Pandora Poised to Make a Profit ... If It Cuts the Music It Offers

Pandora released a new set of financial statements that suggest it may be about to achieve a miracle: Make a profit from an online content business that is free to users because it relies on advertising. But that profit may have to come at the price of the very thing its users most love about it -- the seemingly endless number of songs it offers.

Anyone trying to make a go of it in digital media ought to pay close attention. As this column has noted ad nauseam, ad-based digital media content models tend to have one thing in common: They don't work. Unless your business also has a subscription side, there doesn't appear to be enough ad demand to cover costs at all but a few mega-sites such as Huffington Post (AOL).

Here are Pandora's latest numbers, including its fiscal year through January 2011 (click to enlarge):

It almost -- but not quite -- made a profit in FY 2011. The loss came despite soaring ad revenue because of two things: "Content acquisition" (the expense of buying licenses to the music it plays) and marketing (the cost of attracting enough listeners to extract the revenue it gets from advertisers who want those ears).

I plotted Pandora's costs vs. its revenues in this chart, to see which of the trend lines appeared to be winning:

As you can see, the revenue line does seem to be rising faster than the total costs line. (The "marketing" and "content" lines form part of "total costs.") This bodes well. But when you dig into the percentage increases for the individual line items, danger lurks: Pandora's total dollar revenues may be moving faster than its total dollar costs now, but those percentage increases are declining.

Meanwhile, the reverse is happening on its costs: Their percentage increases are increasing. In sum, while Pandora's revenue is currently on course to outpace its expenses, its expenses may be growing faster than its revenues. Here is the same data presented in percentage growth form. Note that revenues are downward pointing, whereas all Pandora's big cost lines are increasing:

We only have four years of data so we can't draw too many conclusions. (I omitted the 2008 numbers because they're so small they throw things wildly out of whack.) But we certainly know that the law of big numbers -- you can't sustain consistent percentage increases on a larger and larger base forever -- will hit its revenue line before it hits the cost line. (I'm not the only one wondering whether Pandora's sudden, meteoric growth is sustainable, by the way.) The good news for Pandora is that its workaday operating costs -- admin and product development -- are relatively small, not significant, and are drastically lower than its overall dollar growth.

There are two items of bad news, however:

1. If we assume that the increase in Pandora's marketing costs were required to boost the audience and thus the ad revenue, then we also have to assume that Pandora cannot cut its marketing budget.
2. That leaves the content acquisition budget. Pandora can cut this. But that means it would have to acquire fewer songs, or cheaper songs, to run its service. It's a path to profitability, but at the expense of its listeners -- the very listeners it depends upon.

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