Are Investors Losing Patience With Pandora?

Critics are circling Internet radio company Pandora after shares fell as much as 14.5 percent and closed down 10.3 percent Friday following the company's second-quarter earnings release. Shares were down over 2 percent in Monday afternoon trading.

Revenue and user growth can lead analysts, investors and onlookers to overlook a lack of profitability. Top-line performance was strong. Driven by mobile advertising, Pandora revenue grew 38 percent to a record $218.9 million in the second quarter.

But there were some red flags. Analysts had expected a higher number for revenue per thousand hours, or RPM, explains Barron's. CRT Capital Group analyst Neil Doshi told Bloomberg that mobile ad revenue was below expectations.

Pandora Beats Revenue Expectations, But Falls Short of Profit

Another problem was the drop in listeners. The number of unique monthly users dropped to 76.4 million in June, from 77 million in May, one of the few declines of the last few years. Pandora CEO Brian McAndrews attributed the dip to the "seasonally slower summer period."

Active listeners may have dropped since May, but they've grown 7.5 percent since last year. McAndrews also noted a 20 percent year-over-year increase in listener hours per active user -- probably helped by listener caps in effect a year earlier -- and the increase in share of U.S. radio listening to 8.9 percent from 7 percent a year earlier.

Longtime Pandora critic Rich Greenfield, an analyst at BTIG, told Bloomberg that usage is "stagnating" because of increased competition. "That's going to scare the market for what's supposed to be a rapid growth Internet company."

Some concern was also shown for RPM. Mobile advertising RPM grew to $36 from $32.56 a year earlier but still lagged far behind desktop RPM of $62.43. Mobile monetization is critical for Pandora. Mobile listening accounted for 83 percent of Pandora's total listener hours.

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Analysts had mixed but not particularly negative reactions. According to Benziga, Canaccord, CRT Capital and FBR all left their price targets unchanged, while JP Morgan raised its price target to $42 from $41. Cowan dropped its price target to $38 from $41 and said it expected user growth and RPM to improve in the second half of the year.

Pandora reminds some of Amazon. Both companies are growing through reinvestment (Amazon is getting some heat for the strategy too.) When disrupting an existing market and fighting for market share, a well-capitalized Internet company may choose growth later -- and a more stable future -- over profits now.

"The reason that revenue growth doesn't translate into direct EPS upside is we plan to aggressively reinvest the dollars as we make them, and that doesn't change," Pandora CFO Mike Herring tells Billboard, adding that reinvestment will focus on sales and engineering.

Pandora has spent heavily on building a local sales staff that currently has 109 sales people in 37 markets to target local radio budgets. It's worth the effort. Local advertising commands higher prices, and Pandora believes two-thirds of radio advertising is local. Herring says local advertising currently represents 20 percent of Pandora dollars received from radio budgets. He believes it will someday be 50 percent.

But unlike Amazon, Pandora can't drive growth by introducing new product categories. Pandora is a radio company that sells advertising. Aside from improving RPMs and slowly growing monthly active listeners, its best growth opportunity is international expansion. Although McAndrews had nothing concrete to announce, he did say Pandora wants to expand internationally and eventually "reach billions of people around the world."

Of course, an expansion into a new market would require the same business cycle that already has some investors and analysts worried: launch the service, acquire listeners, create partnerships, build an advertising staff, monetize traffic and, someday, turn a profit. It will require investors to have patience. As Amazon has shown us, patience can wear thin even for the best Internet companies.