Unpacking Pandora's "Risk Factors"

Categories: Tech
Every time a company offers stock to the public, it must submit an S-1 form to the Securities and Exchange Commission. It must provide a prospectus that includes financial information as well as the risks potential investors would face in buying shares. Because lawyers and accountants, as opposed to marketing people, are in charge of producing the form, the S-1 represents a rare instance of a company being honest. In the case of companies like Pandora Media, it also represents an opportunity for hilarity.
The "Risk Factors" section of Pandora's S-1 amounts to a statement by the company warning: "What, are you crazy? Don't buy this stock, you fool!"
That warning doesn't really pertain to IPO investors. When the Oakland-based online -music firm goes public Wednesday morning, lots of people will make money -- including, of course, current investors -- but also those who buy in and ride the bubble for a while.

But anyone who thinks Pandora might be a solid long-term play should really take the company's own warnings to heart. That's because Pandora, as it exists, is made to lose money. Because of the ridiculously high royalties it must pay to the music labels and the ridiculously low ad rates it is able to charge, Pandora actually loses money every time someone listens to a song.

Growth for the company means growth of losses. Unless it somehow manages to get the labels to renegotiate the royalties in 2015, when the current agreements expire (a highly unlikely scenario), or manages to charge much higher ad rates (also unlikely), or figures out some entirely new way to make money, it will never earn a profit.
Let's take a look at some of the risk factors in Pandora's S-1:
"Our relatively new, evolving, and unproven business model."
Well, "relatively" is a relative word. Pandora has been around since 2000. It has never earned a profit.
"Our ability to retain our current listenership, build our listener base, and increase listener hours." This is a risk, but maybe not for the reason you think. It's a risk if listenership grows, not if it doesn't grow. There is little risk of Pandora losing listeners or even, at least in the short term, of its growth slowing. Listeners are flocking to the service -- which really is very good. There are now about 90 million accounts. The problem, of course, is that each new listener means more losses.
"Our ability to effectively monetize listener hours, particularly with respect to listener hours on mobile devices." Again, the trend here sounds good, but actually is very bad. Apple says Pandora's app is the second-most popular ever on the iOS platform. Mobile is where most of Pandora's growth now comes from. The problem is that mobile ads generate even less money than Web ads do. So Pandora's losses are even greater.
"Our operation under an evolving music industry licensing structure that may change or cease to exist, which in turn may result in a significant increase in our operating expenses." If the licensing structure ceases to exist, so does Pandora. The company that is asking public investors to finance it is warning that its very existence is at the mercy of the music labels. You can argue that labels are clueless when it comes to online distribution, and that they don't seem to have a coherent strategy, and that if they allowed services like Pandora to thrive, they might sell a lot more music. And you would be right.

But relying on the music labels to behave rationally is not a good basis on which to run a public company.

Dan Mitchell has done work for nearly every media organization in the world. That's an exaggeration, but he has written for Fortune, The New York Times, Slate, Wired, National Public Radio, The Chicago Tribune, and many others.

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