Seeing the performance of internet stocks like Facebook (NYSE:FB) and Pandora (NYSE:P), I really need to remember to eat my own cooking and actually buy those stocks that I think are undervalued. Since my last writeup in December of 2012, Pandora shares have jumped over 150% as investor worries about monetizing mobile users and staving off competition have eased considerably. For better or worse, there's still enormous uncertainty about the eventual business model for Pandora – meaning that bears can credibly argue that Pandora is overpriced now just as bulls make the case that Pandora is still a buy.
Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.
Strong Growth To Start The Fiscal Year
Pandora continues to pick up steam and managed to exceed analyst expectations even as those numbers were raised throughout the quarter.
Revenue rose 55%, leading to a small beat relative to the average estimate. Ad revenue rose 49%, but the real surprise was the 100% growth in subscription revenue. While this is still a relative small part of the business (about 16% of revenue), the company now boasts over 2.5 million subscribers and added more in the quarter (about 700K net new adds) than in the prior year. Mobile revenue was also up strongly (up over 100%) as both hours and revenue-per-thousand hours increased significantly.
Profitability is still in the future for Pandora, but there were signs of progress on margins as well. Gross margin (for which I included content acquisition costs) improved almost four points from the year-ago level as the new cap on free mobile listening helped limit costs. Operating loss still increased, though (from about $20 million to over $28 million), and EBITDA remains negative.
SEE: Understanding The Income Statement
Advertisers Stepping Up
More and more, it looks as though Pandora is being treated as a radio company by advertisers, and not as an internet company. To that end, the company's market share in leading radio markets like New York City, LA, San Francisco, and Houston) increasingly means that the company can not only not be ignored by advertisers, but that the company can expect better rates. To that end, integration into STRATA and Mediaocean should only hope.
On a positive note, ad revenue rose faster than listening hours this quarter (49% versus 35%). Still, I won't completely dismiss the somewhat cautious commentary of other media companies like Disney (NYSE:DIS) and CBS (NYSE:CBS) regarding advertising spending. By no means am I suggesting that these companies are one-to-one peers with Pandora, but I think the point stands that more cautious ad spending could be a risk factor for Pandora if the economy doesn't pick up.
Adding Value And Building A Viable Model
Pandora management has at least a few more years of difficult decisions ahead of them. As many companies in the broadly-defined internet space have learned (and I'm including companies like Facebook, Groupon (Nasdaq:GRPN), and Amazon (Nasdaq:AMZN), there are often choices to be made between what the users want and what makes sense for the business model.
So far, Pandora seems to be managing this balancing act pretty well. The 40-hour cap on free listening did reduce mobile listening hours, but it also seemed to spur more subscriptions and limited content acquisition costs. Simply put, if Pandora can keep its users happy and keep ad revenue growing ahead of content costs, this model can really start to work. Keep in mind, though, that content costs are going to rise through 2015, so there is going to be constant pressure on management to keep up with its monetization efforts (particularly in shrinking the nearly two-to-one gap between desktop and mobile users). Improved rates will help, but management may also have to consider increasing ad density (minutes of ads per hour of music) and moves like that may annoy or alienate users.
The Bottom Line
I'm an avid user of Pandora myself, and I think the company has every chance to outdo traditional radio companies like CBS, Clear Channel, and Citadel as well as Sirius XM Radio (Nasdaq:SIRI). There's some risk that an entrant like Apple (Nasdaq:AAPL) or Amazon could disrupt the model and market share growth, but any market that's worth anything will have competition sooner or later.
At this point, the biggest risk to Pandora shares is likely just the uncertainty regarding the long-term “steady state” profitability of the business model. Free cash flow estimates for fiscal 2016 range from the mid-$40 millions to over $100 million, and the spread doesn't narrow much as the years go further out. That means any shortfall (or outperformance) in the near term can have a disproportionate impact on the fair value of the shares.
SEE: 5 Must-Have Metrics For Value Investors
I've upped my revenue expectations for 2020 and beyond by about 10%, which boosts my expected revenue growth rate to about 22%. I expect Pandora to generate a 10% free cash flow margin in FY2018 and grow into the mid-teens thereafter. That works out to a fair value a bit above $17 today, which makes this a stock worth holding (particularly given the possibility of outperforming estimates), but not such a compelling buy right now. Were the company to announce a move like a secondary stock offering, that could open a window of opportunity for investors.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
Investing BasicsIf volatility and emotion are removed, passive, long-term investing comes out on top.
RetirementDetermine the risk to a company's EPS and financial condition resulting from an underfunded pension plan.
Bonds & Fixed IncomeHistorically, international investing has worked out well for investors, but this may no longer be the case.
Stock AnalysisThese three stocks are resilient, fundamentally sound and also pay generous dividends.
Investing NewsAre stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
Investing NewsHere are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
Investing NewsHere are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
Stock AnalysisIf you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
Mutual Funds & ETFsExplore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
Stock AnalysisExamine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>