How an Accounting Trick Turned Pandora From a Money-Loser Into a Cash Machine

Last Updated Sep 29, 2011 7:31 PM EDT

Pandora (P) got mostly good reviews for its Q2 2011 earnings because it beat analysts' estimates for revenue growth and because the company claimed it would be profitable if it were not for stock compensation costs for its executives. In fact, Pandora made a loss of $12.3 million on revenues of $67 million despite an influx of $52 million in cash.

These numbers seem nonsensical: How does a company that increases the cash in its checking account by $52 million still manage to "lose" money? The answer is that Pandora appears to have borrowed a page from Groupon's playbook: It is making money temporarily by delaying the royalty payments it must make to the record companies whose songs it plays. (It's also benefiting from a one-time sale of stock in its it IPO that netted the company $92 million.)

On paper, Pandora is heading toward bankruptcy. For every song it plays, it must make a royalty payment. As each new listener plays more songs, Pandora's costs mount up. Pandora's operating expenses are in a suicide pact with its revenues. Pandora is officially required by the SEC to warn investors that its business is "unsustainable" for this very reason (see page 37). Here's what that looks like in a chart:

Pandora's revenues and expenses suggest that if CEO Joe Kennedy simply exercised enough discipline over his operations -- by cutting a third of his marketing budget or half of his admin expenses -- he could swing the company to profitability.

The key: "accrued royalties"
But that's not the whole story. On the cashflow statement, Pandora appears to be taking advantage of what amounts to an accounting trick to generate cash. Pandora's operating activities generated $3.4 million in Q2, mostly because of $6.4 million in "accrued royalties." Pandora said that was:

... due to the timing of royalty payments and an increase in the number of listeners.
Translation: We didn't yet pay the royalties on the songs that our increasing number of listeners played on our service. $6.4 million is roughly 10 percent of Pandora's quarterly turnover. The company appears to be chancing its arm on this tactic in Q3 also: It ended Q2 with an "accrued royalties" liability of $24.5 million on its balance sheet, up from $18 million the year before -- money it owes but has not yet paid.

The whole system is enormously clever, and Kennedy should be congratulated for it: By combining the IPO money with cash generated temporarily from delayed royalty payments he has found a way to generate cash even though Pandora's business fundamentally loses money. The IPO cushion -- Pandora has $95 million on hand and total liabilities of only $60 million -- combined with the delayed royalties may take him through to 2015, when Pandora's royalty contract ends and the company must win lower fees in a renegotiation.

That, however, depends on Pandora continuing to grow revenues and listeners. Cash-generation schemes based on temporary delays in payments due only work as long as the new money coming in is greater than the old money owed.