Like most growth stories, Pandora (NYSE:P) is a work in progress. While that can sometimes make it appear that management doesn't really know its market or have a solid plan, I believe changes to policies like the listening cap have more to do with the ongoing evolution of ad revenue and user monetization. With Pandora continuing to grow its users, hours, and ad revenue at rates well above the market, I continue to believe this is an exciting, albeit volatile, growth story.
More Progress In Q2
Pandora reported 55% GAAP revenue growth in the fiscal second quarter, with an underlying growth rate of 18% in listening hours in 30% in users. Subscription revenue more than doubled once again (up 143%) as frequent listeners continue to see value in restriction-free access, while ad revenue rose 44% (almost 82% of the total). 
Both Facebook (NYSE:FB) and Groupon (Nasdaq:GRPN) have reported good progress with their mobile businesses, and Pandora isn't getting left behind. Mobile revenue nearly doubled overall, and rose to nearly three-quarters of the total, as mobile RPM growth of 55% outpaced desktop RPM growth of 4%. Even with that progress, though, mobile RPM is still only about two-thirds that of desktop users.
Importantly, Pandora is doing a good job of attracting new users and monetizing them relative to content costs. Gross margin improved by more than eight points from last year (and nearly 15 points sequentially) as content acquisition costs rose 35%. The company is still in the red on an operating basis, though, as the company reported a nearly $8 million GAAP loss.

SEE: Earnings: Quality Means Everything
Cap Comes, Cap Goes
One of the underappreciated challenges of managing a growth company is actually managing that growth – that is, not pursuing top-line growth just for its own sake and destroying the margin structure in the process.
Pandora has relied on listening caps at various points to help control its content costs, and this summer saw some sluggishness in listening growth as the 40-hour cap and new, stricter, skipping policies constricted utilization from mobile listeners. As part of the “fine-tuning” I mentioned in the intro, though, management believes that it can now adequately control costs with the skipping policy and offset those costs with better mobile ad revenues such that the mobile cap is going away on September 1st
Here Comes Apple...
Pandora has established a strong foothold in the radio market, becoming far and away the most popular internet-based player with over five times the session starts of Clear Channel's in June and almost 24 times the session starts of SlackerApple's (Nasdaq:AAPL) iTunes Radio is on the way, though, with an expected launch this fall. 
I expect Apple will succeed in luring some of Pandora's users, but I don't think it will be “game over” by any means. Contrary to what some people appear to believe, Apple isn't the last and only name in mobile devices or media services – there are still plenty of us out there who don't use iTunes at all. Moreover, the customization features of Pandora stations should make the service at least somewhat sticky – meaning that Apple is really going to have to offer something special and different to grab significant share from Pandora. On the other hand, Apple is Apple and you underestimate that company at your own peril.
The Bottom Line
I expect that Apple's entry into the market will lead to a period of noticeably lower growth for Pandora, but I think it will be just a pause along an attractive growth trajectory. On a longer-term basis, I'm more concerned about Pandora's ability to effectively negotiate its content rights and costs than I am about Apple poaching its listeners.
It's easy to get swept along with growth stories and raise expectations to illogical and unachievable levels. I hope that I'm not doing that here, but I am bumping up my long-term revenue growth expectations to about 24% and my long-term free cash flow margin estimate to 17.5%. For what it's worth, those expectations would put Pandora in 2022 roughly on par with where Sirius XM (Nasdaq:SIRI) was in 2012 in terms of revenue and cash flow.
With that, the fair value moves up to $23, suggesting Pandora is one of the relatively rare undervalued growth stories. Still, it won't surprise me if these shares get cheaper around the time of Apple's introduction, so shareholders will need to be able to overlook the volatility in these shares to reap the long-term gains.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    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 >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center