The longer Pandora Media (NYSE:P) trades in the public markets, the more it seems like a company in a growing market but with its own less-than-ideal business model.
Speaking at a Citigroup investment conference this week, Pandora CEO Joe Kennedy said the radio industry has reached at “a tipping point” in moving from terrestrial radio to Internet radio. Not only does Pandora have an early lead in Internet radio, it also has the chance to increase revenue per listening hour – for example, with the ability to serve visual ads to radio listeners.
And sure enough, the headline figures of Pandora’s first earnings report since its IPO were appealing enough: Revenue rose 117% to $67 million. Total listener hours grew even faster – by 125% – to 1.8 billion. That was enough to let Pandora claim a 3.5% share of U.S. radio listening in the quarter. One year earlier, the share was 1.8%.
As impressive as all that sounds, it obscures a darker truth: Bringing music to the masses is often a tough business. Pandora may be a useful service, and one increasingly popular with music lovers.
But as disruptive as Internet radio is supposed to be, one thing hasn’t changed: It simply costs too much to acquire the music to make much of a profit.
In Pandora’s case, profit is a matter of perspective. The company reported a profit of 2 cents a share when excluding items, and a loss of four cents a share on a GAAP basis, which includes the costs of warrants the company has issued and stock-based compensation.
Analysts had been expecting a loss of 3 cents a share before items, according to Thomson Reuters, so the two-penny profit was a surprise. Even so, the stock closed at $12.37 Wednesday, only marginally higher than before the company’s earnings report.
That suggests investors are wondering whether Pandora can sustain profits for long. In its most recent 10-Q filing with the Securities and Exchange Commission, Pandora said, “we expect to continue to incur operating losses on an annual basis through at least fiscal 2012,” which means operating losses for at least two more quarters.
And the prospect of longer-term profitability in Pandora relies on the company’s ability to keep revenue growing while spending less on operating costs. But there isn’t much sign that this is happening: In the second quarter of 2011, Pandora spent 5% of total revenue on product development and 22% on sales and marketing, both identical with the ratios a year earlier.
Meanwhile, administrative costs rose to 13% of revenue in the last quarter from 9% a year earlier, while content acquisition costs rose to 50% from 48%.
While triple-digit revenue growth is welcome, at some point Pandora will have to see that kind of growth without a corresponding rise in operating costs.
Nor is it entirely encouraging that the number of listening hours is growing at a faster pace than revenue. As Pandora explained in the 10-Q, “Listener hours define the number of opportunities we have to sell advertisements.” So although Pandora is growing at an impressive rate, it’s not tapping its full inventory.
If Pandora can sell ads on its full inventory, it might help turn its operating losses into profits. In terms of costs, there’s little room to cut the biggest line item – content acquisition. And the second largest cost, marketing, is necessary as long as Pandora continues to reach out to mainstream users and battle competitors like Spotify, Google (NASDAQ:GOOG) Music, Amazon (NASDAQ:AMZN) and Apple’s (NASDAQ:AAPL) iTunes’ cloud service.
That leaves little room for Pandora to reduce costs, and it will make it hard to justify a $2 billion market cap. Pandora may have accomplished the unexpected feat of swinging to a profit from a loss (albeit when excluding certain items), but it has a tough road ahead if it expects to wring out a profit that deserves a valuation like that.