As Pandora Reaches Saturation How Will It Spend The $379m Raised Last September?

Capital is no longer a limiting factor for the world’s most recognized music service

Having previously warned that growth was slowing, Pandora ‘quietly’ raised $379.1 million in an equity offering during September 2013.

Pandora has never made a profit, generates minimal positive cash flow from operational activities and inhabits a market that is fundamentally unprofitable. Considering this, we think the company was wise to take advantage of its gravity-defying stock price to strengthen its balance sheet.

The financing increased the company’s cash balance from $53.6 million (as of Jul 31 2013) to $442.4 million (as of 31 Oct 2013) – plenty to provide financial security for many years to come.

If we look at Pandora’s quarterly results from 1Q10 to 3Q13, we can clearly see that most of the major indicators are approaching saturation:

  • Active users (levelling off at around 70 million) 
  • Total listening hours (flat at around 4 billion per quarter) 
  • Avg. listening hours per active user (stuck at around 3.5 hours per week) 
  • Percentage of total listening time that is mobile (maxed out at around 80%)

Here are some charts that show what aspects of Pandora’s business are saturating:

Importantly, two key metrics have not so far shown any signs of saturation: quarterly revenue and average revenue per active user: both been steadily increasing since at least 1Q11: 

Pandora has managed to increase revenues mainly by serving more ads and also, to a somewhat lesser extent, by increasing the proportion of active users who choose to subscribe to the company’s ad-free premium subscription product, Pandora One, which costs $36 per year (see the red curve at the bottom of the following chart):

There will be a limit to how much the company can increase revenues by serving more ads: too many ads will damage the user experience, which will mean that users will listen for fewer hours, which will in turn mean less revenue.

Considering that the average revenue being generated per active user is just $0.85 per month (Q3FY14), or about $10.00 per year on an annualised basis, we would say that the company could definitely be doing a better job of monetising its active user base which numbered 70.9 million at the end of Q3FY14.

Pandora’s revenue problem cannot be solved simply by increasing listening hours (e.g. adding more users, persuading users to listen for longer) because this just means more royalty payments and higher streaming costs.

Most growing companies remain unprofitable because they are investing operating profits back into operations – in order to grow the business. This ‘invest to grow’ strategy is commonly seen in retail businesses and it can also be seen in the world’s largest online retailer, Amazon.

But with growth now slowing down Pandora cannot make the excuse that it is investing to grow the market: the company’s challenge is now to monetise its audience of circa 70 million active users.

The only way forward for the company will in our judgment be in finding a way to sell non-music products and services to its base of active users.

If Pandora was able to sell just $10 worth of non-music merchandise to the average active user per year, then this would increase annual revenues by about 100%. Although these revenues would not come for free, they would have a far higher gross margin than the revenues that are presently coming from the company’s core music service.

We are not suggesting that the company should compete with Amazon, but somewhere between Amazon’s online retail model (which now includes music services) and Pandora’s subscription music model there is likely to be a way for Pandora to effect a transition from red to black. With a cash balance of $442 million (Q3FY14), the company now has the resources to make such a transition, although time will tell whether Pandora’s new CEO realises that the future lies in online retail, not music.