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Company Background

Pandora Media (NYSE:P) has been the dominant player in the Internet music streaming space since introducing the Pandora Radio service back in July 2005. According to the company, its share of the Internet Radio market stood at 74.9% as of April 2013 and the number of active listeners now total 70.1 million. Pandora was among the companies who pioneered the concept of streaming music to users over the Internet based on the users' artist or song preference and their feedback on computer generated recommendations. Most Pandora users opt for the free music streaming service which is supported by audio or visual ads, while approximately 2.5 million users pay an annual subscription fee of $36 per year for unlimited streaming without ads, along with upgrades in features.

Threats From Intensifying Competition

The Internet music streaming space is crowded with competition. Wikipedia lists 30-plus companies offering similar or competing services to Pandora, not including indirect competition from the more traditional online digital media stores such as iTunes Store, Google Play, and Amazon MP3 Store as well as other services like TuneIn Radio that offers streaming live broadcast radios. Spotify and TuneIn have become more formidable challengers to Pandora over the past few years and their growth in recent month have accelerated. On a combined basis, Spotify and TuneIn are comparable to Pandora with 64 million+ active listeners and more than 6 million paying subscribers. They also offer unique features that differentiate their offerings from Pandora including unlimited free mobile streaming (Pandora limits free mobile streaming to 40 hours per month), offline mode for downloaded songs, recording of broadcast radio shows, and live broadcast of musical events.

The biggest threats facing Pandora might be coming from the just launched Google Music All Access and the rumored imminent launch of Apple's iRadio. The new Google streaming music service is competitively priced at $9.99 per month for unlimited music streaming without ads. Compared to Pandora that has no music catalog of its own, Google's music library contains millions of songs. Users can listen to music online or download for offline playback and can even skip music without restrictions. Another distinctive feature is the ability to play the user's own music collection of up to 20,000 songs. Early reviews from tech news sites Lifehacker and The Verge have been positive and suggest that the new Google service is a viable alternative to Spotify or Pandora.

Apple has reportedly reached a deal with Universal Music and Warner Music, two of the world's biggest music labels, to include their music in the rumored soon-to-be-unveiled iRadio music streaming service. Despite a lack of details from Apple, many in the media believe the new iRadio would closely resemble that from Pandora, a free music streaming service supported by ads. There are also reports that Apple is ramping up its new iAd network in preparation to handling advertising sales at iRadio. If the rumors are proven to be correct, the new iRadio would very likely step up the competitive pressure on Pandora by another notch in slowing down the growth of active users, at the least, if not resulting in outright taking away market share and directing the advertiser dollars away from Pandora.

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Inability to Effectively Monetize Advertising on Increased Mobile Usage

Slower growth or declining active user base due to increased competition could further delay the time when the company can attain sustained profitability.

After achieving double digit quarter-over-quarter growth in active users and listener hours during FY2011 and FY2012, growth in these two metrics since FY2013 have tapered off into single digit growth rates. Revenue growth also has bucked the robust growth trends in recent years and flat-lined during FY4Q13 - FY1Q14 at around $125 million. This resulted in the company swinging from a small profit of $2 million in FY3Q13 to post a loss of $28.4 million in FY1Q14 due to content acquisition costs rising 26% to $82.9 million and sales and marketing expenses soaring 50% to $40.1 million. The Copyright Royalty Board sets the royalty rates that Pandora pays for streaming music. The current rate for performance of $0.13 in 2013 is slated to increased to $0.14 in 2014 and $0.15 in 2015. Therefore, Pandora has to contend with this variable cost structure which makes it difficult to scale at least through 2015.

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(Source: Pandora)

Pandora derives most of its revenue from advertising (84%) while its Pandora One subscription service has been slow in taking off until very recently. Over the past few years, number of listener hours of mobile device has grown substantially and now surpassed the number of listener hours on traditional computers. In fact, listener hours on mobile device and connected devices accounted for 77% of total listener hours by FY2013. In terms of the cost of providing the streaming music content, royalty fees on mobile listener hours and traditional computers are calculated on the same basis. However, the advertising revenue that could be generated from mobile streaming is 45% less than that from a traditional computer.

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(Source: Pandora)

As the company disclosed in its FY2013 10K, the biggest challenge has been the company's inability to monetize the shift to mobile listening of its user base and inability to penetrate local ad markets:

While we have generated revenue from our advertising products at a rate that exceeds the growth in listener hours in certain fiscal years for traditional computers and for the fiscal year ending January 31, 2013 for mobile and other connected devices, to date we have not been able to grow our total advertising revenue at a rate that exceeds the growth in our listener hours. Part of the challenge that we face in increasing sales to monetize inventory generated by mobile devices is that radio advertising has traditionally attracted primarily local advertisers and we are still at an early stage of building our sales capability and penetrating local advertising markets. In addition, to the extent that our listener base on mobile platforms may skew to different demographics than we have historically sold on our traditional computer platform, we must identify such demographics and convince advertisers of the capabilities of mobile advertising to maximize advertising inventory utilization across our multi-platform ad campaigns.

Therefore, there is legitimate concern over whether and how quickly Pandora is able to generate revenue from its advertising products delivered to mobile and other connected devices as effectively as it has for advertising products served on traditional computers. Google's entry at this time and possibly Apple's new iRadio in the near future will further aggravate this situation in competing for advertising dollars.

Valuation

Currently, Wall Street analysts as a group are still relatively optimistic for continued robust revenue growth at Pandora; the company is forecast to grow revenue in the next two fiscal years by an average of 40% per year. Analysts also expect Pandora to earn $0.04 per share in FY2014 and $0.27 per share in FY2015. On a trailing twelve month basis, the company's current market cap is trading at 6.2 times of sales which is at the high end of its recent two year range. Given the expectation that intensifying competition would slow down active user and revenue growth, continued increase in royalty rates and marketing expenses, and the company's continuing difficulty monetizing mobile usage, I expect the company to post FY2014 revenue of around $600 million, slightly below the low end of the company's FY2014 guidance and valuation multiple to contract to 4.0 - 4.5 times of trailing sales. This implies that the 9 - 12 month price target of Pandora's will be in a range between $13.3 - $15.0 per share ($2.4 billion - $2.7 billion) based on 180 million shares outstanding.

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Source: Avoid Pandora At Current Level Amid Growing Competition From Google, Maybe Even Apple