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.