You Can't Close Pandora's Box Now

| About: Pandora Media (P)

Despite a strong 15% after-market surge after a strong quarter, Pandora (NYSE:P) stock erased its entire gain and then some Friday to close down over 4%.

Opportunity beckons as now is the perfect opportunity to pick up a core internet property at a 20% discount to where it was before traders oversold the stock on failed momentum. Pandora has just crossed the chasm from popular Internet radio website to legitimate Internet business with huge monetization and leverage ahead. Pandora is one of the few Internet 2.0 businesses that: (1) has a dominant position with 70-75% share of the $16 billion Internet radio market and (2) is a net beneficiary of the move to mobile media consumption. Thank the momentum hedge fund traders for the opportunity to pick up Pandora 4% lower before they reported what leading Internet sell-side analyst Mark Mahaney labeled an "inflection point quarter" in upgrading the stock to buy. Consensus adjusted EBITDA estimates increased anywhere from 50% to in some cases over 100% for the out fiscal years.


Pandora is the leader in Internet radio, providing customizable stations and playlists to listeners. The basic service allows a listener to customize up to 100 personalized "stations" based on artist or type of music/comedy preferences. Pandora creates the customized stations through its Music Genome Project database and playlist generating algorithms. Pandora is currently available on 1,000 devices including all iOS, Blackberry, and Android devices and pre-installed in an ever increasing number of automobiles. Pandora derives the vast majority of its revenue from advertising (87-88%) while the remainder comes from subscriptions (12-13%). However, subscriptions broke out to 18% of revenue this past quarter on important changes instituted just a couple months ago.

In the U.S. Pandora has 200 million plus registered users of which only 2.5 million are Pandora One subscribers. Pandora One is their premium service whereby listeners pay $3.99 per month or $36 annually for no listening cap, much improved audio quality, ad free, and fewer interruptions. The other option for listeners is to pay a $0.99 fee for the right to continue listening for the remainder of the month.

Listening Cap Translates Into Paying Subscribers- Win Win

Four years ago, Pandora adopted a 40 hour monthly listening cap for desktop users but reversed course September 2011 increasing the listening hurdle to 320 hours which hardly anyone surpasses. This past March they "re-instituted" the 40 hour cap only for mobile users. Less than 4% of monthly active listeners reach the monthly limit, with an average of 20 hours per month per user across all devices. The result of the monthly mobile cap? Not even in one full quarter, Pandora added 700k net new subscribers to its premium account package, more than all of last year combined. (Note listeners who paid the $0.99 fee were not included in the net subscriber number.)

Assuming these listeners don't opt for Spotify or Google (NASDAQ:GOOG) Music rather just moderate their Pandora listening, Pandora incurs less costs as they pay license fees per listening hour. In fact active users increased 35% year over year, only a slight deceleration versus the seasonally strong 38% y/y in the January quarter. Total listening hours also increased 35% y/y to 4.2 billion hours despite the cap. Back of the envelope math suggests that roughly 3.8 million users reach the monthly cap on average, thus there are 3.1 million users who will have a choice to make over the coming months to stop listening or upgrade to Pandora One.

The major impediment to the business model is Pandora's high fixed cost licensing structure. Pandora currently pays royalties to SoundExchange pursuant to the Digital Milliennium Copyright Act of 1998 that increases through 2015. Over the last three years, per track royalty rates have increased 25% and they are expected to increase an additional 9% in 2013 and 16% the following two years according to management. Pandora benefits additionally from the premium subscription as high usage listeners opt to stop streaming music in a given month when they reach the 40 hour limit. The monthly caps have helped offset these increasing costs. Content acquisition costs declined 400 bps year over year to 64% of revenue, sharply reversing a negative trend. In 2015, Pandora expects to participate in royalty negotiations for the first time, which will hopefully lead to a less onerous schedule.

CRB Rate

Pureplay Rate(non-sub)*

Pureplay Rate(sub)


*The rate applicable to our non-subscription service is the greater of the per performance rates set forth in this column or 25% of our U.S. gross revenue.

Advertising Opportunity

Pandora accounts for 8% of all U.S. radio listener hours yet only 2.5% of total radio advertising spend. Advertising revenue accounted for 88% of total last fiscal year. Pandora employs three types of advertising- display, audio, and video ads. Audio ads have seen the greatest growth rate recently according to management as they benefit the most from mobile penetration due to their natural fit. Mobile listening hours represented 77% of total last fiscal year up from 69% and 54% the previous two fiscal years, respectively. Mobile advertising RPM increased 30% to $23.23, marking the third consecutive quarter of accelerating year over year growth. Computer advertising RPM increased 4% to $48.16, while modest it was the first y/y growth in over a year and it also accelerated for the third straight quarter. Monetization continues on a strong upward path both on desktop and mobile. Part of the improvement in monetization stems from Pandora's integration with leading media buying platforms- STRATA and Mediaocean. The STRATA integration began its rollout in February of this year while Mediaocean started in April. The benefits of the tie in's with the media buying platforms are in the early stages and will accelerate as systems and salespeople become increasingly integrated.

Local Advertising is a MASSIVE opportunity

The primary advertisers on radio are local merchants advertising their wares and services. As users can access Internet radio via more than their car, the local advertising market seems a very bountiful area for Pandora to harvest. BIA/Kelsey forecasted a seven fold rise in mobile local media by 2017 to $9.1 billion from 1.2 billion in 2012, a nearly 50% compound annual growth rate. Pandora has addressed the opportunity by directly targeting 28 of the top local markets with 72 direct salespeople. In addition, they are targeting their first 50 local markets (additional 22) with inside tele-salespeople and by expanding the scope of nearby salespeople. Interestingly, Pandora front-end loaded their salesforce investment this fiscal year so they should see some leverage over the next three quarters in this area after growing the sales and marking expense line by 61% and 72% y/y, respectively. According to CFO Michael Herring,

The majority of our sales person investment for the fiscal year is in place. I mean we still add people where we think the right investment is possible as investment dollars become available. But the big push to get people in market was over the last two quarters.

Compelling Risk/Reward for Stock

As the company transitions its business to a more subscription heavy business model to balance the strong advertising contribution, it should accelerate growth while increasing predictability. Controls seem to be in place to limit expenses while the local ad market revenue and mobile monetization tailwinds seem to be hitting stride. If Pandora were a private company, the valuation would have probably increased 25% after a quarter like this one but in the world of hedge funds with monthly performance hurdles, traders lock in profits and move on in trades when their returns are reached. To get a company like Pandora marked down 20% from after hours prices after crossing a chasm from great Internet property to viable business model seems like too rich an opportunity to turn down. Pandora continues to grow revenue well north of 50%+ annually and looks poised for continued re-acceleration. In terms of valuation, the stock trades at 42x CY'14 and 20x CY'15 EV/EBITDA consensus numbers that are likely way too conservative given they model fairly sharp decelerating top line growth when all evidence indicates a re-acceleration given the arguments outlined above. After this quarter alone sell-side analysts ratcheted their EBITDA estimates up enormously. Five top analysts who cover Pandora increased their EBITDA estimates 109% and 58% for FY'14 and FY'15, respectively (see table below for specifics).

Adjusted EBITDA
Firm FY'14 --> FY'14 % increase FY'15---> FY'15 % increase
William Blair $ 5.1 $ 12.1 137% $ 21.3 $ 51.3 141%
GS $ 7.7 $ 11.6 51% $ 14.3 $ 23.1 62%
MS $ 17.0 $ 19.6 15% $ 71.0 $ 67.6 -5%
RBC $ 5.0 $ 20.6 312% $ 42.2 $ 72.8 73%
Pacific Crest $ 17.1 $ 21.9 28% $ 79.8 $ 94.6 19%
AVERAGE 109% 58%

In addition, costs are being contained finally while the big catalyst would be a positive reworking of the royalty agreement when it comes up for renewal in 2015. A near-term catalyst would be the announcement of a bonafide CEO to lead the company forward. If Pandora continues to slow cost growth and ramp local advertising and subscriptions, we will look back a couple years hence and realize the stock was probably trading at 15x CY'14 EBITDA. Pandora is likely to continue a strong stretch of beat and raise quarters on both the top and bottom line as Street numbers remain way too conservative still.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in P over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.