What Does Goldman See In Pandora?

Aug.21.13 | About: Pandora Media (P)

Pandora Media (NYSE:P) has just received a resounding ratings upgrade from Goldman Sachs, which has raised its rating from Neutral to Buy with a one-year target price of $27, compared to the previous target price of $18. The timing of the upgrade appears to be delayed, but there is no doubt that prices are taking off as a result -- even though there is still some skepticism among some investors about the stock. The main reason behind the upgrade seems to be the gain in mobile advertising.

Though some concern was expressed about the competition, Goldman used the phrase "underappreciated" to describe the company's substantial customer base. The firm also expects to see revenues grow faster than expenses, a weak point in the past when it appeared to investors that increasing revenues were being nullified by rising royalty payments. The previous high in terms of the target price on Wall Street was $24 and the consensus estimate was only $20.32, which makes Goldman easily the most optimistic about the stock among all the Wall Street analysts.

It is difficult to analyze the reasons for this optimism when you consider that the consensus EPS estimate for this year is $0.04 per share on consensus revenues of around $633 million. The numbers for next year are $0.30 per share on revenues of approximately $867 million. The earnings multiple appears to be high, but Pandora could, of course, justify the multiple with performance that comes in ahead of expectations. The shares hit a high of $21.50 before closing 5.8% up at $21, and the only time prices reached these levels was just after its IPO in June 2011.

Growth in Advertising

As Heath Terry of Goldman points out, the "revenue per thousand listener hours" (RPM) -- which is the revenue that it generates on free listening of tracks supported by advertising -- has reflected accelerating growth for the last three consecutive quarters in a row. Mobile advertising RPMs are now touching 50% of the RPMs from desktop advertising, and it should be remembered that mobile advertising is typically about 33% of desktop advertising. The difference is not due to pricing, and it is likely that as advertisers become more familiar with the benefits of mobile advertising and Pandora's expanded sales force begins to deliver, the gap will continue to shrink.

Because mobile listener hours account for roughly four-fifths of the total, this growth could lead to profitable operations on a sustainable basis. Moreover, for the first time, advertising revenue growth outpaced the expenses of content acquisition in the first quarter of this year ending in April. Increased content costs have been a problem for investors and, as these can realistically be expected to grow further, increased advertising revenues growing at a faster pace is the only route to consistently profitable growth.

What the Future Holds

Subscription revenues have also shown accelerated growth for the last three consecutive quarters, helped by more aggressive marketing and the ability for subscribers to upgrade on iTunes and Google Play. As a result of all this, Terry now expects an EPS of $0.06 per share on revenues of $158.8 million against the consensus of $0.03 per share and revenues of $156 million, respectively. For fiscal 2014, he now projects an EPS of $0.20 per share on revenues of $635 million compared to the consensus estimate of $0.04 per share and $633 million, respectively. He now believes that the adverse news that had earlier depressed stock prices is now behind us, and that most of the major investment risks have been eliminated.

The Bottom Line

It is important to remember that in the music streaming business many recording artists believe that they do not receive sufficient royalties, without appreciating that there is a difference between streaming and downloading. One million streams is not exactly the same as one million downloads. Companies like Pandora say that they are not selling ownership of the music and that streaming is actually in the long-term interest of recording artists. If you believe that Pandora can sustain its recent performance and that Goldman's bullishness is justified, by all means go out and buy the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.