Growing User Dissatisfaction Leads to Pandora Short Call

By: SumZero Staff | Published: September 24, 2012 | Be the First to Comment

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I am recommending a short position in Pandora. At the current valuation, by my estimates, the Company needs to grow its' audience by almost 300% and increase its' mobile pricing by 120% (desktop still grows at 25%). While it may be able to accomplish one or the other, I think it is unlikely that the Company is able to do both.

The short thesis focuses on three main tenets:

1) Competition will challenge Pandora's market leading position
- Pandora has been under a lot of competitive pressure over the past few months with the introduction of a number of different online radio services including Songza, Spotify, turntable.fm, iheartRadio etc.. Additionally, one of the most successful digital music franchises, Apple, is rumored to be launching a similar service;
- A study of Pandora done by Bridge Ratings shows that because of its' lack of library depth Pandora users grow dissatisfied the longer they listen to the service. The report states that 85% of Pandora users love the service after 6 months but that number drops to ~40% after 3 years;
- The numbers are starting to reflect both of these trends as quarter over quarter hour growth has trended to 17% to 14% to 7% over the past three quarters.

2) Pricing growth will be a challenge as they continue to focus more and more on the mobile space. It is likely that the majority of ad growth in the mobile space will be audio-only. The best comparable in the space is Cumulus radio. Currently in its' ad business, Cumulus earns about $0.01 of ads per listener hour. It is likely that Pandora's audio only customers will be experience a lot of sticker shock when they come through the door with pricing that is 3 - 4x as much as that

3) There is very little operating leverage in this business because of built-in cost increases related to cost per song increases. Under the current song acquisition contract, Pandora content costs per song is projected to grow at 8% every year through 2015. That means that a lot of the expected pricing increases will result in very little earnings growth (running to stay in place)

Valuation / Risks

- I think the Company is aggressively valued above $10 / $11 a share and should be worth closer to $5 based on slower audience growth and less pricing traction as they face competition and audio-only sticker shock
- You need to be careful how you trade this short as it is extremely volatile. Always have dry powder to add, and take gains when it is down big (the stock has routinely moved 20% over a couple days in the past 2 weeks.
- Sentiment and technicals are already really bad with the stock being 40% short and high borrow cost

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