Pandora's Terrible Business Model

Loving the Product, Auditing the Business

This analysis dates from 2016, which shows, because the listening long ago moved to Spotify. Capitalism is real and competition is real, and that ending is foreshadowed by everything below. At the time, Pandora played every day, on the computer, the streaming box, the smart speaker and in the car, and stations doubled as a fun shorthand for asking people what they listen to.1 The advertisements were annoying, though not 55-dollars-a-year annoying, and that thought triggered the professional reflex: how much money does this company actually make?

The Income Statement Says No

Cutting to the chase, Pandora lost money. Free financial data sources make the check easy, with clean interfaces and the crucial toggle between quarterly and annual figures.2 The income statement told a three-line story. Revenue rose considerably, from 427 million dollars in 2012 to 1.1 billion, which looks great in isolation. Expenses rose just as fast and exceeded revenue every single year, which is bad news. The result was a net loss every year, which is completely unsustainable. Growth without margin is a treadmill, and the treadmill was speeding up.

The Cash Flow Says How

A company losing money every year still needs cash to survive, and the cash flow statement revealed the sources, none of them comforting. In 2013 Pandora raised 377 million dollars by issuing more stock. In 2015 it issued 301 million dollars in debt. Both moves punish someone: dilution hurts existing equity holders, and debt layers fixed obligations onto a business with no profits to service them. When operations do not fund a company, the funding comes from investors' hope, and hope is a depleting resource. The stock chart confirmed the depletion. Financial and stock performance can diverge in the short run, so perhaps the market shrugged at the losses? No. From the initial public offering in June 2011, the stock fell 19 percent while the broader market rose 57 percent. Ouch, on both an absolute and relative basis.

Reading Management's Story

With the x-ray complete, the investor relations materials show what leadership tells its owners, and the argument ran nine steps. Lots of people listen to radio, with 91 percent of Americans tuning in 18 hours weekly, mostly terrestrial, leaving room for internet radio to take share. Pandora held 58 percent of internet radio, more than double its closest competitor, Spotify.3 Usage kept growing, more people listening more often. The car represented the next frontier, though this argument creaks on inspection, since most cars already stream from phones and much drive-time listening is talk and sports rather than music. Advertising supplied over 80 percent of revenue, with Pandora ranking among the biggest mobile advertising players behind the social and search giants, serving a respectable customer list. Management promised rising revenue per thousand impressions (RPM), the standard measure of advertising yield. The deck closed with the classic concept page of strategic drivers, the mix of new products and new distribution that consultants recognize as aspiration arranged in boxes.

Where the Economics Actually Broke

The structural diagnosis deserves its own paragraph, because the losses were not mysterious. Music streaming carries a brutal cost line: royalty payments scale with listening, so every additional hour of the beloved product dragged content costs up nearly in lockstep with revenue. Advertising-funded models need either pricing power over advertisers or cost lines that flatten with scale, and this business had neither, while the subscription tier priced at 55 dollars annually converted too few listeners to change the mix. Competitors with deeper catalogs, global footprints and device ecosystems could cross-subsidize their music economics indefinitely. A company whose costs are variable, whose prices are capped by free alternatives and whose rivals treat the category as a loss leader is playing a game where operational excellence delays the ending without changing it.

The Verdict

The conclusion wrote itself. Pandora enjoyed a huge first-mover advantage and did not do much with it. The service operated in only four countries while Apple and Spotify outmaneuvered it globally, and the company stayed afloat largely through paid-in capital and fresh debt. By the time it began shopping itself to buyers, the stock had fallen 60 percent and the market capitalization sat near 2.5 billion dollars, which was still not cheap relative to the economics. The postscript completes the case: Pandora eventually sold for 3.5 billion dollars, a reminder that strategic acquirers sometimes pay for an audience that public markets have stopped funding.

Questions the Case Should Prompt

The audit method invites a short interrogation of any growth-stage company you encounter. Does gross margin improve with scale, or do costs track revenue upward permanently? What fraction of users pay, and what would move the fraction? How long can current cash burn continue at existing balances, and what must be issued to whom when it runs out? Is the moat an audience, a technology or merely a head start that better-funded rivals can erase? And does management's investor narrative address the loss-making mechanics, or does it change the subject to market size and engagement? Companies with good answers deserve patience through losses. Companies without them deserve the skepticism this one earned.

The Reusable Lesson

The method outlives the company. First, separate affection from economics, because loving a product daily says nothing about whether its business works. Second, run the sequence: income statement for the what, cash flow for the how, stock performance for the market's verdict and investor materials for management's story, read skeptically. Third, watch for the signature of trouble, revenue growth celebrated while expenses grow faster and financing activities quietly fund operations. Any professional can run this audit in an evening with free tools, and every professional should, especially on the businesses they admire most.

• 1Pandora
• 2Google Finance
• 3Spotify