After a 193% Surge, This Stock is Ready for a Big Plunge

Roughly a year ago, short sellers were loading up on shares of online music service Pandora (NYSE: P). Rising competition in streaming radio was expected to keep a lid on growth, but short sellers, which controlled more than half the float in November 2012, clearly missed the mark. Pandora has gone on to deliver impressive gains in 2013, up 193% since the start of the year.

Although Pandora has been a great revenue growth story, with sales rising from $55 million in fiscal 2010 to $427 million in fiscal 2013 (ended in January), the company has also expanded EBITDA losses, rising from $14 million in fiscal 2010 to $31 million in fiscal 2013.

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Short sellers expected Pandora’s growth to slow as competition began to build and for those EBITDA losses to remain stubbornly high. The shorts were wrong on both counts. Sales growth is expected to remain above 50% in the current fiscal year, and analysts now expect Pandora to generate positive EBITDA by fiscal 2015.

What changed? Credit goes to a savvy focus on mobile platforms. Management has done an outstanding job of building an app-focused business model, and consumers have readily embraced the radio streaming service.

A number of new cars now enable streaming direct from smartphones, and Pandora radio is the preferred choice for many, especially when compared to traditional radio or the pricier service offered by Sirius XM Radio (NASDAQ: SIRI).

Advertisers have responded as Pandora’s user base rapidly expands, thanks to the fact that the typical active Pandora user now spends more than 20 hours listening to it each month.

Pandora offers two choices to consumers: a free service that runs ads between various songs, and a paid subscription service that doesn’t run ads. The offerings are driving a virtuous cycle for the business. “Growth in mobile usage drives mobile advertising, while the growth in mobile advertising drives subscriptions,” noted analysts at Albert Fried in a March 8 note to clients.

Pandora’s business model really hit an inflection point in the most recent fiscal second quarter, when sales rose 26% sequentially to $157 million. Analysts currently think that Pandora will continue to boost sales an average of 45% year-over-year in the third and fourth quarters of fiscal 2014.

Yet some cracks in Pandora’s business model are starting to emerge, and the company may actually be hard-pressed to continue growing at a rapid rate.

And the reason for that view is Apple (NASDAQ: AAPL). The consumer electronics giant has finally entered into this niche with its iTunes streaming radio service and has cultivated an 11 million user base fairly quickly. Analysts at Stifel Nicolaus believe that Apple’s popularity will trim Pandora’s usage rates by 10% to 15% over the next six months.
Are signs of trouble emerging? Pandora’s active user base grew 25% in September (to 72.7 million users) compared to a year ago, though that growth rate is down from 28% in August and 30% in July.

The key concern is that Apple is in a better position for streaming radio vis-a-vis the recorded music industry. Apple has agreed to not only pay a slightly higher rate for each song streamed ($0.0013 per song versus $0.0012 for Pandora), but will also remit a portion of its iTunes ad revenues to the record labels. “As Apple offers ad revenue sharing and Pandora does not, we think artists will be motivated to promote Apple streaming radio,” note Albert Fried analysts, who have an $18 price target on P.

Competition is also coming from the legacy radio networks. Clear Channel, for example, recently held a major concert event to highlight its intention to beat Pandora at its own game with its iHeartRadio streaming service.

The problem with these rising headwinds is that investors will start to more closely analyze Pandora’s growth metrics, which have been stellar, but could start to cool. Closer scrutiny comes with a market value that now approaches nearly $5 billion.

That’s a lofty value for a company that is only expected to generate $111 million in EBITDA by fiscal 2016, according to Goldman Sachs (NYSE: GS). Analysts at BTIG think that the rising competition will keep Pandora from reaching $100 million in EBITDA until fiscal 2017. Their $10 price target (representing more than 60% downside) equates to 16 times their 2016 EBITDA forecasts.

Pandora’s stock has had a great run thanks to an uninterrupted flow of impressive quarterly results. But the quarters ahead look a lot more challenging, and by the time the dust settles, this stock could move back down to the mid-teens.

Short sellers, many of whom were forced to cover their positions as this stock surged, are back in the game. From the end of August until the middle of September, the short interest spiked 6%, from 28.4 million shares to 30.2 million shares. And this time around, I think they’re going to be right.

Recommended Trade Setups:

— Short P above $24
— Set stop-loss at $30
— Set initial price target at $18 for a potential 25% gain in six months