I Love Pandora, but This Company's Singing the Blues

Although I've recently latched on to Sirius XM's , I've long been a closet admirer of rival Pandora -- for the music, not the business model. I'm all for supporting the "little guy" or the struggling artists, but when it comes to Pandora's business model I have my doubts. The company just heightened that fear.

Content can't both be "king" and free
On Wednesday, in a blog post on its website, Pandora announced that it is installing a 40-hour monthly limit on anyone listening for free via a mobile device. Those who exceed that 40-hour limit will be presented with several options: to listen on a personal computer, pay a nominal fee of $0.99 for the remainder of the month, or sign up for the ad-free subscription service. According to the company, fewer than 4% of its active listeners will feel the effect.

That's all well and good, but it's hard to not see this as the "tip of the iceberg." More importantly, it continues an issue beyond Pandora's control -- that is, it doesn't own the content that's at the center of its business. As such, it has to pay a license fee/royalty to use it. But here's the problem: These costs keep rising and eating into the company's bottom line. Recently, there have been myriad articles with writers taking up the fight with some righteous anger.

But is that really what Pandora needs? Let's stop pretending it's a situation where it's "Pandora (good guy) vs. (bad guy) record label." Who are we kidding? It's business. Pandora knew the nature of this industry when it decided to pursue its model, and investors knew the risks, which Pandora fully disclosed prior to its IPO. Content can't both be "king" and free. This is what such companies as Netflix , with its consistently rising content costs, fully understand.

Perception, reality, execution
Pandora's perceived dependency on content costs is one thing. Management, however, has a responsibility to sell the strength of its model and seek to continually evolve. Pandora has failed to do this. What it was in 2000 is what it is today. Conversely, Netflix has evolved from a strictly mail-order model to the most dominant streaming platform on the market today. But it wasn't easy. It had to make some tough decisions to help offset its leveraged balance sheet, for which it paid dearly in massive subscriber losses. Where was the outcry in support? But Netflix recovered.

Today, Netflix's strong domestic and international growth offsets fears of rising costs. It is viewed as an infrastructure under construction. Likewise, Sirius XM battled these same issues. In fact, Sirius had it much worse during a period when the entire economy was in the toilet. However, Sirius kept the fight going. And it ultimately benefited Pandora and other companies such as Spotify when Sirius received a favorable ruling against SoundExchange, the organization that collects royalty payments for musicians.

As Fool contributor Rick Munarrizrecently discussed, the ruling, which is very favorable to Sirius, only increases the royalty payments by 1% this year and by only half of a percent every year after until 2017. This makes it very cost friendly since Sirius passes these rates on to subscribers, which is the cable industry's model. And it's the only thing to keep the bottom line from bottoming out. The most successful companies know how to do this in the least intrusive manner. Besides, let's not act as if Pandora is some charity. It's in business to make money.

Facing the music
Unfortunately, if recent guidance is any indication, songs have been sad and things aren't looking so bright. After beating Wall Street earnings-per-share estimates by $0.04 in the third quarter, the company guided for a fourth-quarter loss of $0.09, while citing fiscal cliff concerns. On the news, the stock plummeted 20%. But was that the end of it? Granted, the possibility existed that advertisers were avoiding making long-terms commitments to Pandora while waiting for a resolution. But to go from a plus $0.04 EPS to a negative $0.09 is a pretty meaningful spread.

However, the cliff was averted, so where does Pandora stand now? The company's been mum on this issue. . And, based on the advertising guidance given by Google, companies are looking to spend more. So while I applaud Pandora for realizing that it can offset its costs by impacting fewer than 4% of the listenership, the move diminishes my confidence in an already shaky model. This is the reality. Pandora needs to face the music and gradually alter the ratio of ad-driven revenue to subscription, for sure, and this can't happen soon enough.

For years, Pandora has won millions of devotees among music fans but few supporters on Wall Street. The online jukebox has put up dramatic growth numbers in its listenership and seems to be redefining the way we consume music, a transformation that's only likely to grow. But high royalty rates and competition from all corners threatens to silence this upstart before it ever grabs the microphone. Can Pandora translate success with its listeners into a prosperous business model that will deliver for investors? Learn about the key opportunities and potential pitfalls facing the upstart radio streamer in The Motley Fool's new premium research report. Not only will you get the kind of insight normally found from high-priced Wall Street brokerages, but you'll also receive a year's worth of free updates. All you have to do is click here now to activate your subscription to this invaluable investor's resource.

The article I Love Pandora, but This Company's Singing the Blues originally appeared on Fool.com.

Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends and owns shares of 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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