Are You Ignoring This Company's Risks?

Are You Ignoring This Company's Risks?

Pandora hit a fresh all-time high on Thursday after the company announced new CEO Brian McAndrews. Now, with a market cap over $4.25 billion, and countless questions surrounding licensing, profits, and competition, investors might be have less optimistic days ahead.

What's so good about McAndrews?
Honestly, not much. McAndrews has essentially zero experience in the music industry. He's an advertising guy; he was the CEO at the digital marketing company aQuantive, which was bought by Microsoft for $6.3 billion in 2007.

Unfortunately, Microsoft has since written off most of that acquisition, leading some to suggest that McAndrews' aQuantive wasn't as effective as advertised. Either way, it's rather hard to find the connection between McAndrews and Pandora, and its near $400 million in added market capitalization since he was announced as CEO.

It appears as if investors are hoping that McAndrews will bring advertising growth, but what about all of the other issues that lie beneath the radar?

What about royalties?
Personally, it would have been nice for Pandora to hire someone with some level of experience in the music industry. Because right away McAndrews is going to have to battle the music industry on royalty rates that Pandora pays for each song .

Currently, Pandora pays a fraction of a penny (0.12 cent) per song played, equaling over $200 million last year to the music industry . Seeing as how Pandora continues to grow, and new competition has emerged, it appears as if the music industry has more leverage than ever before to battle Pandora for higher rates.

For a company that's already having a tough time in producing a profit, higher costs could be crippling.

What about profits?
Next, what about profits? During the company's last quarter revenue growth of 58% year-over-year was spectacular! However, a common trend is that spending outweighs revenue growth. In particular, sales/marketing costs were up 95% to $46 million.

In theory, a company is being efficient when revenue growth outshines both research and development and selling, general, and administrative costs year-over-year. For Pandora, this is simply not the case, and they have been unable to prove that profitability can be a part of their long-term future.

In comparison, Sirius XM , who is a major competitor, has operating margins of 26.6% over the last 12 months, compared to 23.7 % in 2012. While Pandora is growing faster, part of their problem is making inefficient investments.

Sirius XM has a return on equity of 13.23 %; Pandora's return on equity is negative 53.5%! While the company does have certain operational costs that can't be ignored, Pandora must be make better investment decisions if they are ever going to see profits like Sirius XM, or reward investors with Sirius-like gains.

What about the new guy?
Speaking of competition with Sirius XM, Pandora is also facing new competition from this little company called Apple . For Apple, iTunes Radio is another piece of iOS ecosystem. Even if Apple has great response to their $24.99 a year iTunes Match feature, and strong advertising revenue, it's hard to imagine a scenario where this one service is fundamentally impactful to a company that's earned nearly $170 billion in revenue over the last 12 months.

However, Apple's entrance into the Internet radio space could be devastating to Pandora, as they have never faced such competition. In particular, mobile revenue was Pandora's largest growth driver in its last quarter, producing $116 million, a 92% increase over the prior year . No doubt, much of that growth came from Apple products. Now, iPhone users may not all switch to iTunes Radio, but rest assure that most will at least try the new service.

As a result, Apple could be a Pandora killer, and it is really hard to fathom Pandora's momentum given the release of iTunes Radio just a week away. In a technology world where being new is also cool, iTunes Radio will be flashy, different, and is essentially what Pandora used to be.

Stay Away From Big Decisions
With all of the immediate threats that Pandora faces, I will be most impressed with McAndrews if he's able to keep calm under pressure, and not make any major decisions initially.

Sure, we can look at the 0.13 cents that Apple is paying to the music industry (plus ad share) and assume that Pandora should strike a quick deal to boost its current 0.12 cent payout by 0.01 to the music industry . We can also demand a major platform change from Pandora following iTunes Radio's launch in order to boost growth. However, what Pandora needs right now is the absence of a Netflix-like move.

For example, Pandora is valued much on perception, and the idea that it will continue to grow. As a result, investors have ignored much of their problems, much like Netflix in 2011 when it was priced at $300.

Back in February, Pandora implemented a 40 hour per month cap on free mobile listeners , and then removed that cap last month . For the new CEO, it's important that this fickleness does not take place.

Pandora is walking a thin line in potentially making a drastic change to increase profitability and maintain competitiveness against juggernauts like Apple, or making a change that spooks the market. Therefore, the possibility of such change becomes a risk, because if Apple is successful, Pandora might get desperate, which would show in their actions.

Final Thoughts
Overall, there seems to be too many risks right now. I'm not suggesting that Pandora is a bad company, or that it won't stand the test of time to become the next Sirius XM. However, after a 160% gain in 2013, no profitability, and a slew of challenges on the horizon, Pandora looks poised to see a 2011 Netflix-like fall. Now, whether or not it sees a recovery like Netflix is unknown. Regardless, it is a big gamble to be buying Pandora right now, with little upside and a great deal of risk.

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Brian Nichols owns shares of Apple. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple. 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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