Pandora’s Shell Game with Royalty and Revenue

thimblerig definition

Remember when Pandora used to complain about how royalty costs were over half their revenue?  Let’s take a look at their income statement for the last 12 months (“trailing twelve months” or “ttm”) from Yahoo! Finance:

Pandora Income Statement

“Total Revenue” of $1,100,000,000.  Because as Sean Parker will tell you, you know what’s really cool?  A billion dollars.

“Total Cash” of $363,600,000.

And at least at the moment, zero debt.

So stop right there–what do you think the response would be if you walked into any business school in the world (and not just the good ones) and asked the first MBA you met this question: How would you like a case study of a public company that has a $2.69 billion market cap, and that has government mandated vendors (that’s the artists and songwriters) whose selling price (aka royalties) is set below market by the government, and that has a billion dollars in top line revenue, and has $360 million in cash, and has no debt (so far)–but can’t seem to make a profit?  Think you might get a few ideas from the MBA set?

Let’s add an additional fact–out of control overhead.  Consider Pandora’s year-over-year income statement for the last three years:

Pandora YOY Income Statement

Pandora’s top line revenue is essentially doubling every year.  Great right?  I couldn’t be happier for them.  Gross profit (revenue minus all costs directly related to sales, like royalties) is really going gangbusters.  Nothing but cash, right?  And a very respectable growth rate.

But what else is growing at a phenomenal rate?  Something called SG&A for “Selling” (which includes some overhead costs that typically would grow with expansion), and “General & Administrative”–also known as executive compensation, legal fees and a few other things.  The SG&A line and various ratios of SG&A are often used as a measurement of how well a company is managed.

So notice–while income grew 215% from 2013 to 2014, and gross profit grew 300% over the same period, what happened to SG&A?

It also grew 252% year over year (faster growth rate than revenue) and is on track to be approximately $525,000,000, a 35% increase year over year.  On a trailing twelve months basis, SG&A will be approximately $504,752,000.

Pandora Media Income Statement, Trailing Twelve Months 2015

Pandora 2015 YOY
Pandora Trailing 12 Months 12/15

So SG&A is running at approximately 50% of total revenue in 2015 and has been increasing at a rate that exceeds revenue for the last three years.  If your band made gross profit of $X, how would you pay yourselves 180% of X?  In your case, that would probably be debt.  In Pandora’s case, it’s easy–they raised a bunch of money from selling stock, so they just move that money out of cash and into executive compensation, among other things.

Pretty sweet deal, right?  But now they are coming to you and asking you to take a lower royalty with no discussion of how far out of control their SG&A ratio is.  There’s two ways to make that operating loss number go positive–reduce the cost of revenue (that is, your royalties) or make the SG&A go down (their salaries).

The difference between the two aside from whose ox is gored is that Pandora employees get stock in addition to their salaries.  We don’t.

We are being asked to give Pandora a discount–also known as an investment in Pandora–but we get no stock.  Don’t you usually get stock when you make an investment?

If you ask those MBAs, I would be willing to bet today that any MBA would choke on the size of Pandora’s SG&A.  If you take a ratio of 2014 SG&A/2014 Revenue, that ratio is 42%.  That number is out of this world–it’s typically in the 10% to 25% range.

There may well be explanations for why it costs so much money to run Pandora, I just haven’t heard any. Remember–Steve Jobs took $1 a year in salary:

From 1997 until his death, Steve Jobs took home just $1 a year in salary, and most years he collected no bonus. Just $1.

Steve cut a tough deal with iTunes, but he never asked us to take a haircut because he wasn’t making enough money from Apple.

So before we take another haircut on royalties for Pandora’s benefit like we did the last time around, I for one would appreciate at least an explanation of why their SG&A is out of control instead of the usual meme of “royalties are too damn high.”