Should you buy Pandora now?

The stock ran hot right out of the box but overheated and plunged, tempting many investors.

By Motley Fool Pick of the Day Jun 21, 2011 2:35PM

By Anders Bylund

 

Pandora Media (P) took the plunge and hit the public market. Now you, too, can own a piece of your favorite streaming music service. But Mr. Market has hated this stock so far -- if you were first in line to buy shares on Wednesday, you've lost 44% of your investment already.

 

Fellow Fool Rick Munarriz called it: Amid Pandora's scorching hot IPO, he told you to stay away from the launch. Though revenue is growing like gangbusters, costs are tagging along as well and the company hasn't figured out how to turn a profit. And the share offering price more than doubled from the initial plan as fellow online darling LinkedIn (LNKD) and others threw chum in the IPO waters. LinkedIn hasn't done much better, by the way. Just short of a month into its public life, the stock has taken a 25% haircut from where it opened on its first day.

 

I have publicly stated that I want to own Pandora shares, going so far as calling it a serious threat to Apple (AAPL) iTunes and Sirius XM Radio (SIRI). I still think that's true because Pandora out-Apples Apple itself in the user friendliness department, and that's worth a lot. But I'm not interested at any price, and the introduction prices looked too frothy even for me.

 

Where's the trigger?
So what's Pandora really worth? At what prices would I make good on my intention to buy in?

 

Well, like Netflix (NFLX) before it, Pandora is treading new ground in media-based business models. But Netflix has figured out how to turn its 23 million customers into profits and even stretching its income to cover the cost of buying more and better streaming-media licenses. This is a story I know well, a model that the market at-large is starting to appreciate, and it all just works.

 

By contrast, Pandora's prospectus is a bit ominous: "We offer our service to listeners at no cost and we generate revenue primarily from advertising. We also offer a subscription service to listeners." So advertising first and foremost, supplemented by premium subscription services. I'd be more comfortable the other way around, except Pandora would instantly lose millions of subscribers by imposing mandatory fees on everyone.

 

Of course, Google (GOOG) makes most of its billions in advertising, even monetizing media services like YouTube these days. So why not Pandora?

 

And that's a great question that I would like to see answered before buying in. You see, Pandora's a pretty light advertiser. The browser-based version sometimes goes hours between ad displays -- the company features less than one minute of advertising per streaming hour -- though I do see a new "buy" tab on each song nowadays that rips a page from Google's YouTube playbook by directing you to iTunes and the Amazon.com (AMZN) music store. On my Android phone, the ads are ubiquitous -- but it's almost always the same annoying LivingSocial spot obscuring the album art.

 

In short, Pandora needs a more varied set of advertisers and a better method for displaying the ads. What's going on right now just isn't working and probably annoys consumers more than it inspires them to click on the pretty picture of a frozen yogurt.

 

So I don't have a set price in mind but a corporate event: I'll take a serious look at Pandora shares when the company figures out the advertising game. Until then, this ticker belongs on my watchlist but not in my portfolio. Here's an idea: Why not partner up with online ad-space leader Google to manage the ad flow?

 

Everything you can do, I can do better
Oh, but Google is a wannabe competitor, right? I'm using the beta version of Google Music right now, and it's not a bad substitute for Pandora sometimes. The service gives me access to my own music library on the go without investing in multiple 32-gigabyte memory cards to store it all on. Google hosts my files and lets me listen anywhere. It's good if I know exactly what I want to hear and already purchased the media.

 

But then, Pandora is different. Like set-schedule radio services such as terrestrial radio or Sirius XM, Pandora stations often lead me to music I've never heard before. For example, I like Snow Patrol and spun up a Pandora station based on their haunting hit "Run." On my way to the grocery store, the station surprised me with an Armin Van Buuren trance mix of that song, and I hit "thumbs-up" because it was darn catchy. Now I'm a bigger fan of Van Buuren than of Snow Patrol, and went through a four-month spell of listening to nothing but progressive trance. And so we grow. None of that could have happened by using Google Music because I didn't own the trance mix of "Run."

 

For the record, the just-announced iCloud music service from Apple looks like the worst of both worlds. It's limited to the music you already own and will never lead you anywhere new, and it's reliant on iTunes versus the more open Web format seen in Amazon's and Google's offerings.

 

And Google does ad business with competitors all the time, so rivalry is no reason to stay away. Hey, Amazon's cloud services manage huge chunks of Netflix's online services. "Co-opetition" is the name of the game.

 

What do we do now?
Pandora is great, but its business model isn't. Don't invest a penny here until you can see and understand how the company plans to make money. The following model has been proposed many times and typically ends up in tears and disaster:

  1. Start an online service with millions and millions of members.
  2. ???
  3. Profit!

You need to know what the question marks in step 2 really mean. Right now, they don't mean much in Pandora's case. Just add the stock to your watchlist and walk away.

 

Fool contributor Anders Bylund owns shares of Google and Netflix, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Google and Apple. Motley Fool newsletter services have recommended buying shares of Netflix, Google, Amazon.com, and Apple. They have also recommended buying puts on Netflix and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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