Media Misses the Boat on Pandora’s Growth

Pandora has challenges ahead, but growth isn't one of them

By Tom Taulli, InvestorPlace Writer & IPO Playbook Editor

Pandora (P) has announced a follow-on offering of 14 million shares, and in the frenzied analysis, some media outlets seem to think the company also provided a “warning” on its growth. But Pandora has done no such thing … which is exactly why its stock price is sitting right where it was yesterday.

Yes, it’s true that Pandora’s filing mentions the following:

“We have experienced rapid growth in both listener hours and advertising revenue. We do not expect to be able to sustain these growth rates in the future and our business and operating results may suffer.”

However, that exact warning was also disclosed in the company’s 10-K, which was filed back in March!

Keep in mind that Pandora’s disclosure is part of its “Risk Factors” section, which includes a laundry list of all the terrible things that could possibly go wrong. In legal parlance, this is known as boilerplate. You can find nearly identical statements from other growth companies like LinkedIn (LNKD).

That said, Risk Factors still can be a valuable tool for investors, as some will also include fairly specific details — such as a lawsuit or the loss of a big client.

Indeed, there are some Risk Factors found in both the 10-K and Pandora’s most recent filing that are worth noting. One that’s particularly scary is the royalty structure that the company must pay:

“For our fiscal year ended January 31, 2013 we incurred SoundExchange related content acquisition costs representing 55.9% of our total revenue for that period.”

The rates will come up for renewal in 2016, and it’s impossible to know what the new levels will be. But you can bet they’ll be costly. Pandora states:

“If we are unable to reach a new agreement for commercially reasonable rates with SoundExchange as the representative for sound recording copyright owners entitled to receive statutory royalties for the period 2016 through 2020, then our content acquisition costs may significantly increase, which could materially harm our financial condition and inhibit the implementation of our business plan.”

Another interesting Risk Factor concerns the rampant competition. RDIO, Spotify and Rhapsody are just a few of the rivals, but perhaps the biggest threat comes from the tech incumbents like Apple (AAPL) and Google (GOOG). According to Pandora’s filing:

“Apple and Google have recently launched competing services, and they may devote greater resources than we have available, have a more accelerated time frame for deployment and leverage their existing user base and proprietary technologies to provide products and services that our listeners and advertisers may view as superior.”

As you can see, there’s much for investors to be worried about Pandora, especially after the stock price has already staged a monstrous 165% move to the upside. But an immediate threat to its growth doesn’t really seem to be at play.

Also, if you take a look at the filing, there are many reasons to be optimistic: The company has a tremendous brand, a user base of about 200 million and a strong local sales force in major radio markets. And growth in the mobile ad market still appears to be in the early stages.

Realistically speaking, the truth is somewhere in the middle. Pandora is in a good spot right now, but competition is ratcheting up, which means its margins likely will become compressed due to discounting. (In fact, Pandora already has ended its 40-hour monthly cap on free mobile listening.) And if its onerous royalty structure gets any worse, Pandora could suffer further pressure.

I would expect Pandora to continue to grow at a nice pace, but for profits to remain elusive.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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