What is Pandora?
Pandora Internet Radio (also referred as Pandora Radio or simply Pandora) is an automated music recommendation service available in the United States, Australia and New Zealand. The service plays musical selections similar to song suggestions entered by a user. The user provides positive or negative feedback for songs chosen by the service, which are taken into account for future selections. While listening, users are offered the ability to buy the songs or albums at various online retailers.
Last Earnings Announcement
On December 4th, Pandora announced its earnings results and immediately plummeted to nearly a 20% loss. The popular media’s presentation of this event was of Pandora’s failure to maintain strong triple-digit growth, which raised questions of the company’s potential move into profitability in the coming year. The company’s lowered guidance became the story for the media, and was the focus of several investors as they pulled money out of the company.
However, Pandora also beat earnings estimates by 400%. With an ex-items EPS of $0.05, the company outperformed considerably on earnings. The company saw tremendous revenue growth, increasing share of mobile data usage and–most crucially–a 7% growth in total radio usage. In short, Pandora’s performance in terms of its core business model is fast growing, and there is little competition in the market.
Yet people sold.
We at Zolio like the Pandora story because it’s a clear case where we can see the dumb money and the smart money. And the dumb money and smart money aren’t always who you would think they are–after the earnings release, several professional investors were downgrading Pandora. It is difficult to believe, or even understand, how dumb money and smart money overlap. There is an assumption both in the professional investor world and amongst the public that the amateurs are the dumb money and the pros are, to borrow a book title, the guys with more money than God. The reality is that there is a huge overlap between who outperforms and who is an amateur investor. Things like misunderstanding Pandora are why this happens.
A Closer Look at Pandora
So let’s look more closely at Pandora to understand who is the dumb money and who is the smart money.
First, there are the fundamentals. Pandora announced that its mobile advertising revenue grew by 112% year over year, while internet radio has become 7% of total radio consumption in the U.S. Additionally, Pandora has hired a huge sales force nationwide in several markets to sell ad space to local advertisers. Plus, Pandora announced it is working hard to integrate itself on several software platforms that will make it easier to buy ads on Pandora. All of this is tremendously positive.
What are the negatives, then? Well, Pandora lowered its guidance and said its revenue would be between $72 million and $75 million. Investors had expected revenue of about $87 million. Why the differential? Pandora’s management said that the upcoming fiscal cliff as a real danger to the company’s revenue. This was then discussed heavily on the firm’s earnings call.
One of the biggest challenges is the shift from desktop to mobile. Mobile advertising comes at a steep discount to desktop advertising, and since Pandora is listened to heavily on mobile phones, this means that Pandora is getting less and less money from clients for its ads. This is a real challenge for Pandora–how can it keep its exponential growth if the product it sells is getting discounted in the market?
It’s not our job to answer that question here–but it is the job of every investor (regardless if professional or amateur) to figure this out. It’s also the investor’s job to identify the right questions to ask. In our opinion, those investors in the room at the earnings call failed to do that. Instead of asking about Pandora’s changing revenue mix–which was not broken down in as much detail as investors would like–they instead followed along in discussions of the fiscal cliff and its impact on advertising.
The Age-Old Song and Dance
Outsiders might perceive investors and corporate management as being on the same team. They’re not. It is a complex symbiotic relationship that constantly requires renegotiation and compromise. One could argue that all business relationships in a capitalist economy work this way.
Think about it this way: if you have a mortgage, how do you feel about your bank? Few people say they love their banks, but the fact is that people could not buy the homes they have if it weren’t for banks fronting a large portion of the money–and taking on a large part of the risk–needed for you to buy that house in the first place. While you don’t like your mortgage payments, or the interest you will lose forever on those payments, you also need the bank for you to live there in the first place.
The relationship between common stock holders and a company’s management is very similar. Management needs to issue common stock to get the cash it needs to make a rapid expansion (this is especially true for new, small-cap companies like Pandora). Stockholders need the company to keep expanding for it to make its returns. Both have the same goal in sight: exponential expansion. Just like you and your bank have the same goal of you paying off your mortgage at the end of the term. But both do not have the same short-term goals in sight. This is why some banks charge a prepayment penalty to people who pay off their mortgages early, and why management will often try to steer Wall Street away from higher expectations.
This is why we think Pandora has set expectations so low. They will over perform next quarter. Plus their new CFO, who is yet unproven, will be able to demonstrate competence that will pay off in long-term trust from investors in the long run. The lowered guidance, then, demonstrates a level of savvy and long-term thinking from Pandora that, frankly, Facebook (FB) failed to show when it first went public.
Our Own Takeaways
Listening to the Earnings Release call with Pandora highlighted for us three things:
1. Pandora is struggling with the transition from desktop to mobile.
2. Pandora is very well managed by a team of smart, competent people.
3. Smart money will see through Pandora’s obfuscation.
And this, in Zolio’s opinion, is what separates the dumb money from the smart money. The dumb money scans the headline as it moves along the ticker and responds. The smart money listens to the full earnings call, researches the company, the investors, the industry, and makes a move accordingly. Those three points aren’t the only ones to take away from that earnings call, but they are definitely three points that should be integrated into any investment model before buying into Pandora.