There seems to be no middle ground in the world of digital media for investors. It is either a black hole that money disappears into never to be seen again or a cash cow.
One of the biggest black holes in digital entertainment these days is Pandora Media (NYSE P). Pandora has managed to attract around 79.4 million active listeners by giving music away for free. The problem is that Pandora has to pay for the music it gives away for free.
Why Pandora Does Not Make Money
Currently, the service has to pay around 14.5¢ for every 100 streams of a song. That does not sound like much until you start crunching the numbers. Basically, Pandora has to pay $1.45 for every 1,000 streams of a song, $14.50 for every 10,000 streams of a song, $145 for every 100,000 streams of a song, $1,450 for every one million streams of a song, and $14,500 for every 10 million streams of a song.
This can quickly add up, especially for big-time stars like Beyoncé. For Beyoncé, Pandora is a great deal; she gets her songs distributed to 79.4 million potential customers, and Pandora has to pay her for the privilege. Pandora has essentially turned the whole concept of advertising on its head.
Instead of having a producer paid to advertise a product, the advertiser has to pay the creator. Now, to make matters worse, the rate Pandora will pay is about to go up starting next year.
Starting in 2016 Pandora will have to pay around 17¢ per 100 streams of a song, according to a ruling from the U.S. Copyright Royalty Board, the agency that sets the rates. This was something of a “victory” for Pandora because the music industry was asking for 25¢ to 29¢ in royalties, CNN reported.
Copyright Ruling Will Not Help Pandora Make Money
It is hard to see how this will help Pandora, which is not making money under the current regime.
Pandora reported a negative net income or loss of -$137.97 million on September 30, 2015. That loss was $93.17 million more than in September 2014, when Pandora reported a loss of -$44.38 million. Pandora’s losses grew by nearly $100 million in one year under the current music royalty prices, and those prices are about to increase.
Not surprisingly, the Board’s ruling led to unrealistic optimism among Pandora’s boosters. Its share price when from $12.45 on December 14 to $14.77 on December 18, 2015—a day after the board’s decision.
One fact is clear here: The Pandora boosters were not taking a look at the streaming service’s financial numbers. In September Pandora reported a free cash flow of just $2.492 million, a profit margin of 27.58%, and $54 million in cash from operations. It also reported having $364 million in the bank.
The numbers show us that Pandora cannot make money with its present business model at a time when some of its basic costs are about to go up. Those rates will be high in the U.S. and higher in Australia, where it will pay 20¢ per hundred songs, according to The Age.
Under the new rates, Pandora will pay $1.70 per 1,000 streams, $170 per 100,000 streams, and $1,700 per one million streams in the United States. Pandora will have to either dip into its cash reserves or borrow money to cover those added costs, eating up what little free cash flow it has. That means Pandora’s debt to equity rate of -24.8% is sure to grow.
Pandora’s Flawed Business Model or Why Sirius Makes Money and Pandora Does Not
The real cause of Pandora’s problems is its deeply flawed business model. Pandora has no real float, unlike another digital media service, Sirius XM Holdings (NASDAQ: SIRI).
Sirius, which charges a subscription for its products, reported a net income of $518.21 million in September 2015, an increase of $102.89 million over September 2014, when it reported a net income of $415.32 million. Sirius is making more money because it charges monthly subscription rates of between $4.00 and $15.99, depending on the service.
Since Sirius had 28.96 million subscribers in third quarter 2015, according to Statista, that adds up to a lot of float. That float has also been increasing. Sirius had 26.7 million subscribers in third quarter 2014 and 24.4 million subscribers in third quarter 2013.
The increase in subscribers paid off in other ways. Sirius reported a TTM revenue of $4.465 billion on September 30, 2015, more than four times Pandora’s revenue of $1.096 billion. That revenue has been increasing slowly but steadily; Sirius reported a TTM revenue of $4.09 billion in September 2014 and $3.691 billion in September 2013.
Pandora’s revenue has actually been growing, but as we saw above, it has not translated into revenue growth. Pandora reported a TTM revenue of $822.18 million in September in 2014 and $605.27 million in September 2013. Pandora seems to be caught in a classic online business trap; it loses money as its revenues grow.
Sirius XM is actually a very healthy company judging by its financial numbers. It reported a profit margin of 14.24%, a free cash flow of $158.9 million, $1.266 billion in cash from operations, and $152.54 million in cash and short-term investments on September 30.
Sirius is making money, which validates the subscriber-based business model for digital entertainment. Pandora does not, which shows that giving entertainment away for free is a bad business model, especially at a time when consumers are becoming less tolerant of advertising.
Sirius also offers a highly diversified supply of entertainment. It gives its subscribers sports, comedy, talk and news in addition to music. Its offerings include some exclusive content, such as Howard Stern. The New York Times reported that Howard just signed a new $80 million deal to stay on Sirius for another five years. That sounds like money well spent.
Pandora Has No Future
The sorry truth is that Pandora’s business model is just so flawed that it is hard to see how it will survive. My prediction is that sooner or later Pandora will collapse into the death spiral and either disappear or end up as part of a large entertainment conglomerate.
The only hope Pandora has to survive is to become so popular as to force the music industry to cut its costs. Since that does not seem very realistic, Pandora has no future.
If you want to buy a digital entertainment stock, buy Sirius XM. It is cheap, it has a bright future, and it makes money. Sirius was trading at $4.00 a share on December 18, 2015, yet it offered investors a 66.79% return on equity. The story of Pandora and Sirius proves that subscriptions and the float that they generate are the future of digital media.