Tech-Hungry Investors Take the Bait With Overvalued Pandora IPO

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Internet radio company Pandora Media Inc. (NYSE: P) raised $234.9 million in its initial public offering (IPO) Tuesday, luring investors who were looking to get in on this year's batch of Internet stocks.

The Oakland, CA-based company sold 14.7 million shares at $16 each, up from $9 when the company first announced its IPO. Pandora shares jumped more than 40% as trading started yesterday (Wednesday), but closed only 8.9% higher at $17.42.

While many analysts like Pandora's long-term outlook, they say the company's financials don't explain its $2.6 billion valuation.

"It's not that we think Pandora won't be profitable," Richard Greenfield, an analyst at BTIG Equity Research, told MarketWatch. "We don't think that profits will be enough to justify the valuation."

Greenfield said the IPO would have been "more compelling" at between $4 and $5 a share.

Pandora is cashing in on investor excitement surrounding tech IPOs. Tech IPOs overall have initially provided higher gains, outpacing the Standard & Poor's 500 Index by 3%, and many investors are flocking to the sector.

By only selling 9.2% of its shares outstanding – much lower than the average float of 24% for tech IPOs in the past year – Pandora has attracted eager investors afraid of missing the boat.

"There's pent-up demand for high-growth, exciting business models," said Scott Billeadeau of Fifth Third Asset Management. "There's demand and there just aren't many ways to get access to it. After LinkedIn, there's definitely some chasing going on."

Pandora's first-day jump is more modest than Internet IPO counterparts Linkedin Corp. (NYSE: LNKD) and Russia's biggest search engine operator Yandex NV (Nasdaq: YNDX), which both rose more than 55% in their debut trading sessions. But analysts say Pandora's price is still higher than the company's outlook supports.

Caught up in the thrill of the chase, investors have ignored that Pandora's profitability is threatened by increasing competition and costs. The company has provided nothing substantial to show it can overcome these threats and give investors solid returns.

"There's not a lot of new information coming to market," Anupam Palit, an analyst at GreenCrest Capital, told Bloomberg Television's "InsideTrack." "There's just a lot of dollars chasing very little supply."

The Pandora IPO gave the company a market value of about $2.6 billion – 19-times last year's sales. That far outpaces competitor Sirius XM Radio Inc. (Nasdaq: SIRI), whose $7.7 billion market value was only 2.7-times sales.

The company, started in 2000 under the name Savage Beast, earns 87% of sales from ads targeted to its 34 million active listeners. It has five times as many users as it did in 2009 and revenue more than doubled last quarter, hitting $137.8 million

The hours Pandora's listeners spend tuned in to their customized online radio stations has grown quickly – but that has pushed up what the company pays to stream music. Royalty costs hit $69.4 million last year, increasing 21-fold since 2007. Pandora paid $29 million in royalty costs in 2011's first quarter.

Additionally, Pandora will have to contend with the onslaught of online music providers.

Besides Pandora rival Sirius, startups like Slacker Inc., Rdio Inc., Last.fm and London's Spotify Ltd. will pose a challenge.

It could also lose users to big-name tech companies that create their own online music offers.

"The environment is going to get incrementally heavier," said GreenCrest's Palit. "You've got Google, you've got Amazon, you've got the [Apple] iCloud coming, and these companies have a lot of storage capabilities. So when you think about taking enormous music libraries, and storing them in the cloud, you've got serious competition."

Apple Inc. (Nasdaq: AAPL) Chief Executive Officer Steve Jobs made an appearance June 6 at the Worldwide Developers Conference to introduce the company's new iCloud music service, a cloud-based version of iTunes that allows users to access music, videos books and photos from any Apple device.

Without a clear plan to profit in the face of mounting obstacles, analysts warn investors to avoid Pandora while it's trading far above its initial planned IPO price.

"I think we are seeing a little bit of irrational activity right now," said Palit. "Investors should stay on the sidelines, wait for these valuations to come back to earth."

Pandora's President and CEO Joe Kennedy refused to comment Wednesday on analysts' overvaluation claims.

"We're not focused on the stock price," Kennedy said to FoxBusiness' Stuart Varney. "We're focused on an enormous opportunity to redefine one of the major consumer categories, radio, and define what radio can be in this Internet-connected age."

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