Pandora Is A Fundamentally Flawed Stock

One of the difficulties of evaluating firms in the nascent stage of business growth is trying to figure out the role that share dilution will have on returns. That is one of the reasons why I have never covered Pandora as an investment. It is committed to having a debt-free balance sheet, and has also lost money every year it’s been publicly traded. That combination leads to heavy share dilution: Pandora had 163 million units in 2011, and now has 215 million pieces of ownership claims (i.e. shares of stock). If you’re a long-term shareholder of Pandora, the consequence of Pandora’s delayed onset of profitability is that each share of Pandora will perpetually earn 31.9% less than would be the case if Pandora had been profitable in 2011.

This fact isn’t a deal-breaker. If a company has the possibility of earning such lucrative future profits that the returns would be excellent even adjusting for the share dilution, you could be wise to purchase shares. But it is worth analyzing why a company with 200 million registered users like Pandora has not yet succeeded in finding moments of profitability.

The short answer: The ability to license music is expensive, and the gap between advertising income and music licensing costs is not great enough to cover the operational expenses of a business like Pandora.

It might help if I first mention the regulatory framework that covers music streaming. Music regulations are broken into two categories: interactive, and noninteractive. Interactive means that you have authority over the song you hear–think of programs like Spotify Premium and the closed-down Rdio and Grooveshark. These services are governed by general contract law, and receive no special federal intervention that automatically grants services like Spotify Premium the right to play popular music.

The public policy reason why the U.S. government gives artists the authority to decline to participate on an interactive service like Spotify Premium is because the ability to hand pick a song would deter a listener from becoming a customer that purchases the album or song individually. If Bruce Springsteen produces an album, he should have the right to prevent customers from listening to the top tracks anytime they please (and when people put it on Youtube, it is up to Columbia Records or a do-gooder to notify Youtube of the infringement so that it can be taken down).

If Spotify Premium wants to give its customers the right to hear Springsteen’s new River Outtakes Album, then they will have to negotiate for that right specifically with Columbia Records. Normally, record labels represent a consolidated portfolio of low and mid-tier stars, but the top artists in the world are able to secure opt-out clauses in their record that also give them some input. If you are a new star that just produced your first album through a record label, the record company will be able to sell your music to stream on Spotify Premium as part of a package with similar-grade assets without needing to acquire the consent of you the artist.

If you are a superstar like Bruce Springsteen, Taylor Swift, or Bono, then a firm like Spotify Premium will have to work out a deal with your record label and also secure your consent to the deal. The only major star that failed to secure this type of provision early in his career is Billy Joel (that I’m aware of).

The other type of streaming experience is noninteractive–music where you do not specifically get to choose the song that you will hear. In this scenario, the public policy logic from Congress is that the streaming service does not pose a direct threat to the artist’s ability to sell the record. Hearing Born to Run once per day at random on a digital streaming service is too attenuated to serve as a disincentive to buy the album outright, so Congress has chosen to give noninteractive streaming services the authority to play any Springsteen song even if the Boss himself doesn’t want it played.

Congress created a Copyright Royalty Board that determines the rate a streamer must pay to have access to all music released in the United States, and then the streaming firms must send payment to the SoundExchange that in turn compensates the artists/labels. The Copyright Royalty Board sets a consistent rate for every song regardless of artist’s popularity. Whether a noninteractive streamer played Bruce Springsteen or Uncle Joe’s Garage Band, it costs $0.0014 to play the song. As such, Uncle Joe considers the Copyright Royalty Board a friend because he collects more from noninteractive streamers than he would be able to negotiate on his own with an interactive streamer, and Bruce Springsteen would consider it a foe because he would receive higher payments through a privately negotiated exchange. Because of this incentive discrepancy, the label companies for popular artists act as watchdogs–eager to call foul anytime a noninteractive radio station violates statutory licensing terms.

Although you can select the type of music you listen to on Pandora, you can never specifically select the song. This is the critical distinction that permits Pandora to be classified as a noninteractive streamer. To get an idea of the Copyright Royalty Board’s regulations for remaining a noninteractive streamer, consider the following limitations facing Pandora and all other noninteractive streamers: Pandora can only play 2 songs in a row from the same album, play 4 songs from one artist in a four-hour period, and can never play three songs in a row from the same artist (there are also less business relevant restrictions such as the bar against encouraging listeners to record the song they are hearing). The point of these regulations is to make sure that listeners do not view services like Pandora as a fair substitute good for purchasing the album itself.

To complicate matters a bit more, Pandora had been exempt from these general Copyright Royalty Board for the past five years because of the Webcaster Settlement Act contained a Pureplay Agreement that permitted internet non-interactive streamers to only pay $0.0014 per song from 2011 through 2015 rather than the Copyright Royalty Board’s posted $0.0025 rate.

For 2016 through 2020, the rate for non-interactive subscription services will be $0.0022 and the rate for non-interactive non-subscription services will be $0.0017 per performance. In each year from 2017 through 2020, the rate will be adjusted accorded to the commercial price index. As such, Pandora is looking at a 21% increase in basic streaming costs (although the effective rate increase is only 15% when you include the 19% of Pandora users that are subscribers).

I mention all of this to give you an idea of how difficult it is for a company like Pandora to earn a strong profit over the full course of a business cycle for decades on end. It is not currently able to generate advertising and subscription income that can compensate for the cost of royalty payments as well as running the business, and it will have to deal with a 15% cost increase in 2016. When the inputs are this high, it’s hard to create shareholder wealth. This is something that I regard as a long-term fundamental flaw that should deter investment in Pandora.

When I study the long-term investments that work out well, there is often one common element: the ingredient or material costs are minimal. Coca-Cola only needs to purchase dirt-cheap water, sugar, flavoring, and aluminum. Wells Fargo only needs a customer to put in $1 in order to loan out $8 at a rate substantially higher than what depositors with a savings account can earn. Once Johnson & Johnson secured the patent for Tylenol, it only cost a little over $1 to create a bottle of pills. Pandora doesn’t have this advantage–it will be perpetually struggling to improve the spread between advertising income and royalty payments. The input costs of streaming music are just too high to create meaningful profits that can be extracted from the business. For that reason, I would eliminate the stock entirely from consideration as an investment.