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Henry W. Schacht
Henry W. Schacht

Love Pandora, Hate the Stock

June 15, 2011 | About:

Once again we see that investors can't draw a distinction between a great product and a good company.

I've been using Pandora for years. For my hours of listening pleasure, I have paid the firm exactly zero. I listen to what I want and don't pay. What a wonderful combination. But how does this translate into a company I want to own?

Clearly somebody gets it. Pandora (NYSE:P) seems to be the only stock going up in this afflicted market. Profitable companies that may actually pay dividends (horrors) are so passe. We want to speculate... er, invest... in companies that are sexy and cool and have GROWTH.

With the affinity shareholders firmly in control of Pandora, it now warrants a $2+ billion market value. Not surprisingly, the Pandora IPO has been Topic #1 on CNBC all day.

Pandora Radio may be a free service, but CEO Joe Kennedy's comments are truly priceless. According to CNBC, he said:

We have a great track record of growing revenue.

We respect the need for operating margins.

We are putting no particular time frame on profitability.

We are putting no time frame on any financial metrics.

We have the ability to redefine radio.

Gotta love how each quote flows nicely into the next one. Pandora does a great job of growing revenue. When you start with revenue of zero and go up, the growth rates are impressive. Wal-Mart (NYSE:WMT) grew revenue quickly in the beginning also. One store + one store = 100% revenue growth?

Well, Pandora has the added benefit of being able to run with operating margins at less than zero, if the above quote is to be believed. Pandora has a "need for" positive operating margins? Hey, it is a novel concept. Sell a service for less than it costs to produce and they will come! Hello revenue growth! We'll make it up on volume.

And we're talking about OPERATING margins... not profit margins. Pandora, it seems, isn't even covering its cost of goods sold, let alone S,G&A. Taxes? Not to worry. I smell REFUND.

No time table whatsoever on when (if ever) Pandora will actually turn a profit. But no matter... kids these days think those are evil anyway. Economic necessity? Proof you are using resources wisely? Nope. Evidence of greed, corruption, coercion, and abuse. We aren't takers... we're givers! Wealth isn't created or destroyed. Just spread around. And Pandora is likely to redistribute plenty of wealth.

In the meantime, Pandora is a perfect New Age company. A feel good company that doesn't feel the need to make money.

Haven't we seen this all before? Oops, did I just betray my age?

Yes, I'm just old enough to remember the "new value metrics" like price per click, share of eyeballs, etc. And when there is no profit, just find the biggest number you can find and calculate a multiple from that.

Bloomberg was kind enough to point out that:

At the offering price, the company [Pandora] had a market value of about $2.6 billion, or about 19 times last year’s sales, compared with about 2.7 times for Sirius XM Radio Inc. (SIRI), the subscription-based satellite-radio service. Sirius XM had a market value of about $7.7 billion as of yesterday’s close.
Who knew that Sirius at $7 billion could be made to look cheap? But there it is...

Nonetheless, at least one intrepid analyst (John Tinker at Maxim Group) thinks that Pandora is worth a Buy rating and a $23 price target. He first makes a market share argument -- "Pandora only has 3% of all radio listening – suggesting a lot of runway.” What else? Well, Tinker says the company is “revolutionizing the broadcast radio business.” Sound familiar?

Barrons.com goes through the whole argument... Sales and users increasing at a torrid pace. Advertisers are salivating. Just you wait and see...

As for profit? This is my favorite part of the article -- Barron's says:

[T]he company will probably have $1.7 million in Ebitda this year, but a negative $2.1 million next year, as it ramps up R&D expenses and marketing spend. Gross margin is slipping, Tinker notes, as content costs go up. The company’s spend on music copyright licenses amounts to 50% of sales, he notes.
The problem is structural, as shown by Tinker’s comparison of Pandora to Netflix (NASDAQ:NFLX): “NFLX was basically profitable from day one through its physical distribution of DVDs. P is not yet profitable; the music business model has been disintermediated and fragmented by Apple (AAPL) and has still not recovered, whereas the movie/TV business is harder to fragment.”
For that reason, Tinker values Pandora at what he calculates to be half of the market premium that Netflix enjoys, resulting in a forward multiple of 13 times enterprise value as a multiple of projected gross profit.
How did I know that Netflix (NASDAQ:NFLX) would be mentioned?

Disinter-what? Is that a fancy term for what is happening to the economics of the radio/music business? Are they being destroyed? Does that mean that Pandora could REVOLUTIONIZE or REDEFINE the music and radio business, but never EVER turn a profit? The internet is after all a great deflationary device that crushes profit margins.

But ignore all that, don't miss out!

Don't question the valuation... remember that "multiple to projected gross profit"! The beauty is that analysts can "project" any profit they want. With infinite revenue growth, gross margins will surely come. Out of respect for the CEO no doubt. Profits will probably follow? Let's not ruin a good thing!

Didn't we get in trouble with pro-forma numbers before? Sorry, that's just my age again.

Where are Henry Blodget and Mary Meeker when you need them?

Somehow the Pandora IPO could not be more appropriately (or ironically) timed. On a day when everything that has a gross margin above zero seems to be down, investors have found a cause and an escape.

But instead of buying P shares, I'm going to turn off CNBC and turn on Pandora...it's a LOT cheaper.

Disclosure: Short NFLX.

About the author:

Henry W. Schacht
Henry W. Schacht, CFA is the founder of Schacht Value Investors, an investment management firm serving individuals and institutions. He currently serves as President and Chief Investment Officer. He earned his MBA at the University Of Chicago Graduate School of Business and a BBA in finance from the University of Notre Dame. Mr. Schacht is a member of the Association for Investment Management & Research (AIMR), the Investment Analysts Society of Chicago (IASC), and the National Association of Corporate Directors (NACD).

Rating: 4.2/5 (17 votes)


Ego0131 - 6 years ago    Report SPAM
Good article. Hope not too many people read it. Allows me to pick up more SIRI at a great price. :-)
Mrilluminati - 6 years ago    Report SPAM
Well very good points (coming from someone who almost invested in "P" today). However, I should be the devils advocate and remind myself as well as others of the colossal profits that can be made via the "no profit" or "giving strategy". IE Craigslist. Indeed Pandora has a higher cost of sales. And the CEO of craigslist is a modern day Jesus, or crazy (maybe they are one in the same) But it is a FACT that the "giving strategy" isn't without its rewards. LOL Look at all the millionaires that Jesus made on TBN (2000 year later). Maybe Pandora got their IPO too early, but maybe they didn't. Look at all the word of mouth advertising they got today for being the #1 story on google news. The price for advertising will only increase. Maybe RIGHT NOW isn't the best time to invest in Pandora, but after the initial hype fades, as well as their deficit, I have a feeling that the charitable Pandora will have a noticeable pay out. Just a thought. What are yours?
Hschacht - 6 years ago    Report SPAM
A negative gross margin is a very strong sign that there is something wrong with the entire structure of the business. All the "word of mouth" on earth won't change that.

This isn't a company that will make money given enough scale... it just doesn't work.
Noblepaladin - 6 years ago    Report SPAM
Lot's of companies tried to dominate the music scene and none of succeeded. Remember when Napster was suppose to dominate? They had the "best" and largest file sharing service at the time and accumulated a huge user base. After some lawsuits, they converted to a subscription model and now they are in obscurity (It's owned by Best Buy right now). The majority of the users left and went to KaZaa. Once KaZaa started putting ads into the program, all the users left.

Historically, consumers of free music products leave the moment they have to pay or when there are ads. And also, it is very easy for a college kid to create an irrational business model (Napster and KaZaa faced lawsuits for facilitating piracy, BitTorrent doesn't make revenue for the creator) because he is just excited at making a cool program or his payoff is purely in making himself famous (and therefore automatically hired at VC firms or software firms with very high compensation). Pandora is the coolest free music program right now, but when is the next money losing, but really cool gimmick coming along? You have people constantly attacking the business even though they don't make any money doing it!

Apple's is successful mainly because of their superior hardware. That is what brings users to the iTunes store, and that is what allows them to strong arm content providers to give them good deals. Also, selling MP3s is a much better business because they only have to stream the data out once. Pandora has high costs of constantly sending data out. I'm not saying that Pandora won't ever make money. At some point they will try to monetize it and put more ads in. However, once they do that another competitor will make an ad-free music service (even though it is an irrational business model) and steal all the users.
Bill Smith
Bill Smith - 6 years ago    Report SPAM
Nice article, Henry. When I heard about this IPO on the heels of the LNKD IPO, I thought, "Here we go again." People seem to never learn. If I remember the quote correct, WEB said IPO stood for "Initially Probably Overpriced." I'll be waiting with baited breath for your article when Facebook IPOs :-)
Hschacht - 6 years ago    Report SPAM
Thanks, Brewer... Facebook will be a fun one... this stuff is so stupid that I almost feel ridiculous having to point some of this stuff out! "We respect the need for gross margins" ????

Are you kidding me? They really think that investors are that dumb... and in this case, he's right. But they seem to be catching on today.
Dan Dellegrotti
Dan Dellegrotti - 6 years ago    Report SPAM
"I've been using Pandora for years. For my hours of listening pleasure, I have paid the firm exactly zero. I listen to what I want and don't pay. What a wonderful combination. But how does this translate into a company I want to own?"

It doesn't. Pandora is great precisely bc you dont have to pay for it. You just cannot monetize every good idea.

Nice write-up.
Hschacht - 6 years ago    Report SPAM
Thanks Dan. I agree. And yet, they have monetized it... what was it that PT Barnum said? Oh, right. There is a sucker born every minute.
Bill Smith
Bill Smith - 6 years ago    Report SPAM
I think I know the answer, but do they even have a history of financial information--anything at all?

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