Welcome to 1999... Pandora's big debut... Respecting operating margin and cash flow... Which stocks to short... Icahn on board at Forest Labs... Do you like the stocks we recommend?...
Comparisons to the late-'90s technology bubble abound...
Once again… Silicon Valley firms are rushing to sell stock to an overly eager public. Once again… these businesses are trading at absurd valuations. And once again… the business models are flawed.
Businesses like LinkedIn, Groupon, and Facebook aren't trading on fundamentals. They're trading on the potential earnings power of tens of millions, in some cases hundreds of millions, of users. Unfortunately, no one is sure how that full potential will be reached.
Groupon, which serves its subscribers with daily discount deals, lost $413.4 million last year. It is set to debut at a value of more than $20 billion. Facebook, the social networking site, could reach a $100 billion valuation with an initial public offering (IPO). Shares of LinkedIn, the professional networking site, doubled in its first day of trading. The market cap hovers around $10 billion, meaning the company trades around 1,200 times earnings.
Today, shares of Pandora Media, the online radio company, began trading. And the public loves it...
Shares of Pandora jumped as much as 40% today to $23 following the company's initial public offering. Pandora priced shares at $16 late Tuesday – above the recently raised offering range of $10-$12. The IPO raised $235 million, almost double the expected amount. At $23 a share, Pandora is valued at $3.7 billion.
Longtime Digest readers know we don't touch IPOs. These companies go on "road shows" with teams of investment bankers pitching shares. And it's the investment bankers' job to price shares of these debuting companies at the highest possible amount.
Typically, only two parties get rich on an IPO – the bankers and the owners of the company. Regardless, hordes of investors salivate over the latest, hot offering.
On to Pandora's numbers... Pandora provides its radio service to 90 million people (the vast majority of whom are free users). The company earns 87% of its revenue – $119 million last year – from advertising. The rest comes from subscribers who pay a premium for ad-free listening.
In its 11-year existence, Pandora has never posted an annual profit. It lost $1.8 million last year. The company's revenue more than doubled to $51 million in the quarter ended in March. But its net loss increased to $6.75 million from $3 million. Pandora expects to lose money through at least fiscal year 2012.
How does the company lose ever-larger amounts of cash as its revenues grow? The company pays large royalties to record labels to stream their music. And as Pandora's users listen more, fees increase. According to Pandora's latest securities filing, "As the volume of music we stream to listeners increases, our content acquisition expense will also increase, regardless of whether we are able to generate more revenue." It's like the old business joke, "We lose money on every sale, but we'll make it up on volume." It's not a business model I'd invest in.
Worse, the company will earn less money as its users switch from computers to mobile devices (advertisers pay less for mobile ads). The proportion of hours of music streaming to mobile devices hit 60% last quarter, up from 4.6% in 2009.
Pandora CEO Joe Kennedy appeared on CNBC this morning to discuss his company's offering. And he failed to answer the one question on everyone's mind... "When and how will Pandora make money?"
His only response was, "we respect the need for operating margin and cash flow." Kennedy refused to give guidance for earnings. And when asked why investors should buy shares of Pandora, he answered that investors understand the "long-term opportunity" and the "track record that we have" of growing revenue.
He also continually repeated how the company has "such an enormous opportunity ahead of [it]" and how Pandora will "redefine radio."
When pressed further, Kennedy could only use adverbs to stress his points... "We deeply respect operating margins and cash flow," and "we're tremendously excited about our opportunity."
We're not selling these soaring technology IPOs short (the market can stay irrational longer than you can stay solvent)... But we're certainly not buying. On the topic of short selling, I'd like to offer a quick refresher...
At S&A, we like three types of short sales. The first is shorting frauds (like Enron). However, these don't happen that often, and they're difficult to identify. Next, there's shorting overly indebted firms (like General Motors). These companies are easy to identify – they can't afford their interest payments. The third category we short are the "buggy-whip makers," or companies that offer an obsolete product or service.
You should never short a stock based on valuation. There's no catalyst to cause a decline... And they can rise much faster and longer than you'd think.
Yesterday, Extreme Value pick Forest Laboratories (FRX) received notice from billionaire investor Carl Icahn that he plans to nominate four candidates to the drugmaker's board of directors. Icahn has been involved in several multibillion-dollar takeovers in the drug sector, including ImClone, Medimmune, and Genzyme. The announcement sent Forest shares up 2% on speculation Icahn's involvement could lead to a takeover. Extreme Value readers are up 32% on the position.
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New 52-week highs (as of 6/14/11): Forest Laboratories (FRX).
We hope you "like" the stocks we recommend... Send your feedback to feedback@stansberryresearch.com.
"I live about 30 miles from where the Iowa farmland sold for $13,000 acre. The farmer who paid this price is not looking at the return of their investment on this individual piece of land, but the return on their entire operation. They can include the farming of this additional land in their operation with the equipment they already own; take out the fences and farm it as they already owned the land on both sides of this piece of land. A second factor that is considered is more acres that they can spread manure on. Farmers can only spread a certain amount of manure per acre per DNR regulations in Iowa so this also becomes a major factor in the price of farmland. There are many other factors a farmer, other than the rent price for a return on their investment, uses for calculating a return on an investment that a non-farming individual would not consider." – Paid-up subscriber Dick Blankespoor
"If you traded stocks people liked like aapl, qqq, oih, nflx your strategy would work. Love your analysis though." – Paid-up subscriber Don
Goldsmith comment: I'm not sure if you're referring to a particular service we offer or our business in general. Either way, recommending stocks just because people like them is a terrible way to run an advisory... and a great way to help your subscribers go broke.
Regards,
Sean Goldsmith
Baltimore, Maryland
June 15, 2011