Pandora Still Has Hope

By Stephen D. Simpson, CFA | December 06, 2012 AAA

Why any company would want to tie themselves in any way to Pandora's Box (which contained all the evils of mankind) is beyond me, but there's more to Pandora (NYSE:P) than a name. Pandora has quickly established itself as the dominant Internet radio platform, but many investors have struggled with reconciling Pandora's market share to its ability to monetize its user base and (eventually) post solid operating leverage. Although the post-earnings reaction on December 5 seems overdone, it's not really surprising given how much of Pandora's value lies in the future and how sensitive that value is to even small changes today.

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Basically Good Numbers for Fiscal Third Quarter
Pandora didn't really disappoint with the numbers it posted for its fiscal third quarter. Revenue rose 60%, with ad revenue up 61% and subscription revenue was up 52%. Active users increased by 47% in the quarter and listening hours rose 67%.

Pandora likewise made progress on its road to profitability. Gross margin improved about a point and a half, while EBITDA jumped 136%. Operating income likewise posted a huge jump from a small base (up 187%). It's worth noting, though, that content acquisition remains a huge cost item for the company - content acquisition costs rose 74% from last year and made up 55% of revenue (from about 50% last year).

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Mobile and Monetization
With content costs so high (and going higher per-song for several more years), it's vital for Pandora to monetize its users. While there was progress here in the third quarter, it wasn't universally great.

Pandora's revenue per thousand hours (RPM) fell 9% for desktop users (to $56.40), while rising 14% to $26.96 for mobile. The desktop decline was due in large part to removing the 40-hour per month cap, but it's worth noting that that trailing 12 month trends for both RPM stats are not looking excellent. It's also worth noting that mobile listening was up 85%, so Pandora has to face some of the same questions as companies like Groupon (Nasdaq:GRPN) and Facebook (Nasdaq:FB) with respect to lift monetization of mobile users.

Guidance Today, Competition Tomorrow?
Competition is a frequently mentioned issue with Pandora, and we'll get to that in a moment. More pressing for this quarter, though, was the company's negative guidance revision for the fourth quarter. Against a prior Street expectation of $130 million in revenue and 2 cents in earnings per share, management guided to $121.5 million and a loss of 8 cents. Management cited the fiscal cliff, which is leading advertisers to get considerably more cautious with commitments.

Any downward guidance revision in a company's early days as a public company is bad, but it happens. More to the point, similar expectations have been laid out for other radio and media players like CC Media Holdings (OTC:CCMO), CBS (NYSE:CBS) and Disney (NYSE:DIS), so Pandora wouldn't be alone in seeing an impact from more cautious ad spends.

Competition is certainly a relevant long-term concern, though. Pandora has already grabbed about 7% share of the radio market and has surpassed both traditional radio and SIRIUS XM (Nasdaq:SIRI) in terms of share momentum. Frankly, existing competition (including Clear Channel and Spotify) isn't the threat, but rumors that Apple (Nasdaq:AAPL) has been negotiating with labels and intends to bring out a streaming service are worth worrying about.

Although it would be surprising in some respects to see Apple mess with a business that has the economics of the music/radio industry, it could make sense as part of a larger strategy to enhance the value of Apple mobile devices and cross-promote its products. Say, for instance, that Apple offered free high-quality streaming audio on Apple devices - that could perhaps encourage some customers to switch from Samsung or other rivals. Even if it's not offered as a freebie, the success of the iTunes concept suggests that Pandora investors can't afford to ignore the risk that Apple could present.

The Bottom Line
I'm accustomed to rarely, if ever, finding anything looking like value among companies posting such strong revenue growth. Nevertheless, the skepticism on Pandora is such that it may just actually offer some value.

If Pandora can grow its revenue to about $1.3 billion in 2017 and post close to $100 million in free cash flow, and keep the growth up to $2.6 billion and over $300 million, respectively, by decade's end, then these shares may be worth a look.

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Clearly that's a big target for a company that produced $274 million of revenue and negative free cash flow in the last fiscal year. But if you look at the growth trajectory of SIRIUS XM (from $242 million in revenue in 2005 to $3 billion last year, and more than $400 million in free cash flow), it's not implausible. Of course, the Pandora-SIRIUS XM comparisons only go so far (they have always had very different models and target audiences), but I would argue that they are at least relevant as a logic test for Pandora projections.

In any case, while this guidance revision is certainly negative, investors who buy into those bullish projections that Pandora can approach $100 million in free cash flow in 2017 and more than $300 million by the end of the next five years are looking at a stake with a fair value of close to $11 today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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