Pandora Preps For Battle

Sep.16.13 | About: Pandora Media (P)

By RJ Towner

Internet radio giant Pandora (NYSE:P) posted solid second-quarter results. Revenue rose 57% year-over-year to $157 million, slightly above consensus estimates. Earnings-per-share on a non-GAAP basis was much higher than the prior year at $0.04, which was also much better than consensus expectations. Free cash flow during the quarter was a negative $8.5 million as the firm continues to invest heavily in future growth.

Goodbye Hours-Cap

Perhaps the most important development during the quarter was that Pandora will remove its 40-hour cap on mobile listening effective September 1. After re-implementing the hours-cap in February, total listening hours declined 7% sequentially (but were still up 18% year-over-year though) to 3.88 billion. Pandora had no choice, in our view, but to switch to a free model. Stiff competition from the unlimited listening service Spotify hurts, but more importantly, Apple's iTunes Radio (NASDAQ:AAPL) is set to be released shortly. Sources report iTunes Radio already has a strong lineup of advertisers, and the enormous built-in user base could be a powerful headwind for Pandora. Mobile revenue surged 92% year-over-year to $116 million during the second quarter, but iTunes Radio will likely impair the rate of expansion.

Aside from having a more difficult time wining ears, Pandora's subscriber growth is likely to slow under the new arrangement. Consumers will no longer be capped at 40 hours and be coerced into subscribing when that limit is reached. The combination of an hours-cap and competing service for iPhone/iPad users will turn Pandora into almost exclusively an advertising business.

Betting on Advertising

Unfortunately for Pandora and its shareholders, margins on an advertising-driven model aren't as strong as margins on a subscription-based model. CFO Mike Herring detailed this problem, saying on the conference call:

So, it is true that the local sales dollars are more expensive to acquire and it takes more investment both in people and in time. And so in general on a per-sales rep basis, you overall would have lower quotas and achieve a lower total dollars than a national sales rep, but because of the CPM difference that we talked about earlier, where their local CPM is going to be 3 or 4 times that of a national account, the leverage that comes from pricing more than makes up for the cost of sales increase on that revenue. So, when we talk about moving that revenue, that RPM up driving that RPM higher with higher CPMs coming from a local sale is actually more accretive to sort of a bottom line than driving that RPM through selling more national revenue.

Apple can easily afford to spend money to drive local advertising dollars, and we also think iTunes Radio will benefit from the Apple halo. Businesses may want to access the iTunes Radio format over Pandora because it would associate their brands with Apple-one of the most valuable brands in the world.

Looking Ahead

Not all is dire at Pandora. Revenue growth was fantastic, the firm now owns 7.1% of the radio-listening market, and the company continues to focus on integrating its products in cars like satellite-radio competitor Sirius XM (NASDAQ:SIRI). Sirius has proven that easy integration can drive product adoption and revenue growth.

Going forward, Pandora expects third-quarter non-GAAP revenue of $174-$179 million driving non-GAAP earnings per share of $0.03-$0.06. For the full-year, Pandora anticipates generating non-GAAP revenue of $640-$655 million driving non-GAAP earnings per share of $0.00-$0.05. Both figures represent a substantial improvement over fiscal year 2013.

Valuentum's Take

With new competitive pressures on the horizon and the firm focusing on a lower-margin business model, it is hard for us to get excited about Pandora at this time. We have no plans to add the name to the portfolio of our Best Ideas Newsletter.

Disclosure: I am long AAPL. 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.

Additional disclosure: RJ Towner is Director of Research Development at Valuentum. AAPL is included in our actively-managed portfolios.