Business Matters: Three Things to Watch for in Pandora's Q2 Earnings Report
Business Matters: Three Things to Watch for in Pandora's Q2 Earnings Report

One reason for the wide swings in Pandora's stock price is due to wide differences in enthusiasm about the company. Investors with the greatest belief in the company purchased at $24 per share. Others waited until the price dropped below the $16 offering price and bought as low as $12.16. Even those who bought Monday at $16.50 are showing a great deal of belief in the company by valuing it at over $2.6 billion.

But maybe Pandora's stock swings really reflect investor ignorance of the digital music space - the Internet radio space, more specifically. After all, absolutely nothing about the company's financial situation or the fundamentals behind its value has changed in the last week.

It's not hard to find examples of poor understanding of the digital music marketplace. A Monday morning post at investing site Seeking Alpha titled " Spotify Launch Should Be Music to Pandora's Ears" is Exhibit A. Here's an excerpt:

"While the launch of yet another Internet radio service may mean more competition for the likes of Pandora (NYSE:P), it should actually be looked at as a gift-wrapped opportunity for the Internet radio leader. The reason is that Spotify will come in at a price point of $10 per month. Having another major player with a higher price point gives Pandora the ultimate in flexibility."

It's true that Spotify's expected price of $10 a month is higher than the $3.99 per month Pandora charges for ad-free listening. But Spotify and Pandora are actually dissimilar in a number of important ways. He continues:

"Yes, Spotify will take some ears away from Pandora, Sirius XM (SIRI), and even terrestrial radio, but in the beginning the numbers will not be very material. The beauty here is that if Spotify, which carries name recognition, starts to see success in the U.S. at $10 per month, it will help to validate the Internet Radio model. This is good news for investors in Pandora."

It's hard enough to lump all forms of radio into the same bucket without adding Spotify, too. But the main fact here is that Spotify is a completely different type of service than Pandora. It's positioned differently in the marketplace. And its price will probably have little bearing on how consumers view Pandora's price (especially since Pandora gets about 85% of its revenue from advertising and just 15% from premium users).

Needless to say, investors will have a more difficult time understanding Pandora's business model and market strategy if the financial press can't get it right. The Wall Street Journal got it wrong in an otherwise good article last week. In explaining Pandora's challenge to match increases in listener hours with an increase in advertising, the Journal also lumped Pandora and Spotify into the same category:

"As it competes for revenue, Pandora must battle traditional radio companies with strong sales forces and better local advertiser relationships. Yet boosting ads risks alienating users, whose choice of Internet radio options will only increase. European rival Spotify has signed deals with three of the big four music labels in preparation for a U.S. launch."

For investors to properly value Pandora, they need to understand the competitive landscape in which it operates and appreciate the differences between types of digital music services. If mainstream digital music consumers have proven anything in the last 10 years, it's that they will flock to free services and shy away from paid services. Pandora's free-with-advertising model allows it to attract mainstream listeners and take listening hours away from other types of radio. Any service like Spotify that charges $10 for on-demand listening is in a different ballpark altogether.