Is a high cost structure making Pandora investors short the stock?



Additional challenges

With shorts piling on, the stock plummeting well below the IPO price, and signs of rising competitive threats, it appeared there was little to get excited about for investing in Pandora. The launch of competitors Spotify, Songza, and IHeartRadio, as well as the looming entrance of Apple’s iRadio, highlighted to investors the lack of a meaningful barrier to entry that would enable Pandora to defend its user base. But also, bearish investors began to view Pandora’s cost structure as potentially unsustainable. Pandora is a member of the Global X Social Media Index ETF (SOCL), which seeks to provide exposure to an index of social media stocks.


Content costs

Additional difficulties facing Pandora centered around the company’s cost structure. In particular, high royalty fees to music producers questioned whether the company would ever be able to break a profit.

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In 2009, Pandora reached a settlement with music industry representatives that would govern the fees the company pays in order to broadcast songs. These royalty fees, which are fixed at $0.0012 per track for ad-supported streaming and $0.0023 for subscription-based streaming, are directed to musicians and producers to compensate them for their copyrights.

The chart above shows the challenge facing Pandora, as it depicts royalty costs as a percent of revenue. Through the end of the company’s 2013 fiscal year, royalty costs have averaged 56% of revenues. As a result, Pandora has been unable to produce positive earnings per share since its IPO. In other words, in order to generate profitability, Pandora would need to either increase the revenue per song played by inserting more ads or reduce the per-song royalty fees, which are fixed until 2015 as a result of the settlement. While management has a long-term target for content costs at 40% of sales, these obstacles still provide Pandora bears with additional credibility to support their case. However, with Pandora stock up near new highs, it appears the short thesis has fallen, well, short.

We’ll look at what bears have been missing in the next part of this series.


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