Pandora Will Be Profitable

Investors and analysts alike punished Pandora (NYS: P) after a disappointing earnings report earlier this month. The stock fell about 25%, and Citigroup and Raymond James both downgraded it on fears that profitability has receded even farther into the distance for the Internet radio upstart.

CAPS members are similarly bearish on the stock, giving it just one star (out of five), with many citing issues with Pandora's ad-dependent business model, competition from entrants like Spotify, and the company's lack of profitability.

All that negativity is a bit striking for a recent IPO with a phenomenal growth rate in a new industry. Revenue doubled over the year, and in its latest quarter, listener-hours about doubled and revenue jumped by 71%, a disparity that management blamed on seasonality. The strong growth continued in February, with listener hours and radio market share doubling to 975 million and 5.74%, respectively.

Investors have been scared away by rising content acquisition costs, which have outpaced revenues, but the Internet radio industry is just in its infancy, and with the proliferation of smartphones, listening should surely grow. Clearly, there's an opportunity here, and as a first mover Pandora would seem to have a claim to the throne. Even the bears seem to agree that Pandora's a good product, so what can they do to turn things around? Here are three potential solutions:

More ads
Increasing the number of ads seems like the most obvious solution to the problem. With only three or four 15-second ads in an hour, Pandora's content is much less commercialized than standard broadcast TV and radio. The average terrestrial radio station plays about nine minutes of ads per hour, while TV ads generally take up 16 to 18 minutes of every hour. The opportunity to simply increase the number of ads certainly exists, but management's priority seems to be to grow its user base first and fully monetize it later, a popular approach employed by other freemium services and Internet titans like Facebook. On the earnings call, CEO Joe Kennedy said that as Pandora becomes one of the largest radio stations in major markets, its relevance to traditional radio advertisers will "skyrocket."

While more ads could drive users away to competitor services, it could also increase the number of subscribers to Pandora's $3/month ad-free platform, to which it's struggled to attract listeners. Stabilizing its ad-model and growing the ad-free side in one fell swoop would be ideal, but for now management seems to be taking a "build it and they will come" approach.

Better ads
Critics have disparaged Pandora for its dependence on ads, likening it to forgotten tech-bubble stocks, but the ad-based business model has scored huge profits for some other companies -- and not just traditional media providers. Google and Facebook have grown into Internet giants and still largely rely on selling advertising. Pandora's directed ads are still a work in progress, though, and users are often surprised by the products they're being pitched.

There's also an opportunity to harness the GPS capabilities of mobile devices. For example, Pandora often targets ads based on the ZIP code of the listener, but with GPS-enabled smartphones it's easy to imagine ads targeted instead to your current location. This could provide an appealing opportunity for businesses like hotels and restaurants to advertise to road trippers, or for a site like Groupon (NAS: GRPN) to offer spur-of-the-moment deals based on your location. Mobile advertising will become only more sophisticated as it grows, and Kennedy said it's expected to expand to a $13 billion to $20 billion industry in 2015 from just $1 billion to $2 billion last year. Management believes Pandora is No. 2 in mobile-ad sales, after only Google.

Given Pandora's popularity and its ideal position as an advertising vehicle, it certainly could be a worthy acquisition target for a company like Google. In many ways Pandora is an audio version of YouTube, the popular video-sharing site that Google bought in 2006, when YouTube was still unprofitable, for $1.65 billion. Pandora's market value is similar today, at $1.73 billion.

Get creative
Perhaps more than any other industry, music recording has undergone a brutal disruption in the last ten years. Record stores used to be neighborhood mainstays instead of dustbins, people listened to albums instead of playlists, and they kept their music on a shelf instead of a computer. The file-sharing enabled by MP3s didn't just upend the way we listen to music but the whole business model itself, from the creator all the way down to the consumer. The traditional process of record labels signing artists, promoting them, and taking a profit is dying, and a new model will eventually emerge.

One bright spot amidst the industry gloom has been concert sales, which have nearly doubled over the past decade. Music sales, meanwhile, have dropped from $14.6 billion in 1999 to $10.4 billion in 2008 despite undoubtedly growing consumption. There's no reason why Pandora can't capitalize on its relationship with over 100 million listeners to promote concerts and new artists. SiriusXM (NAS: SIRI) occasionally offers subscribers free concerts, and Pandora can vertically integrate in a similar fashion by signing new artists and promoting them live and on its radio stations. Unlike competitor services, Pandora's Music Genome Project is essentially designed to introduce listeners to new music they would like. For artists, this could be a very appealing platform with which to partner.

This one goes to 11
Upstream integration may sound farfetched for a company like Pandora, but signing artists would not be much different from what Amazon (NAS: AMZN) has done with its publishing division or Netflix's (NAS: NFLX) move into original content. Both companies have established trusting relationships with millions of consumers and are simply taking the next logical step in leveraging that audience backward to the creative end of the industry. What Amazon is to books and Netflix is to video entertainment, in many ways Pandora is to music. If management chooses to go this route, they should be able to find willing partners on the creative side.

Considering the recent upheaval in the recording industry, this looks like just the opening act for internet radio. Counting out a business whose usage rate is doubling annually and who stands to benefit from the mobile revolution seems like a mistake. I've made a positive CAPSCall on Pandora, as I think the upside potential outweighs the negatives. Management still has plenty of work to do controlling acquisition costs, but the potential for this platform is massive, and focusing on growth instead of profitability at this stage of the game seems reasonable. Popular products generally figure out a model that works. As the music industry as a whole finds its way, Pandora should as well.

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At the time thisarticle was published Fool contributorJeremy Bowmanowns shares of Google and SiriusXM Radio, and has sold covered calls of SiriusXM Radio. The Motley Fool owns shares of Google and Motley Fool newsletter services have recommended buying shares of Google,, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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