Pandora (NYSE:P) is one of those stocks that, for whatever reason, tends to evoke a great deal of emotion here on Seeking Alpha. Either it is the next big thing in music, set to destroy Sirius XM (NASDAQ:SIRI) and the rest of the "traditional" radio industry, or it is a company doomed to fail. In our view, the truth lies, as it often does, somewhere between those 2 extremes. While Pandora is unlikely to have a material impact on Sirius XM, we also think that the company can, in the long run, deliver results for users, advertisers, and shareholders, and in this article, we will outline our thinking on Pandora's long-term trajectory. For purposes of disclosure, we currently have no position in Pandora. Unless otherwise noted, financial statistics and management commentary used in this article will come from the following sources: Pandora's Q3 2013 (the company has an odd fiscal year) earnings release, its Q3 2013 conference call, or its Q2 2013 10-Q. We will first focus on this quarter's results, then delve into Pandora's guidance for Q4 and the road ahead.
Q3 2013 Overview: On the Road to Profitability
After the markets closed on December 4, Pandora posted its Q3 2013 results. The company's non-GAAP EPS of $0.05 beat estimates by 4 cents. Total revenues of $120.005 million beat estimates by $3 million. Pandora also posted a GAAP profit of a penny per share this quarter.
In Q3 2013, total revenue grew by 59.99% from a year ago, and mobile revenue grew by 112% to $73.9 million, marking another quarter where mobile makes up the majority of Pandora's revenue. Despite what critics are saying, Pandora has been one of the few companies to effectively monetize mobile, and its expertise in this field is showing up in its financial statements. The 112% rise in mobile revenue outpaced the 85% growth that Pandora saw in mobile listeners (total active users grew by 47% in Q3 to 59.2 million). We break down Pandora's revenue on a year-over-year and sequential basis below, as well as its content acquisition costs (more on that a bit later) and operating margins.
Pandora Financial Overview (in thousands)
|Q3 2013||Q2 2013||Q3 2012|
|Ad Revenue as a % of Total Revenue||88.54%||88.27%||87.97%|
|Subscription Revenue as a % of Total Revenue||11.46%||11.73%||12.03%|
|Year-Over Year Growth Ad Revenue||61.03%||N/A||N/A|
|Year-Over-Year Growth in Subscription Revenue||52.36%||N/A||N/A|
|Year-Over-Year Growth in Total Revenue||59.99%||N/A||N/A|
|Sequential Growth in Ad Revenue||18.88%||N/A||N/A|
|Sequential Growth in Subscription Revenue||15.69%||N/A||N/A|
|Sequential Growth in Total Revenue||18.5%||N/A||N/A|
|Content Acquisition Costs||$65,713||$60,522||$37,658|
|Content Acquisition Costs as a % of Total Revenue||54.76%||59.76%||50.21%|
|Operating Margin (GAAP)||1.81%||-5.24%||1%|
|Operating Margin (non-GAAP)||7.7%||0.72%||4.57%|
As the chart above shows, Pandora's latest quarter was one of continued growth. The company saw growth in both subscription and advertising revenue, and the company saw growth both sequentially and on a year-over-year basis. But more importantly, Pandora's content acquisition costs (as a percentage of revenues) have fallen on a sequential basis. While we do admit that content costs are a challenge for Pandora, it is a challenge that we believe the company can overcome. Pandora's advertising revenue grew faster than its content costs, and mobile revenue growth outpaced mobile listener growth by a wide margin in Q3 2013. As Pandora works to further monetize its mobile user base, revenue growth should continue, and once user growth slows, the rise in content acquisition costs will slow as well. This trend is already beginning to manifest itself in Pandora's operating margins. The company saw an improvement in its margins both sequentially and year-over-year, on both a GAAP and non-GAAP basis. This margin expansion occurred despite continued growth in the company's headcount. Pandora boosted its headcount by 38% compared to a year ago, growing from 481 employees to 662 employees, with sales staff growing by 75%. We believe that Pandora is well on the way towards a time when its business model is shown to be viable. Content costs are not an insurmountable challenge, and as mobile monetization continues, content costs should begin to be brought under control (with mobile being the biggest source of listening hour growth, it is also the biggest driver of content costs).
In Q3 2012, Pandora made meaningful progress on monetizing its mobile user base. In fact, the company admitted that its aggressive efforts to monetize its mobile customers have slightly hurt its desktop business. On the company's conference call, CEO Joe Kennedy stated that,
"Our mix of listener hours and advertising revenue continues to shift towards mobile. Listening on mobile and other connected devices represented 77% of total listener hours during the third quarter. Web total RPM for the quarter was $56.40 compared to $62.06 in the same quarter last year. Mobile and connected devices total RPM was $26.96 compared to $23.60 last year. Mobile monetization remains a core focus and we're pleased with the progress we've made as reflected in our record high mobile RPM. We remain focused on our mobile product as hours and ad revenue continued this shift towards mobile. Our goal is to provide consumers with the best personalized radio experience in the world and center stage for that is the mobile environment."
When pressed on the issue of why desktop RPM is falling, Kennedy responded by stating that with mobile accounting for 77% of Pandora's usage (as measured by listening hours), the company is intensely focused on that front, leaving it "under-optimized" on the desktop side of things. He notes that his view of long-term desktop RPM above $60 is intact. In Q3, desktop RPM dropped because Pandora left money on the table, not because its business is deteriorating. It was a calculated move on the company's part to shift focus to monetizing mobile, and the results are showing up in the company's financial statements.
Balance Sheet Analysis
Pandora's balance sheet offers several clues into the company's present position, and we believe that these clues are worth mentioning. The company ended Q3 2013 with $90.581 million in cash and investments, and no debt. And while it is true that Pandora used $878,000 of cash in its Q3 operations, that is due to changes in working capital; the primary "culprit" was the $17.477 million impact of changes in accounts receivable, as well as changes in prepaid expenses. We do not think that this latest quarter is representative of Pandora's long-term ability to generate cash.
Pandora's deferred revenue also shows that the company is on a solid trajectory. In Q3 2013, deferred revenue rose by 40.27% from the start of the fiscal year to $26.976 million. On the company's Q3 call, CFO Steve Cakebread stated that the rise in deferred revenue is due to continued growth in the company's subscription business; the accounting for subscriptions requires Pandora to defer revenue, even if the cash is brought in upfront.
Q4 Guidance: The Weak Link
Pandora's Q3 results were solid, in our view. The company was profitable on both a GAAP and non-GAAP basis, and cash burn was caused by working capital shifts, not a core deterioration of the company's business. Mobile monetization is improving, and growth continues on all fronts. But, Pandora's shares fell sharply on the back of its Q3 2013 earnings, the cause of this was the company's weak Q4 and full-year guidance.
For the fourth quarter, Pandora forecast revenues to be between $120-$123 million, and for non-GAAP EPS to be between a loss of $0.06-$0.09. Guidance for all of fiscal 2013 was also adjusted. For the full-year, Pandora is calling for revenues to be between $422-$425 million, and for non-GAAP EPS to be between a loss of $0.09-$0.12. Fiscal 2013 guidance was lowered from Pandora's old guidance of $425-$432 million in revenues, and a non-GAAP EPS range of a loss between $0.04-$0.08. At the midpoint of these guidance ranges, Pandora trimmed its revenue forecast by $5 million, and widened its loss estimates by 5 cents. The issue, however, is that analysts had expected Q4 revenue of $130 million, and a non-GAAP profit of 2 cents per share
On its call, Pandora argued that its guidance was cut due to caution surrounding the fiscal cliff. Pandora's Q4 includes January (along with November and December), a seasonally slow month for the company, and the uncertainty stemming from the fiscal cliff has clouded Pandora's ability to forecast its results for the month. Analysts pressed the company regarding this issue, and what it is seeing from its advertisers. CFO Steve Cakebread stated that guidance was cut because,
"What we've really experienced over the past couple of months is increasing caution from advertisers about macroeconomic concern, the fiscal cliff particularly in January. And that really is the difference between what we know now and what we knew three months ago when we last gave guidance. The visibility of January is never particularly good and the cautiousness surrounding January at this point further deteriorates the visibility and drives us to a more cautious position. As you suggest, November and December are seasonally strong months and we certainly expect a good November and December, but are very cautious about January at this point."
The possibility that Pandora is being overly cautious was also raised by analysts, and CEO Joe Kennedy stated that it is impossible to know how much will be "added back" to January's results should the fiscal cliff be resolved before then. He stated that,
"The first part of your [Jordan Rohan from Stifel Nicolaus] question about if fiscal cliff is resolved how much we add back, that's really unknowable at this point. And I think it's obviously a function, just of not whether it's resolved but when it's resolved. The nature of media planning is such that we'd like to see media planning with respect to January going on now and the natural tendency of advertisers is to wait. So, I think if it's resolved then it's resolved soon then some money could flow back in to January. I think there is some risk that most marketers work off of calendar year quarter spending budgets and there is a natural tendency in the current environment to take the money budgeted for Q1 and to say, hey, I'm going to think mostly about spending that in February and March as opposed to spending it in January. And even in this scenario of a resolution of the fiscal cliff, it could be that Q1 spending is more weighted on February and March than it is even typically the case. So, difficult for us to know at this point and hence the caution that you're seeing from us."
In a "normal" environment, Pandora would be seeing advertisers plan their spending for January right now, and it seems that it is not happening. And as the fiscal cliff remains unresolved, the risk that January spending is pushed out becomes greater and greater. It is possible that ad spending could be pushed into February and March (Pandora's fiscal Q1), at the expense of January, and that is the core reason why Pandora is giving cautious guidance. We will need to hear more color regarding this issue when Pandora reports its Q4 and fiscal 2013 results (likely sometime in early March 2013), as well as gives guidance for Q1 2014 and fiscal 2014.
In our view, Pandora's guidance is reflecting the uncertainty that many companies are facing, rather than a deterioration of its core business. We believe that Pandora's long-term potential is fully intact. The company is monetizing mobile, improving its margins, and is working hard to bring content costs under control. Critics will argue that all of this is moot, given that Pandora will be crushed by an army of competitors. The data, however, tells a different story.
Competition And the Looming Presence of Apple: Pandora's Box of Tricks Is Not Yet Empty
Competition concerns have surrounded Pandora since it went public. And yet, the company's user and share data has shown that competition is not an issue. Pandora released its November listener and share data alongside its Q3 2013 results, and the company showed yet another month of market growth. Total listening hours grew by 58% to 1.27 billion in November, and active users grew by 45% to 62.4 million. Perhaps more importantly, Pandora's share of total radio listening in the United States grew to 7.09% in November, up from 4.32% in November 2011 (and from 6.55% in October 2012). Pandora is continuing to gain share, and the company has established itself as the leading Internet music company. On the call, CEO Joe Kennedy brought up this data to show that the company is keeping competitors at bay, stating that,
"We haven't seen evidence of Spotify or any other player affecting the growth that we're seeing. There is some natural moderation in the percentage growth rate, that's law of large numbers. But in absolute terms the amount of growth that we continue to see is extraordinary and I think continues to support the hypothesis that services such as Spotify are fundamentally complementary to Pandora just as Rhapsody, iTunes, etcetera have been for the 7.5 years since we first launched Pandora."
Pandora offers a fundamentally different approach to music than services such as iTunes or Rhapsody. While it is true that percentage growth rates are falling (for example, active users grew by 45% in November 2012, versus 47% in October), Pandora is still growing across all fronts, and is taking market share. Critics argue, however, that none of this matters once Apple (NASDAQ:AAPL) enters the fray. In their eyes, Pandora has no chance of competing with a company that has virtually unlimited financial firepower to create a music service. A deeper analysis of the issue, however, shows that Pandora's position is not as weak as it appears to be. Our last article on Pandora examined the potential threat posed by Apple in extensive detail, and while we will not repeat every issue we addressed in that article, we believe that Pandora has several things supporting it in a potential fight against Apple, including a large and growing non-iOS user base and an expanding ecosystem of devices that integrate Pandora (such as cars and home entertainment systems). Furthermore, Apple's goals of creating a music service cannot be realized without the cooperation of music labels. And according to CNET, Apple's terms for its music service have received a frosty reception at all of the major labels. CNET's sources add that a deal is nowhere near being done. It will be some time before any Apple music service (perhaps it will be called iStream, iRadio, or iMusic) will be launched.
A Potential Strengthening of the Pandora-Musician Relationship
On its conference call, CEO Joe Kennedy cited the strength and potential of Pandora's user data, and gave a solid example of how this data can be used to help artists. In a response to Barrington analyst Jeff Houston, who asked about new ways of monetizing data, CEO Joe Kennedy stated that,
"We have begun to share some data with artists. There's a great story of I think with the lead singer of All-American Rejects came through sometime roughly a year ago and we shared the data in terms of the geography where that band has fans based on the Pandora data that we have. And it highlighted for them that they had an awful lot of fans in Salt Lake City but they had actually never performed in Utah, which they went ahead and did this past year. They were back here about a month ago and talked about how they had sold out performances of tremendously enthusiastic fans in the Salt Lake concert. So that was a pretty gratifying example of the power of our data. We don't really see that data, you expressed the question in terms of monetization, I think relative to the revenue opportunities that we see, we have the opportunity to sell into $15 billion, $16 billion radio ad market on mobile advertising market that's projected to be comparable in size in four or five years. We don't see the data opportunity within the music industry as even close to that. I mean it's many order of magnitudes less than that. So I think it's fundamentally about us participating in and contributing to the development of the artists on our platform but I don't really see it as material from an economic standpoint."
Sharing data with musicians is not about profiting off of it. Rather, it is about expanding the relationship between musicians and Pandora, and showing musicians that Pandora is a useful tool for them to connect and engage with fans in a more meaningful way, thereby increasing the power and reach of their music. And when musicians prosper, so does Pandora. It is a symbiotic relationship, one where Pandora needs musicians to agree to have their songs played on Pandora, and where Pandora shares with musicians detailed data about where their fans are and how they can better engage and connect with their fan base.
As of this writing, Pandora has fallen below $8 on the back of its weak guidance. But, we think that this selloff is overdone. Pandora's business has not deteriorated by almost 20% over the past several days, and we believe that the long-term trajectory of this company is intact. For investors who wish to add to or initiate positions in Pandora, this drop is a long-term buying opportunity. Pandora is continuing to grow its revenues on all fronts, and is making solid progress in monetizing its mobile users. Content costs are slowly but surely being brought under control. Pandora's operating margins shows that its progress in monetizing mobile is leading to tangible results, and the company continues to hold other music services at bay. We believe that Pandora's best days are ahead of it, and that investors who keep their faith with the company will, in the long run, be rewarded for their conviction.
Additional disclosure: We are long shares of AAPL.