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Wednesday, June 15, 2011

Pandora: An IPO Eclipsing Fiscal Gravity?

Pandora, an internet-based radio company oriented to music, sold its initial public offering at $16 per share late on June 14, 2011. The shares opened the next day at $20 and rose as high as $26, only to fall into the teens before market close. At $26, the company had a market value of $4.2 billion, more than the value of AOL at the time. Just two weeks earlier, Pandora’s management had been looking at the $7 to $9 range.  Despite offering only 9 percent of its shares to the public, the company raised twice as much money as it had expected.

Astonishingly, Pandora had not made a profit in its 11 year history. On June 15th  when the share price was over $20,  Pandora’s CEO, Joe Kennedy, refused to say whether the company would make a profit in the next five years. Instead, he pointed to the operating margin and cash flow, and to the business model, as reasons to invest long-term in the company. "Our focus has always been to build a great company. That’s our dream, that’s our passion, that’s our focus," he said, according to CNBC. It can be asked whether investors were engaging in irrational exuberance or on the rational expectation that it can take time for a company to begin showing profits.  

Analysis:

With all the attention typically paid to quarterly earnings, it is refreshing to hear a CEO stress the long-term nature of investing in his company. It would be nice if Pandora’s owners also had a passion in Pandora as a going concern pushing along the technological wave by providing music tailored to individual listeners’ tastes. Such long-term investment would bode well for corporate governance as owners take more of an interest in holding their management accountable through directors and stockholder referendums.

At the same time, Pandora’s reliance on advertising revenue even as an increasing proportion of use is on smart phones may suggest a flawed business model. For internet companies in general (as well as bloggers!), it is difficult to turn non-paying users into subscribers. At the time of its IPO, Pandora had 94 million registered users, most of which were non-paying customers. "The excitement for Pandora is driven by people's usage of the service and the enjoyment of the service," said Richard Greenfield, an analyst with BTIG Research. "But in order to justify a high valuation, they need to get far more advertising, and they need to get more people paying for the service." But this can be difficult in a marketplace where users can simply switch to a free service. While a nice set-up for us users, I’m not sure the business model is viable, given how much internet advertisers pay for clicks of their ads (which in turn is a reflection of users being able to ignore ads).

My understanding is that the phenomenon wherein a very high proportion of customers can use a product for free is pretty much limited to the internet. Tangentially, free wifi at coffee shops and even some restaurants (e.g., McDonalds) has given rise to customers “camping out” for hours to use the free service long after finishing their drink.  Incidentally, as I write this essay, I’m using Starbucks’ wifi long after my ice tea and slice of coffee cake. I’m watching the 100-minute full lunar eclipse live (just showed the video feed to the store’s manager and another customer—both of whom are amazed) as I contemplate Pandora’s business plan relative to fiscal gravity here on earth. It is just such amazement at the marvels of technology that a long-term investor in a company like Pandora can have while participating in the innovation; but lest we lose too much perspective, it is well to observe that a business model is trite, artificial and even profane next to the translucent liminality of the eclipsed rock otherwise known as our moon.

                             The Lunar Eclipse on June 15, 2011                                  The Huffington Post

If Pandora’s advertising revenue is not sufficient to pay for the rights to the music the station plays, then not being allowed by the market to charge most users can mean eventual financial ruin for the company, especially given the extent of the competition facing the company. According to msnbc.com, “Pandora is going up against traditional radio companies, satellite radio provider Sirius XM, music services such as Rhapsody, not to mention services from Apple, Google and Amazon that allow users to access music from anywhere.” The internet platform itself can mean not only relatively low advertising rates, but also low barriers to entry for future competitors.

According to The New York Times, Pandora had just 3 percent of the market at the time of the company’s IPO and had lost $92 million cumulatively since it began. In 2010, revenue of $137.8 million was more than double from the previous year, but the company’s 2010 loss was at $1.8 million. Most significally, the company had never earned a profit and yet investors were rushing to invest in the company’s IPO. "I think it's heavily overvalued," Anupam Palit, an analyst with GreenCrest Capital, said according to msnbc.com. "It's a great company but what we're seeing right now is incredible investor demand for Internet IPOs and a lot of dollars chasing very little supply." In rushing to invest, investors may have been ignoring a fundamentally flawed business model—in effect defying fiscal gravity.

An unsustainable imbalance between relying on on-line advertising revenue rather than subscribers and having to pay labels substantial fees for content mean that Pandora may never earn a profit. According to The New York Times, “the fees [Pandora] pays to record labels for songs remain its largest expense. The cost to acquire content more than doubled last year to $69.4 million. ‘As the volume of music we stream to listeners increases, our content acquisition expense will also increase, regardless of whether we are able to generate more revenue,’ the company warned.” According to The Wall Street Journal, “The company faces hefty payments to music labels and publishers, similar to traditional radio companies, and has yet to offset such expenses with advertising revenues and user fees.” It would seem that the labels and publishers were not making a sufficient allowance for the discounted nature of internet-advertising revenue relative to that of brick-and-mortar radio stations.

I would be remiss if this business analysis did not place Pandora in historical context. In the closing years of the twentieth century and during the first decade of the twenty-first century, managers of “dot.coms” grasped at how to monetize the internet wherein the norm was free content. That norm had such gravitas and the internet itself was so new that business practitioners had trouble simply grasping how to get a handle on the platform. Indeed, the internet itself was changing—prodded along by the likes of companies such as The New York Times that led the way to confining their internet-users to a subscription-basis. At the time, no one knew whether the momentum would shift to this basis across the internet; no one knew whether the free access to stuff on the internet would continue unabated or suffer a decline.

Theoretically, a movement toward “subscription-only” access could pass a threshold-point beyond which businesses (and bloggers) could discount the impact of alternative free venders and the monetization trend would be irreversible. The more traditional, more financially-solid business model could then be applied by internet companies. By the end of the first decade of the twenty-first century, internet-company managers could not even be sure that such a threshold would be crossed. At the same time, relying on advertising revenue seemed to be an insufficient basis for sustained profitability.
In other words, the uncertainty in the air at the time of Pandora’s IPO was not limited to the company. Fundamentally, the world was still grappling with how to make money using a completely new platform. It takes years for such novelty to be understood and thus ably used, even if in hindsight it seems simple. The human mind is indeed quite finite, particularly as it struggles to make sense of a new environment.

 Those people willing to invest in Pandora in its IPO on the ides of June 2011 were indeed taking a risk, and the CEO was correct to stress the long-term (which is the best perspective for stock-ownership anyway). Unless or until the monetization threshold point is hit on the internet as a whole, Pandora’s management (and investors) ought to have been taking seriously the possibility that the company’s business model was not in balance. Content should be in balance with ad revenue, and negotiating with labels and publishers ought to reflect such a balance as even the suppliers cannot earn money from defunct distributors such as Pandora. A viable business model is indeed possible for internet companies before the threshold point unless they face an overwhelming amount of free-content by competitors and ad revenue is miniscule (e.g., blogging). The question at the time of Pandora's IPO was whether the company would go down this route or be able to adjust its business model even without the internet itself reaching a monetization threshold-point. 

Click to add a question or comment on Pandora’s business model and IPO.

Sources:

Margo D. Beller, “Pandora Soars, Then Falls in Market Debut,” CNBC, June 15, 2011.

Pandora Shares Surge at Their Debut,” msnbc.com, June 15, 2011.

Lynn Cowan and Don Clark, “Pandora IPO Is High Note,” The Wall Street Journal, June 15, 2011.

Evelyn M. Rusli, “Pandora Prices Its I.P.O. at $16 a Share,” The New York Times, June 15, 2011.