This summer, Sirius (SIRI +0.00%) offered to buy up Pandora (NYSE: P) for about $15 a share. Pandora balked at the offer, and proceeded to shop itself around to companies like Apple and Amazon.com, but with no success. Last week, however, Sirius was back with another offer.
In this week's episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann take a deep dive into the potential merger. Find out what both companies might get out of joining forces, why Pandora had such a hard time finding another acquirer, how Pandora went from being a first mover in music streaming to stagnant, why Sirius is so interested in Pandora, and more.
A full transcript follows the video.
This podcast was recorded on Dec. 9, 2016.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, December 9th, and we're talking about how Sirius is seriously interested in Pandora. I'm your host, Dylan Lewis, and I'm joined in the studio by David Kretzmann. How's it going?
Kretzmann: Good to be here, man. Thanks for having me.
Lewis: You couldn't contain your excitement with that lead-in.
Kretzmann: Simon Erickson would be proud.
Lewis: I was pretty proud of it. When I wrote it, I kind of snickered to myself as I was writing it up in the editorial pod before. But, yeah, news came out last week that Sirius XM Chairman Greg Maffei reached out to Pandora Media and expressed interest in a potential takeover. No firm details at the moment, but we've seen some speculation in the market. I think it lends itself to a pretty fun episode. I know you and Chris [Hill] briefly touched on it in Foolery. We're going to do more of a deep dive this week.
Kretzmann: Yeah, looking forward to it.
Lewis: Today, basically, we're going to run through the history between these two companies, what a deal might look like, and whether it really makes sense. There's kind of a convoluted structure that might make this look a little bit better upon further exploration than it does at first glance with just Sirius and Pandora. Some history between the two companies. Liberty Media (LMCK +0.00%) (LMCA +0.00%), who owns Sirius XM, I think they have a two-thirds stake in the business?
Kretzmann: Yeah, 65%.
Lewis: They casually approached Pandora about a deal in the summer. That offer, they were floating around $15 per share, which was roughly 20% up from where the company was at the time. Pandora's board balked at that offer, believing that the company's value was closer to $20 per share, and immediately after that, several outlets reported Pandora was shopping itself around to the likes of Apple and Amazon. Didn't get any takers, apparently. (laughs) So, this is a back and forth love saga between these two companies, unrequited love, I guess.
Kretzmann: Something like that. Pandora is in an interesting position, looking over the past 10 years or so of financials that are available for Pandora. This is a company that has never been profitable, it has never produced positive free cash flow. So, when I see that... they lost $270 million over the past year, and they burned over $300 million in cash, you're probably not in a position where you can be overly picky when you're trying to find suitors to potentially acquire you. So, I think Pandora needs this more than Sirius or Liberty or whoever, Apple or Amazon or whoever they think might want to acquire them. I look at this and I don't think Pandora has a whole lot of negotiating leverage at this table.
Lewis: And I think the further and further out we get, if you had talked about Pandora as a business two years ago and what they offer versus on-demand streaming, you'd say, "Yeah, I think the two can co-exist." I was a firm believer in that, because of the passive listening, the music recommendation side of Pandora, seemed strong enough to protect them from people who just wanted to listen to the music they wanted to listen to at that time. Spotify has done a really good job with their curated playlists, and their offering is a lot more compelling now because you can get that curated feel, and listen to the new Bon Iver album that you just want to plow right through.
Kretzmann: You can listen to anything, anytime. And that's a really compelling value proposition for consumers. Spotify now has 40 million subscribers to that service. Apple Music, which just launched last year, has 20 million subscribers already. Those are the big players. Amazon just came out with a service for Prime members that's $8 a month, or $4 a month if you're just listening through your Amazon Echo device. YouTube Music is also getting off the ground a little bit. And Pandora still hasn't come out with an on-demand streaming service. Supposedly, it's going to come out later this year. But the company is still very dependent on that free, ad-based model. They do have about 80 million active listeners, people who listen every month or so. But Pandora has just been very slow adapting to what is a very clearly shifting landscape with music streaming.
Lewis: Yeah, they've let competition pass them by in a way that's kind of surprising because they were really the first player out here doing this, and making music available in this way as a mainstream service. The tough thing for them is, even when they roll out this on-demand streaming option, it's going to be an uphill battle because they're competing against people that have commoditized music in a lot of ways, right?
Kretzmann: Yeah, it's hard to differentiate yourself with music now. Are you going to be able to listen to songs that you can't get on Apple Music or Spotify or Amazon? I don't know, that's a tough thing to do. Maybe you see some of these companies start doing what Netflix is doing with original content with TV and movies. Maybe something like that happens. But it's hard if you're not already part of an established ecosystem like Apple and Amazon. Those are great examples where the music just fits into an ecosystem that they already have with the App Store or Amazon Prime. Pandora doesn't really have that. So, it's going to be an uphill battle, like you said, to acquire customers from people who are already used to streaming through Spotify, Amazon, Apple, or a lot of the other solutions already out there.
Lewis: And those big businesses don't need music to be meaningful for them financially. If anything, it can be a loss leader for them, if it makes their core offering that much stronger. If you're a stand-alone business trying to make it work on your own, it's a lot tougher.
Kretzmann: Yeah. I look at that, and music streaming is really becoming more of a commodity type of business, which you wouldn't have really anticipated five years ago. But Amazon is already upping the ante, saying, "We'll charge $8 a month." And I think, inevitably, you're just going to keep seeing that price ticking down. It will be an increasing challenge for companies to offer something that's different from the other competing options out there. So, I think consolidation is inevitable at this point. But I don't know if Pandora is really all that attractive of a target, if a company is trying to amp up their offerings.
Lewis: So, the landscape being a little bit different, I think one other factor that might push Pandora to be a little bit more interested in a deal is Corvex Management, a hedge fund run by Keith Meister. They have a fairly large stake in Pandora, I think it's around 10%, and they have reportedly pushed the company to explore a sale.
Kretzmann: Do you know when they acquired that stake?
Lewis: I think it was in the spring.
Kretzmann: OK, so they're probably itching for a sale.
Lewis: Yeah. So, it's a lot tougher when you have someone breathing down your neck with a significant stake in your company, telling you that you should be looking to find a buyer. So there might be some more pressure there. If you're looking for numbers on what this might look like, something making the rounds in the news this week was one Oppenheimer analyst establishing a target of $18 to $21 as a takeover value for Pandora shares. At the high end, that values Pandora at twice what it was trading at just a few weeks ago, which is pretty wild. It doesn't seem like a huge premium based on where they are now --
Kretzmann: Which is around $14 or so.
Lewis: Yeah, so maybe a 33% premium. But to be doubling, basically? It's impressive.
Kretzmann: It's not bad.
Lewis: I will say, this is far from a done deal. Many reports have surfaced this week that Pandora is also looking for other bidders.
Kretzmann: We'll see how that goes.
Lewis: Yeah, I think the thought there is that that gives them some leverage if they can find somebody. But it's hard not to see that and think about what happened with Twitter and Salesforce earlier this year. If you have a dancing partner, stick with your dancing partner, because the music is going to stop and you're going to be standing alone on the dance floor.
Kretzmann: And you'll have no one to kiss on New Year's Eve. (laughs)
Lewis: (laughs) Exactly! We're closing up to that time. That was, I think, as good as my serious Sirius pun earlier.
Kretzmann: You're on a roll today, Dylan.
Lewis: That was really solid. I'm glad you're bringing it, too. So, what would a deal look like for these two companies? Sirius is a $22 billion market cap company. Based on the deal estimates I talked about, Pandora would probably be about a $4 billion buy roughly, we'll say. Sirius has about $550 million in cash right now, and about $5.7 billion in long-term debt. It's not going to be a cash acquisition, in terms of funded by cash. This looks like it would be debt or a share-based deal. You think about the size of the market caps, and it's not a huge acquisition, it's not a huge bite. But you look at what it would be doing for them on their financials, this would be a pretty big bet for Sirius.
Kretzmann: Yeah, it definitely would. And Sirius is in a decent financial position. They are generating about $1.4 billion in free cash flow annually. It's a very attractive business model that they have. They dominate satellite radio. They have no competition there. And they're installed in about 75% of new cars that come off the lot. So, they have long-term contracts with Ford, Toyota, and stuff to have that satellite radio technology pre-installed in the cars. And then, they just try to convert new car buyers to become subscribers. It's a very lucrative model, if you can continue to attract and retain subscribers. So, they are generating a lot of cash, and over the past few years, they have bought back a lot of stock. I think the share count is down about 25% over the past few years. So, they're not necessarily a fast grower, but right now Sirius has about 31 million subscribers, that's up from around 20 million in 2011. So, it has been a surprising growing business. You wouldn't necessarily think satellite radio would be a hit. But when you have, essentially, no competition, you have long-term contracts with all the major auto manufacturers, they've done pretty well.
But it would be interesting to see where Pandora would fit into Sirius. Right now, Sirius does have a mobile app, so you can stream and listen to some of their content, including some of their music, on the app. It's not a very robust offering, so perhaps Pandora is a way for them to boost their mobile and digital content. I don't know if Sirius would ever offer a stand-alone streaming service, or something, where you can subscribe and listen to the Howard Stern Show or The Ellen Show or whatever it might be, in addition to all the music options that Pandora brings. That could be one option. Or maybe it's just something to complement their existing service. But, looking at the financial situation of Pandora now, I would want Sirius management to outline a compelling case for how they could turn Pandora around when Pandora, after 10 years of being the first mover and the top dog in the industry for a long time -- how is Pandora going to turn that around and become a profitable addition to Sirius? That question needs to be answered for shareholders to be happy with any sort of deal.
Lewis: Yeah, and you look at what Pandora has been going through, and Sirius buying them would not be them acquiring customers and the potential for dramatically more customers. Their user growth has been pretty stagnant lately. So, the people who use the service really like it. Listener hours are actually trending nicely, but they have had trouble acquiring new users. And for them to drop a lot of money, and to make a more digital streaming type play, I think you want something that is clearly resonating with that audience, and isn't just flat-lining.
Kretzmann: Yeah, and you think about it, and that could be one way that Pandora and Sirius differentiate themselves in the streaming space. If you have additional radio content, like, Sirius has long-term contracts with Howard Stern and a lot of other entertainers, performers and radio personalities, if you complement that with the music streaming, that's something that Amazon and Apple and Spotify don't really have. That could be one way that Sirius makes a bigger entrance into the space with more of a competitive advantage. So, I could see that working out. But again, it would just have to be spelled out very clearly, I think, for shareholders of Sirius to be happy with the deal.
Lewis: And Sirius has not been quiet about seeing the difference in how Pandora operates relative to the other streamers, and saying they like it. Actually, at a June investor conference, Sirius XM's chief financial officer, David Frear, said, "Among the streaming companies, Pandora has a better opportunity for a solid business model." I don't know if the idea there is, their content library doesn't need to be nearly as big because it's not on demand? They're still paying per stream for fees, which can make it tough. I mean, I think royalty payments make up about half of their revenue. So, it's really tough to make the numbers work. By contrast, I think for Sirius, it's 11% or something like that. Huge difference there. But they see something. I don't know if it's valid with what they see, but they seem compelled with the type of business model that they have.
Kretzmann: It would be interesting to see if they see any sort of, I'm going to use the word synergies, between the content that they have with Sirius, and the content of Pandora, or if they would want Pandora to be a stand-alone offering. I look at it now, and similar to you, it clearly hasn't worked up to this point, financially. Something has to give for the company to actually become cash-positive and profitable on a consistent basis. So, maybe there is some way that they can combine the two and make it work. Another reason that this should be taken seriously is, the board of directors at Sirius is just stacked with media heavyweights. You have John Malone, who's obviously the mogul behind Liberty Media. But you also have former presidents and CEOs -- and current CEOs, in some cases -- of ESPN, DirecTV, Discovery. So, Sirius has, as far as a board of directors go, and if this board of directors is interested, that should be taken seriously. They obviously see something with Pandora. To me, it's still not completely clear what that is. But if they can spell it out and make a compelling case, then I think shareholders would be on board, because it is a substantial financial commitment for Sirius. It'll be interesting to see if we learn anything more.
Lewis: Yeah. You mentioned John Malone. That's where there's some nuance here that gets beyond just what we see in the headlines. This time around, I've seen Greg Maffei and it's billed "chairman of Sirius" approaching Pandora for an inquisition. Last time around, it was Greg Maffei, "CEO of Liberty." So, it's curious to see how they decide to go about this, because strategically, it might be a little bit different if Liberty is pulling the strings and ultimately winds up making the deal happen. Sirius is majority-owned by Liberty, like we talked about. Liberty could decide to basically pair that streaming service, Pandora, with the concert and ticket business, Live Nation, which they own about 1/3 of, basically. Pandora has seen a ton of success in using its platform to sell concert tickets through Ticketfly, which they acquired a little while back. That's a very small part of their business now, but you see those types of pairings, and an acquisition makes more sense. It's just, how involved in the other Liberty properties might Pandora be, once it's under their umbrella? Or, will it be something that is siloed to Sirius, because they're the acquirer, and that's it. I doubt it. I think they'd probably explore pretty much anything and everything. But that's certainly a cool thing to watch. When you start thinking about it that way, a deal makes a lot more sense.
Kretzmann: Definitely. And it's not surprising to see those nuances here, because John Malone and Liberty, they are the kings of spinoffs, mergers, all sorts of wonky deals to maximize the financial value of any sort of transactions like this. But that is a really interesting point. When you're approaching this acquisition, how can you make Pandora different from other streaming options? And whether it's through Liberty or Sirius, I think there are some ways that you could see that happening. Exactly what route they take, I think that's the question that'll be on shareholders' minds, if the offer is indeed made. But there are a lot of properties under that Liberty umbrella, beyond even Live Nation or Sirius, that could build more of a moat around that Pandora listener experience.
Lewis: So, certainly a lot to think about for Sirius shareholders. Pandora shareholders, yea or nay on this?
Kretzmann: I think, at this point, Pandora on its own has had no success, and they've been behind the competition moving toward that on-demand streaming option. Supposedly it's coming out. But if you have an offer from Sirius or Liberty, as far as media companies go, they're really the crown jewel. So, I would go for the offer.
Lewis: Yeah. I am a Pandora shareholder, I was thinking about getting out of my position a little while back, and then they made that Ticketfly acquisition, and I just thought it was so compelling. I love the online ticketing space. Right now, that business is only about 6% of their top line. So, it's not grown into a meaningful part. It's firing, I think it's what they expect, but the ramp for that to really take off is kind of long, and it's going to require some patience. So, my feeling is that a deal will probably come in around my cost basis, maybe slightly above it. That would be great. My general feeling with this is, like you said, Pandora has had plenty of time to try to figure it out as a company, and shareholders have given it a lot of leash. If someone else sees a lot of value in that property, let them roll with it and see what happens.
Kretzmann: An early Christmas present for you. It's the type of thing where, it's one thing to own an unprofitable company if it's growing, and you can see a clear market opportunity for the company to grow into, in which case it makes sense, yeah, reinvest back into the business, it's OK to sacrifice profits today if there are bigger profits waiting for you in a few years. But in the case of Pandora, it's not really clear that that's the case, and the company has struggled to generate any sort of lasting, consistent success for shareholders. In that case, yeah, I think Pandora is probably a lot better off being a part of Sirius or Liberty, and just that whole media ecosystem empire that John Malone and company have put together. I think for Pandora shareholders, especially if it was a stock offering or something, and you were given partial shares in Sirius or Liberty, that would definitely be an attractive deal.
Lewis: Well, listeners, that does it for this episode of Industry Focus. You've probably heard some of the other hosts talk about it earlier in the week, but we want your book recommendations. We'll be doing a show later this month discussing some great investing books. David, do you have any off the top of your head?
Kretzmann: One Up On Wall Street by Peter Lynch. Everyone says it, but it's my favorite.
Lewis: Well, we're going to be doing a show later this month. We would love to have some listeners send us some of their favorites. It might be great for some last-minute gift ideas for the investor in your life. If you shoot us an email with your favorites, we'll be sure to include it in the show, and also send along the final list that we collect. So, if you shoot us an email at [email protected], or tweet us @MFIndustryFocus, we can get those over to you. If you're looking for more stuff, you can subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!
