for Pandora.
Even if Pandora can sell ice to Eskimos, its competition will likely be its undoing. I accidentally came across Grooveshark’s site after having a disagreement with Sirius XM (NASDAQ:SIRI) over my satellite radio account. I wanted to find a good internet radio station to listen to while doing research on my computer. Time magazine named Grooveshark one of the 50 best websites of 2010. Pandora, noticeably, wasn’t on the list. Anyway, the music selection is huge, and while there are other sites like MOG.com and Spotify, I’m going to stick with Grooveshark for now. Its 35 million registered users can’t be wrong, and there lies the rub.
It seems certain there always will be another Grooveshark lurking around the corner seeking to take business from Pandora. Oddly enough, I’m sure there’s a calculation available that tells Pandora the optimal number of listener hours to secure new advertising while avoiding piling on expenses. It’s possible that 3.2 billion listener hours could generate just as much or more advertising revenue but produce lower content acquisition costs. Finding this utopia is not likely.
Recent IPOs like LinkedIn (NASDAQ:LNKD), Teavana (NYSE:TEA) and Dunkin’ Brands (NASDAQ:DNKN) have all done well regardless of the growth story because investors believe they’ll grow earnings. Pandora has done poorly because it won’t. The only way I see Pandora making money is if it doubles advertising revenue while keeping listening hours at 3.8 billion or less. If you don’t already own this stock, forget about it — and if you do, sell.