Pandora’s Growth Is Costly

The popularity of Internet radio is surging, and according to Triton, Pandora (NYSE:P) owns a 70% share of the market. Therefore, if you're looking to invest in Internet radio, then Pandora is likely going to be your best bet. On the other hand, this is only from a relative standpoint since more established related investment options exist. Pandora is facing some challenging headwinds, and it has consistently failed to deliver in one key area.

Impressive, but not impressive enough
In the second quarter, Pandora's active users totaled 71.2 million compared to 65.6 million in the year-ago quarter. Revenue jumped to $157.4 million from $101.3 million. However, the faster Pandora grows, the more acquisition costs it must contend with. Due to this negative trend, costs and expenses increased to $165.0 million from $106.6 million.

The increased costs and expenses have led to consistent losses. Consider the last five quarters on a diluted earnings-per-share basis (losses in parentheses):

2Q 2012

3Q 2012

4Q 2012

1Q 2013

2Q 2013

Diluted EPS in $

(0.03)

0.01

(0.09)

(0.16)

(0.04)

Additionally, 82% of Pandora's total revenue comes from advertising. An interesting chain of events is at work here. The consumer is weak for various reasons including high gas prices, a 2% payroll tax increase, a slowly cooling housing market, and underemployment. If these trends continue and the average workers are unable to find higher-paying jobs, then advertisers will see less of a return from their ads.

Put simply, the advertising market is highly sensitive to consumer trends. For now, there is still optimism that our country can dig its way out of the current economic malaise, and the advertising market has held up. Part of this has to do with the high-end consumer, which has benefited from investments in both the stock and real estate markets. However, without wage growth and solid jobs, it will be difficult for this trend to sustain itself. That being the case, the excitement for Pandora could fade quickly at any time.

It's not all bad news. Pandora is growing at a rapid rate, and most investors are highly addicted to growth. Consider Pandora's top-line performance over the past year:

SIRI Revenue TTM data by YCharts

You might have noticed one of Pandora's top competitors, Sirius XM (SIRI) in that chart. As you can see, Sirius XM's top-line growth has slowed, but it's still growth, nonetheless. And there are several reasons that Sirius XM is likely to be a safer investment than Pandora at this point in time. One, Pandora is trading at a very lofty 93 times forward earnings, whereas Sirius XM is trading at "just" 32 times forward earnings. Two, Sirius XM has delivered profits on the bottom line over the past five quarters:

2Q 2012

3Q 2012

4Q 2012

1Q 2012

2Q 2013

Diluted EPS in $

$0.48

$0.01

$0.02

$0.02

$0.02

Sirius XM has 25 million subscribers (subscribers is a key word, as the company isn't heavily reliant on the advertising market), and it's found in approximately 50 million cars. That said, Pandora has also established a presence in the automobile market, developing relationships with 18 car manufactures and counting.

Three, Sirius XM is more fundamentally sound than Pandora. Prior to reading the table chart below, also pay attention to Cumulus Media (CMLS) , which represents an investment in commercial radio.

Forward P/E

Net Margin

ROE

Debt-to-Equity Ratio

Pandora

93

(9.26%)

(53.59%)

0.11

Sirius XM

32

13.34%

13.23%

1.00

Cumulus Media

13

(0.98%)

(16.30%)

7.93

In addition to Sirius XM offering better valuation than Pandora, it offers a positive net margin and ROE, meaning it turns revenue and investor dollars into profit. Pandora, on the other hand, does not.

The one bright spot for Pandora in regards to these key metrics is a debt-to-equity ratio well below the industry average of 1.40. It's not often that you find a growth company with consistent losses displaying quality debt management.

As far as Cumulus is concerned, it might offer the best valuation, but it's not impressive on a fundamental basis, it's debt-to-equity ratio of 7.93 is well above the industry average, and it's extremely sensitive to advertising market fluctuations.

The answer key
Pandora pretty much told its investors what to expect in its latest 10-Q:

"For the foreseeable future, we expect that there will be periods during which our ability to monetize listener hours will lag the growth of listener hours. As our business matures, we expect that the growth rate in our listener hours will decline relative to our increased ability to monetize listener hours. However, we expect to incur annual losses on a U.S. GAAP basis in the near term."

Therefore, don't expect profits to suddenly start rolling in. Also consider that Pandora is offering 14 million shares, which acts as the opposite of a stock buyback and will impact earnings in a negative manner.

The bottom line
If you like to roll the dice, then you might want to consider Pandora as a speculative play. But with the company consistently losing money, trading at 93 times forward earnings, and highly sensitive to advertising market conditions, Pandora is extremely high risk. Sirius XM is risky in itself considering its reliance on the auto industry, but it has established a more solid footing than Pandora and looks to be the best investment option in this group.

Looking for more analysis on growth stocks?
Tired of watching your stocks creep up year after year at a glacial pace? Motley Fool co-founder David Gardner, founder of the No. 1 growth stock newsletter in the world, has developed a unique strategy for uncovering truly wealth-changing stock picks. And he wants to share it, along with a few of his favorite growth stock superstars, WITH YOU! It's a special 100% FREE report called " 6 Picks for Ultimate Growth ." So stop settling for index-hugging gains... and click HERE for instant access to a whole new game plan of stock picks to help power your portfolio.