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Pandora Media Inc (NYSE:P)

F3Q 2014 Earnings Call

November 21, 2013, 5:00 pm ET

Executives

Dominic Paschel - Vice President of Corporate Finance and Investor Relations

Brian McAndrews - Chairman of the Board, President, Chief Executive Officer

Mike Herring - Chief Financial Officer, Executive Vice President

Analysts

Peter Stabler - Wells Fargo Securities

Heath Terry - Goldman Sachs

Doug Anmuth - JPMorgan

Jordan Rohan - Stifel Nicolaus

Ralph Schackart - William Blair

John Egbert - Morgan Stanley

James Marsh - Piper Jaffray

Mark Mahaney - RBC

John Blackledge - Cowen & Company

Laura Martin - Needham Capital

Corey Barrett - Pacific Crest Securities

Jim Goss - Barrington Research

Sameet Sinha - B. Riley

Rob Sanderson - MKM Partners

Brian Nowak - Susquehanna

Operator

Welcome to Pandora's third quarter and fiscal 2014 financial results conference call. All lines have been placed on mute. There will be a question-and-answer session at the end of the conference. (Operator Instructions).

Opening today's call is Dominic Paschel, Vice President, Pandora.

Dominic Paschel

Thanks, Angela. Good afternoon, and welcome to Pandora's third quarter fiscal year 2014 financial results call for the quarter ended October 31, 2013. Some of our discussions will contain forward-looking statements which may include projected financial results or operating metrics, business strategies, anticipated future products or services, anticipated market demand or opportunities and other forward-looking topics.

These statements are subject to risks, uncertainties and assumptions. Accordingly, actual results could differ from today's discussion, please refer to the documents we filed with the Securities and Exchange Commission.

Also, I would like to remind you that during the course of this conference call, we will discuss non-GAAP measures of our performance. Reconciliations to the most direct comparable GAAP financial measures are provided in the tables in the press release and Form 8-K filed earlier this afternoon with the SEC.

For your convenience, supplemental information has been included in today's press release and detailed financials are available on the Investor Relation site. Today's call is available via webcast and a replay will be available for two weeks following the conclusion of the call. To access the press release, supplemental financial information or the webcast replay, please consult the IR section of pandora.com.

With that, let me turn the call over to Brian McAndrews, Pandora's Chairman, CEO and President.

Brian McAndrews

Thanks, Dom, and thank you all for being on the call today. I am very excited to be part of the Pandora team and before I discuss our third quarter results, I would like to share some of my early impression.

I learned in my few years working in the venture capital world that the most important attributes of evaluating a company are the size of the opportunity, the competitive differentiation of the products and the quality of the team. In evaluating Pandora as an opportunity for myself, I prioritized those three attributes. The size of the opportunity for Pandora is enormous as it has been able to tap into a $20 billion plus digital advertising market as well as more recently take part in the $15 billion U.S. radio business with the added benefit of personalization and targeting.

With regards the products, the quality of differentiation are extremely high. Beginning with Tim's vision of the Music Genome Project in 1999 and relaunch of the Pandora in 2005, the company's offering includes million tracks from more than 100,000 artists and has resulted in over 600 billion songs played, more than 5 billion stations created, over 35 billion thumbs up and down registered and now more than 50 algorithms to build on the Music Genome Project to continually enhance the listener experience. And people are listening on over 1,000 consumer electronics devices and in over 100 cars. One of the most gratifying aspect to joining the company has been to hear my friends and colleagues from past lives tell me how much they love Pandora.

It takes a great team to create a great product and to build rapidly growing business around it and the team of Pandora has done just that. From my time with Tim and Mike and other members of management, I have quickly come to understand the passion the people here bring to their job and the strength of the culture that's help to attract and retain great talent, despite some very challenging times the company has endured. A big opportunity, a great product and a talented team. I am fortunate to have the opportunity to be the CEO of Pandora.

As I look forward, my first goal is to continue Pandora's strong momentum. The company is executing very well on many fronts as evidenced by the developments and results we will discuss today.

The Pandora story redefining radio for a connected world is a phenomenal growth story. Pandora has grown active users and listening hours to develop critical mass and become the number one station in 12 of the top 15 local radio ad markets in the U.S.

Pandora recently integrated into broadcast radio ad buying workflow to help us begin to capture our share of the radio ad market. Advertisers are following consumers and increasing their mobile activity and as a result mobile RPM continue to increase.

Pandora offers a wonderful opportunity with significant growth potential. Our primary areas of focus include continuing growth of listening, further strengthening our monetization and managing the cost of content.

A great deal of radio of my time and energy will be spent working with the team to further develop strategies and tactics in these areas. I also want to ensure that the company scales appropriately in all its efforts to continue its evolution from a scrappy startup to a mature company in what has always been a highly competitive environment.

We are fortunate that we have very strong track record and a high quality team, enhanced resources and a strong vision for the future.

Now, I would like to discuss our most recent results. For Q3 of fiscal '14, we experienced continued strong monetization across the board, demonstrated by record advertising and subscription revenue as well as record RPMs and increased operating leverage.

I will take you through some of our financial highlights and operating activities and then turn the call over to Mike, who will walk you through the financial details.

Non-GAAP total revenue reached the record high of $181.6 million, an increase of 50% over $120.8 million in the same period last year. Our non-GAAP Gross margin reached a record high of 45% as we continue to increase revenue while maintaining content acquisition cost.

Cost of content as a percent of non-GAAP revenue decreased from 54% in the third quarter last year to 48% this year. Mobile ad revenue exceeded $100 million for the first time, growing 58% year-over-year to $104.9 million. In this category, Pandora is the third largest player in the world, behind only Google and Facebook.

Moving to non-financial metrics, total listener hours grew to 4.18 billion for the quarter, up 17% compared to a year ago. Within the quarter, listener hours increased sequentially from 1.36 billion September 1.47 billion in October, an increase of 9%. This performance highlights the resilience of our business and our strong loyalty among listeners despite the very high profile launch of Apple iTunes Radio on September 18th.

On a year-over-year basis, October active listeners increased 20% to 70.9 million. This represented a slight decline in active listeners on a monthly sequential basis, decreasing 2.6% from September. We attribute this decline to Pandora's most casual and we engaged listeners experimenting with other services, most likely iTunes Radio.

Our week-to-week analysis suggest the modest declines were largely confined in the first few weeks after iTunes Radio launched. Since then, we have seen active listeners stabilize and begin to return to growth at the end of October.

According to our estimate, which includes third-party data, Pandora share of total U.S. radio listening in October 2013 was 8.06%, an increase from 6.61% at the same time last year. On a sequential basis, market share increased 29 basis points from 7.77% in September. Overall, we are very pleased with our financial and key metrics performance in Q3.

Now, I would like to speak briefly about our product initiatives. We continue to invest in our product and delight our listeners and provide personalized radio everywhere they want to access.

During the quarter, we extended our mobile leadership by releasing Pandora 5.0 for iPad, the biggest redesign for iPad tablet app since launching on the platform when this device was first introduced in April 2010. We optimized the Pandora experience to the larger iPad screen, offering listeners an ideal environment for personalization, discovery, exploration and sharing.

We also debuted a new version of our app, designed specifically for the android tablet platform, which brings the entire experience to design and feature parity with all IOS devices.

Tablet category continues to demonstrate strong growth and momentum and Pandora now natively supports hundreds of different android tablets. We continue our innovation beyond the mobile and tablet opportunity towards the Internet of all things including TV connected devices. During the quarter Pandora was one two launch partners along with Netflix to become available on Google Chromecast, Google's new TV connected device, that wirelessly delivers online audio and video entertainment to the television. Pandora is now available to owners of the Chromecast device through an update to our Android and iOS mobile app which now include a Cast button for simple one touch streaming to the TV.

More than one third of radio listening takes place in the home and we are continually innovating and investing in new platforms that help us seamlessly deliver access to Pandora across a broad range of connected devices. We also continue to provide marketers and advertisers with advanced targeting capability to reach their select audiences. As the advertising world moves toward reducing reliance on cookies, Pandora has a significant edge with its first person registered user data. Leveraging data that users have explicitly provided Pandora combined with our sophisticated analysis of listening and usage behavior, we were able to establish a more accurate understanding of our listeners. This results in the creation of highly targeted proprietary audience segments which offer a more effective solution for advertisers. After finding early success through targeting of Hispanic listeners, we are scaling across multiple market segments in the coming weeks and months. We believe making advertising more relevant for users ultimately leads to a better user experience and is a win-win for both parties.

In summary, we are very pleased with our financial performance and our product innovation progress in Q3, and now I would like to turn the call over to Mike Herring, our Chief Financial Officer for more detail.

Mike Herring

Thank you, Brian. I will walk you through our third quarter financials, discuss our business strategy and finish with some thoughts regarding guidance for the remainder of the year.

Starting with revenue. We ended the third quarter with record total non-GAAP revenue of $181.6 million, representing 50% growth from the year ago quarter, above the high-end of our guidance range. GAAP total revenue was $180.4 million for the quarter.

As a reminder, Pandora presented a temporary non-GAAP adjustment to reflect management's estimate on subscription returns in order to better illustrate the period's activity. Because we have had limited operating history with in app subscription returns, we are required to reserve 100% of the revenue associated with the subscription increase until that return right expires despite all the cost associated with delivering these services, transaction and content fees being incurred in the period. As we expect to have sufficient history to estimate a reserve in January of 2014, the accumulation of these adjustments will be reversed in the first quarter of calendar 2014.

Ad revenue increased 36% year-over-year to $144.3 million, driven primarily by mobile with mobile ad revenue of $104.9 million exceeding $100 million for the first time. Mobile ad RPM reached $36, an increase of 41% from the same period last year. Non-GAAP subscription and other revenue was $37.2 million in the third quarter with a total of 3.18 million subscribers. As we noted when we removed the listening hour limit last quarter, we do not anticipate dramatic growth in net new subscribers for the remainder of the year and we expect subscription revenue to be approximately 20% of the total non-GAAP revenue for the year.

Third quarter GAAP basic and diluted loss per share was $0.01. Diluted non-GAAP earnings per share was $0.06 including approximately $12.6 million in stock based compensation and including approximately $1.2 million in revenue related to our subscription return reserve. Non-GAAP diluted EPS is $0.06 which is at the top of our guidance range, reflecting our continued investment in our growth balanced by profitability. GAAP basic and diluted EPS were based on 184.7 million weighted average shares outstanding. Non-GAAP diluted EPS was based on 208.1 million weighted average shares outstanding.

As we have mentioned before, leverage within the Pandora business model is driven by a central financial dynamic, the ability to drive RPMs in excess of LPM or licensing cost per thousand hours. LPMs are largely fixed with annual increases and thus RPMs expand, we are able to commensurately expand our gross margin. This quarter's results reflect this dynamic with non-GAAP gross margin improving approximately 600 basis points from 39% in the third quarter last year to 45% this year.

Total RPM (inaudible) and subscription revenue is a cornerstone of our future success and that is why we are so pleased with our recent performance in this area. Third quarter fiscal 2014 total RPM, based on non-GAAP revenue increased to $43.48 from $33.96 in the same period last year. This increase was driven by mobile with non-GAAP total mobile RPMs reaching $39.97 compared to $27.23, last year. Total web RPM based on non-GAAP revenue also increased to $57.44 this quarter from $56.50 in the third quarter of fiscal 2013.

LPMs for the quarter increased to $20.83 from $18.47 in the same period last year, due to the annual increase in the licensing rate that went into effect in January 2013, and a higher mix of subscription hours we are announcing.

However, monetization outpaced this increase and thus content acquisition cost decreased to 48% of non-GAAP revenue for the third quarter this year, down from 51% last quarter and 54% in the third quarter of last year.

The continued strong growth in our advertising revenue has allowed us to cover royalty costs with dollars left over to invest back into the business. Our investment this quarter only begins to address the huge opportunity in the future of connected device. We will continue to make investments in our product to provide our users with the best personalized radio experience in whatever context they want to listen. We will also continue to invest in sales and sales support within this quarter.

We have made significant progress disrupting the traditional radio market in a very short period of time, so we are just getting started. We know the model works and that demonstrate that we can drive significant leverage. Given our substantial market opportunity, our [revenue] and market share growth over profitability.

Turning to the balance sheet, Pandora ended the third quarter with $447.8 million in cash, cash equivalents and short-term investments compared to $68.9 million at the end of the prior quarter. We raised $379.1 million in our follow-on offering and we had positive operating cash flow during the quarter.

Cash provided by operating activities was $4.1 million for the third quarter of fiscal 2014, compared to $900,000 used in the year ago quarter of fiscal 2013. We increased headcount 57% year-over-year to 1,041 employees in the third quarter of fiscal 2014 from 652 employees in the same period last year, consistent with our staffing plans.

Overall, our non-GAAP sales and marketing expense represented 25% of non-GAAP revenue in the third quarter and increased 90% compared to the year ago quarter from $23.5 million to $44.7 as we continue to invest take advantage of the market opportunity.

If you consider commissions paid to Google and Apple over in-app subscription, was up from $1.3 million in the year ago to $6.3 million in this quarter. Our non-GAAP sales and marketing expense net of these commissions actually represented 21% of non-GAAP revenue in the third quarter, down sequentially from 22% of non-GAAP revenue net of the $5.8 million in commissions in the second quarter.

Our non-GAAP product development expense represented 3% of non-GAAP revenue in the third quarter and increased 97% compared to the year ago quarter from $3.2 million $6.3 million.

Our non-GAAP G&A expense represented 11% of non-GAAP revenue in the third quarter and increased 87% compared to the year ago quarter from $10.3 million to $19.3 million.

During the quarter, we made our historical calendar quarter financials public and going forward, we will report on a calendar year basis starting with the two-month stub period ending December 31, 2013. The purpose of this change was to align Pandora's business calendar with that of the advertising industry's normal cycle.

Now, I will wrap with thoughts regarding our guidance for the current fiscal year 2014 and the stub period of November and December of calendar year 2013. Following this quarter, we will provide quarterly and annual guidance based on the calendar year.

Starting with what would have been our fourth fiscal quarter for the three-month period ending January 31, 2014. We estimate non-GAAP total revenues in the range of $185 million to $190 million or year-over-year growth at the midpoint of 48%.

We expect non-GAAP EPS between $0.02 and $0.04. We will not be reporting on the stub, on this period going forward and thus we are providing guidance for the two-month stub period, November and December as we transition to the calendar year. For the stub period, we estimate non-GAAP total revenue to be in the range of $132 million to $136 million and non-GAAP EPS to be between $0.05 and $0.07.

The former fourth quarter fiscal 2014 and a two-month stub period, calendar 2013 non-GAAP EPS excludes revenue related to our subscription return reserve, excludes stock-based compensation expense and amortization of intangible, assumes minimal tax expense given our net operating loss position and is based on 218 million diluted shares outstanding.

For the former full fiscal year 2014 with what would have been a 12 month period ending January 2014, we estimate non-GAAP total revenues in the range of $657 million to $662 million or year-over-year growth at the midpoint of 53%. We estimate the former fiscal 2014 non-GAAP EPS to be between $0.03 and $0.05. The former fiscal 2014 non-GAAP EPS excludes revenue related to our subscription return reserve, excludes stock-based compensation expense and amortization of intangibles, assumes minimal tax expense given our net operating loss position and is based on 204 million diluted shares outstanding.

In summary, Pandora is executing well across our entire business. On the top line, we have increased ad revenue, RPMs and gross margin as a result of our intense focused on mobile monetization. As a percentage of revenue, content cost are decreasing and we continue to see operating leverage in the model. From a product development perspective, we continue to innovate and provide new and existing users the best personalized radio experience possible across multiple devices and platforms.

We continue to increase our market share of all radio listening and prosper in an evolving business environment with many competitive threat. Our intense focus on our product has created a loyal user base and a strong brand that give us confidence in our ability to lead the market in personalized radio and ultimately redefine radio for a connected world. We are excited and confident in the challenge and look forward to our future.

With that, we are ready to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Peter Stabler with Wells Fargo Securities.

Peter Stabler - Wells Fargo Securities

Hi. Good afternoon. Thanks for taking the question. Brian, I wonder if you could elaborate a little bit on the computer ad RPMs. We noticed they were a little soft of our expectations. You had regain momentum there recently and then it looks like you took a slight step back and then I have got one quick follow- Thanks.

Brian McAndrews

So, Peter, let me just address this. If you are speaking web RPMs, increasingly we don't distinguish what platform we are delivering the advertising on. It is one of the reasons why did the mobile RPM has seen such growth. So as we look at audio advertising everywhere and don't distinguish as platform delivery, we are starting to spread the revenue across our entire network and since it had previously been concentrated on the web side, it's going to bring those RPMs together. So we look at that as a kind of health in the evolution of our business rather than a commentary on the web business. And then you had a second question? No? Okay.

Operator

Your next question comes from Heath Terry with Goldman Sachs.

Heath Terry - Goldman Sachs

Great. Thanks. Brain, I was wondering if you could give us a sense of your plans for how Pandora's advertising is sold over time. Obviously you have come from a background that's had a lot of advertising technology and Pandora is generally, up to this point, been relying on largely human sales force. So to the extent that you are seeing that as an opportunity, what automation could do for Pandora from a cost to revenue perspective? Then you guys, last quarter, talked about 400% growth in local ad revenues and the relative RPMs or effective CPMs that you see in that business versus the national side? I am wondering if you could just give us a little bit on those?

Brian McAndrews

Terry, This is Brian. I will let Mike handle the second part. On the first part, I think that the company has been making forays into the technology side in terms of integration with Mediaocean and STRATA in terms of trying to find ways to work with technology to make our advertising sales and the process more efficient. So that's the one piece.

Obviously, it has been personnel heavy as well. We do see opportunities over time as the market evolves in areas like programmatic and other to make forays. I think the long-term vision is unclear. It depends on how the market evolves. We are both in the digital space and the audio space. It could evolve in different ways. But I think we clearly see opportunities to invest in technology to make our ad sales more efficient and we will continue to do that.

Mike Herring

And just to address the local opportunity, you know it's the fastest growing piece of our broadcast channel, and because it is sold at the local level, the CPMs, the prices we are seeing are naturally higher, so as we shift from a mix - percentage of inventory towards local, that's been driving our CPMs and we are seeing consistent high CPMs in that $9 to $12 range as highs as in the upper teens to 20s, depending on the local market and how sold-out and mature our ad sales function is in that local market.

Operator

Your next question comes from Doug Anmuth with JPMorgan.

Doug Anmuth - JPMorgan

Thanks for taking the questions. Just two things. First, I was hoping if you could comment on how you are thinking about Nielsen Audio as you go into 4G and what the potential is here for measurement from that number that business is under Nielsen.

Then secondly, I am curious to get your thoughts on geolocation. Actually you talked about the audience segment doing more, but curious in particular what you think about being able to do geolocation perhaps going forward. Thanks.

Brian McAndrews

Sure. I would say on geolocation. I mean I think that is an area where the market can evolve towards in a careful way. I mean, obviously there are privacy concerns and making sure that people are comfortable with that. We are in a fortunate position now where people registering, because we have tremendous amount of geographical targeting ability right now.

As the market evolves further, there is the opportunity to as you say get even more precise in geolocation. I think, we will be very well positioned do that because obviously we are consumed more and more on mobile devices, so we see as that market develops, we will be able take advantage of it and investment in that, but right now we have a pretty robust targeting capability in that area as it is.

On Nielsen, clearly we would like to be measured by Nielsen. I think Nielsen would like to measure us. They want to be measuring all things in media like this, so we will continue discussions with them, and now that Arbitron is part of Nielsen to try to make that happen as quickly as we can, but obviously we are dependent on them in that process as well.

Operator

Our next question comes from Jordan Rohan with Stifel Nicolaus.

Jordan Rohan - Stifel Nicolaus

Thanks, guys. Nice quarter. I am going to ask the $442.4 million question, which is after a very successful secondary offering you guys [left with] cash. Now, there doesn't seem to be anything wrong with the current business something we are lacking from what I can tell, but can you tell us how you think about spending that spending that in more specifically as the negotiation with the labels our SoundExchange or panel of - to negotiate with to get the a compulsory license renewed and extended.

As that continues, what are the prospects for direct deals with the labels? Is there scenario that you can envision, where your cash might be utilized as part of a negotiated agreement with the major labels? Thank you.

Brian McAndrews

Thanks, Jordan. Yes. We are very happy with how this depend follow-on offering went. To a large extent, we felt like raising cash at this point was appropriate, because the success and the momentum the business had, want a better balancing to better capitalize that just ongoing quarterly activity.

That said, having a strong balance sheet does open up different opportunities and allow us to address these opportunities from a position of strength. Although there's nothing that we are ready to announce or talk about now, we are investing aggressively in the in the process that leads to a compulsory license rate being that CRB process is kicking off and we are - significant participant in that process.

In terms of whether that would influence our propensity to do direct deals? They have always been available to us. We have chose today not to do that. Note that, that remains to be seen. All I will say is that having a strong balance sheet does put is in a better position to have the right kind of conversation with people.

Operator

Your next question comes from Ralph Schackart with William Blair.

Ralph Schackart - William Blair

Hi. Good afternoon. Mobile RPM growth has been really strong in the 30% to 50% range, but hasn't been linear to at least to the fiscal year now that you are sort of more integrated with the local buying platforms, so how should we think about the mobile RPM linearity of the growth going forward? Thanks.

Brian McAndrews

You are right that the buying platforms have an important impact in our ability to drive audio revenue out of the broadcast channels. It's been critical. So we have made those investments and we are still working through the integrations there. They are going really well and a larger and larger percentage of our transactions are going through those platforms. The more we drive revenue, the higher RPMs grow.

So the question is, does it change the trajectory of those RPMs or they become more on a lock set basis. You know, I think there is definitely a seasonality to them that will follow just the general seasonality of the ad market but that we could, each year, our ability to increase sellthrough rate to allow us to move RPMs up in a meaningful way and the investment in the buying platforms is really about investing in our ability to drive sellthrough rate.

Operator

Your next question comes from Scott Devitt with Morgan Stanley.

John Egbert - Morgan Stanley

Hi, this is John Egbert for Scott. Just two questions. The first is, between the fiscal year and the sub-period guidance, I think we can back into guidance for the calendar year but would you mind clarifying what that guidance implies for the full 2014 calendar year, on both the top and bottom lines?

Secondly, you guys have been talking about 13% of usage coming from mobile devices, other than smartphones and tablets, with the smartphone cap removed. Is that still increasing as a part of the mix, and is there any material difference in audio ad load on those other types of connected devices? Thanks.

Brian McAndrews

So I will start with the second thing, which is we don't update that mix percentage, just to generally say that 80% comes from mobile and connected devices include those. But you are right to say that the ad load and the ad opportunities on other devices is variable. Different in a connected car environment versus the home device like Roku or Sonos versus a connected TV. But those are also emerging market and that margin don't affect our ability to monetize as much as our ability to generally drive monetization of mobile phones.

So we will be posting results through September 30 on our investor website. You will be able to see the calendars through September 30 and then we do post results for the sub-period in November and December. We will also update calendar financials through the fourth quarter of 2013 but the stuff that we forecasted for November to December implies the fourth quarter calendar revenue of $196 million to $200 million, or growth at the midpoint of 49% and an EPS of $0.06 to $0.08.

Then for the full year, it implies total non-GAAP revenue of $642 million to $646 million in the calendar year and non-GAAP EPS in the calendar year of $0.01 to about $0.03. Obviously those non-GAAP numbers exclude revenue related to subscription return reserve, stock-based compensation, amortization and for the quarter of 218 million diluted shares outstanding and for the year 202 million diluted shares outstanding. So thank you for asking that question. We endeavor to make things as clear as possible.

Operator

Your next question comes from James Marsh with Piper Jaffray

James Marsh - Piper Jaffray

Great. Thanks very much. I guess in your recent press release, you noted listeners would tune in to holiday music earlier in the past and I guess I have seen a lot of these holiday classics are pre-1972 recordings. So could you just remind us how that impacts to your content costs?

Mike Herring

So the holiday listening has earlier relative to Thanksgiving certainly, because we had such a late Thanksgiving this year. I think people aren't waiting and are cranking up the holiday listening. We actually had a press release out related to that. But in terms of the impact from a pre-1972 perspective, a disproportionately small percentage of songs that play on Pandora are from pre-1972 recordings. So the impact on Pandora, specifically, is de minimis.

Operator

Your next question comes from Mark Mahaney with RBC.

Mark Mahaney - RBC

Thanks. Two questions. Could you just update what percentage of your ad revenue comes from audio ads? And then Brian, could you talk a little bit about the automotive market, the automotive advertising market opportunity for Pandora? How high that is on your list? I know it's a multi-year investment cycle. It's a multi-year growth cycle, but how excited you are about that opportunity? Thank you.

Mike Herring

Just quickly. It remains about a 60-40 split audio to digital. That didn't move a lot in the quarter.

Brian McAndrews

Yes, Mark, on the auto business. Yes, I think we see that automotive businesses is a very potentially very strong market for us. We obviously do sales there now and we see tremendous upside. We have sales office in Detroit and also in LA and LA Auto Show is taking place right now and we are obviously playing part in that, so I think we do see tremendous upside there and obviously really appreciate our partnership with the automotive companies from the development side as well with them embracing Pandora and many of them promoting Pandora in their advertises.

Operator

Our next question comes from John Blackledge with Cowen & Company.

John Blackledge - Cowen & Company

Thank you. You mentioned the Hispanic segment as a targeted segment, just wondering what other targeted segments you guys will be focused on in the upcoming months and how big of an will be for Pandora versus terrestrial radio as we go along? Then also just if you can give us an update on the average audio minutes per hour in the average audio spots per hour? Thank you.

Brian McAndrews

I think on the targeting, I think we haven't really talked about what other ones will be. We have a team that works on this, the team of analysts and we have a tremendous head start with our own data and then we have the ability to use third-party data as well, so Hispanic was really meant to be an initial foray to see how successfully we could be and we have been very pleased with it, but yes, we are not really ready to talk about other ones until we get them out in the marketplace.

John Blackledge - Cowen & Company

In terms of minutes and spots per hour, it's been pretty consistent for the last month or two since we rolled out the double, the back-to-back ads spotting, so we have maximum number of ads per hour now. There can be as many as six ads per hour. The average is that given it slowly work its way up and we don't expect that to move overnight, but as sell through rate improves and certainly in the timeframe or probably been moving closer to three-and-a-half to four minutes is the peak, but that's certainly depends largely on demo and on the [day].

Brian McAndrews

This is Brian again. I would just continue with one other point on the targeting. I talked about having the head start toward terrestrial in terms of the data we have, but also the other point is I think because of the Internet connected nature of our communication, we also have the ability to test and share results, so we do the testing of targeting, we are able to show advertisers how well it works, we are able to validate the results and that's obviously a lot easier for us to do and for terrestrial radio.

Operator

Your next question comes from the Laura Martin with Needham Capital.

Laura Martin - Needham Capital

Hi. Brian, for you, following upon Jordan's question. So, Sony just got off stage after five hours and one of the things they started to say, we are happy with the rates they were getting for you guys, but they did say their strategic objective at Sony music is to focus on subscription based services that they thought that was the music business, so I am interested in the kind of new eyes in the room.

Would you be more interested in talking about a subscription or a new kind of product, so that you could deal with the records labels directly even if it was a spin off in the line extension from the core business of Pandora? Then I am interested, Michael, from you on what's the ad load? Now, what's the maximum ad load now in a market where you guys are selling out as much, your maximum local ad inventory in addition to national ad inventory please?

Brian McAndrews

Laura, this Brian. We have continued on our strategy from the beginning of personalized radio that is curated and not an on-demand. You know, what we do in the future? I guess, you could do, there's a lot of different directions we could go, but at this point our models were being extremely well and we are very pleased with that and we do feel that we have really good relationships and partnerships with content providers in our current model.

We believe our current model is really good for artists and really good for the industry, encourages people to buy music, encourages people to discover new music, so we feel that is actually very positive for the business. Having said that, there's a lots of different models that can work and coexist and in the business and that we also believe that while subscription is the way to generate revenue, there is a tremendous amount of revenue in advertising and that's been the history of radio. That's where most of the revenue has come from.

Mike Herring

Yes. Just the maximum ad load today is about six ads per hour. Since we don't do more than 30, we do about 15s and 30s. Now it's about three-minutes an hour.

Operator

Your next question comes from Corey Barrett with Pacific Crest Securities.

Corey Barrett - Pacific Crest Securities

Yes. Can you talk about the pace of your sales headcount additions? How do you expect that to continue in 2014 versus 2013? And ultimately, what determines which local markets you enter, how many and when?

Mike Herring

Sure. So, the pace of our sales hiring does follow a seasonality and we are in the middle or right at the beginning of that seasonality right now. We kind of hire the large majority of our sales people in the fourth calendar quarter, in the first calendar quarter of the year. As sales people change over and we start a year we can roll out new plans. We roll out new programs and go-to-market strategies. We bring in new sales team and we tend to look at what markets are we going in to move into at that time. We had the 29 markets that we address last year from this existing year, from a local perspective. As we look to where to put people on the ground, we look at where inside sales team has been successful in driving revenue, where we think there is potential to where someone on the ground to really take real market share. So we are putting those plans together now. We are looking at which markets are the right ones to put people on the ground, which markets frankly of the 29 that are exceeding our expectations, we want to double down on. It's a multifaceted approach to looking where to invest in and we pretty much have that in place and we are starting to hire today and we are going to be building that sales team pretty aggressively over the next few months.

Operator

Your next question comes from Neil Doshi with CRT Capital.

Unidentified Analyst

Good afternoon. Thank you. This is Rob on the call for Neil. A couple of questions. First, in the subscription business, it looks like RPM grew nicely on both a GAAP and non-GAAP business. Can you talk a little bit about the usage and retention patterns that you are seeing among newer subs and what we might expect going forward?

Then also, following up on a couple of recent questions on ad load. Could you talk about where you think you can take ad loads longer-term and beyond that, are you starting to think about extension strategies for digital advertising or other programming formats like (inaudible). Thank you.

Brian McAndrews

So in terms of the subscription business, we grew our subscription business significantly, a net 1.2 million subscribers in the first two quarters. And obviously, in removing one of the big drivers of that net increase was the mobile listening limit. With the removal of that limit, we saw that the addition of new subscribers dropped somewhat but we also were happy with overall level of the retention we had and the subscribers that we attracted in that timeframe have stayed with the service and continued to use the service from a subscriber perspective.

One thing that we know about our users is, at every level of free listening, when they become subscribers, they tend to immediately start using this service more and become more loyal long-term. So I think, long-term, it's been a really positive thing to move 3 million plus people into new subscribers of Pandora service and we think that has been an important part of our business for quite some time.

In terms of the potential for ad load, we have spent a lot of time testing, Brian mentioned, our ability to test. Its one of the great things about a connected service is that we can test a lot of the changes that we rollout on a small percentage of our audience before we have to roll it out in production and one of the things we test quite a bit is ad load. It's how we developed the double slotting, the back-to-back ad spotting and the concept that we rolled it out is in testing, not only did we increase ad load but we also actually increased listener perception of value and by having larger swaps of music listening without interruption.

So it was a win-win from a listener and an advertising perspective. Still at the three minute maximum that we are at today, we are still a fraction of the 12 to 60 minutes in traditional broadcast radio. So is there room? We think there is. We also think there is tremendous opportunity to drive monetization in a lot of other ways. Subscription is a good example. Display advertising, good example. Our total RPM is $43.48 across our entire platform. It is already at 60%, 65%, 70% of what broadcast radio is doing at only 20% of their ad load.

So we think we can drive a nice revenue business without having to duplicate that other than the traditional broadcast radio.

In terms of other content, we currently don't have a public strategy outside of the comedy channels that we do. We have looked at that from time-to-time and we don't discount the opportunity a potentially in the future. That said, there is so much opportunity in music and such a large percentage, 80% we think of radio listening is in talk, it isn't sports or it isn't worth revisiting other tort type of spoken word. It's all about music and if we can optimize and really take a large market share of that music listening experience. We think that's a pretty great business on its own.

Mike Herring

Yes. To answer your question about advertising, it's a similar answer. I think, we are focused on where the near-term big opportunity in with our own property and we are looking at other ways to extend the advertising for programmatic et cetera, but whether we do things like we like audience extension or other areas. I think that we see them as opportunities, perhaps down the road but not where our focus is right now.

Operator

Your next question comes from Jim Goss with Barrington Research.

Jim Goss - Barrington Research

Thanks. I have got a couple also. First, to the extent that your targeting capabilities should theoretically possibly weren't premium pricing. To what extent do you think the large supply of competing ad spots that now exist and not exist be drawn out like way again your ability to achieve that pricing premium. Then the second one is just a minor thing. The subscription return reserve true-up occur at the end of the stub period and is that incorporated in the calendar guidance that you just provided. Thank you.

Mike Herring

First on the latter part. I noticed there is (Inaudible) third of January, so it will show up in the Q1 one of our calendar quarter ended March 31, 2014 and it will be a GAAP to non-GAAP adjustment the other way, so we will still have a non-GAAP guidance for revenue, but it will be less than what the Number will be because it will be the switching the other direction, so it is separate the estimates for the stub period are non-GAAP numbers that are unaffected by the unaffected by the adjustment for the subscription return reserve.

Brian McAndrews

On the targeting premium price point, I would say that's accurate that we do expect that we can get premium pricing because we are targeting. I think your question was up having more ad loads does that mitigate against that without the question. There is a lot of competition to reap those premium dollars, but we can do it more surgically deliver exactly the audience that they are trying to reach which is the idea behind the targeting. Then we should be able to drive those premium ad dollars, because the return is greater than doing a mass advertising campaign, so I think that you are seeing is a lot among logged-in and content providers to those of us who are reliant on cookies, but can massive targeting campaigns that are strategically critical because we have scale and we have a logged in environment. That kind of format is going to be extremely attractive to advertisers, especially in kind of the brave new world of the logged-in environment on mobile and in Pandora system nicely said to play an important role there.

Operator

Your next question comes from Sameet Sinha with B. Riley.

Sameet Sinha - B. Riley

Yes. thank you very much. I am trying to get a better sense of kind of investments, because. The wording in the press very aggressive previously it was accelerating, so my sense is -so, looking at your stub period minus the fourth quarter guidance. It seems like in the January itself will have EPS of about $0.03, so if you look at the quarter, it looks like probably going negative $0.10 or so. How should we think about it throughout the year and I know it would probably will be reverse strip, but if you can give us some sense that will help us in our market. Thank you.

Brian McAndrews

We are not talking specifically about expectations for Q1. You are exactly right around the seasonality of our results. we did speak directly to that seasonality and the call we did a month ago around that switch to the calendar fiscal year and the seasonality that will be a lot more apparent, but when you at our financials going from our calendar fourth quarter to calendar first quarter. We are coming off a seasonally high advertising season, so that seasonality has a general historical drop. Last year, for example, of about 12% quarter-over-quarter, just from an advertising revenue opportunity perspective. At the same time, the cost of content does a step-up based upon statutory rates of about 8%. And we are also growing some of the investments we talk about from a sales perspective.

So we peak in profitability in the calendar fourth quarter. Take a reset a bit in Q1 and then build again as we go through the year, all the while the key is that, on a quarter-over-quarter basis, looking on a year-over-year basis by quarter, we are improving the profitability over time, improving gross margin and most importantly, growing the top line and our market share so that we have a long-term very interesting business.

Operator

Your next question comes from Rob Sanderson with MKM Partners.

Rob Sanderson - MKM Partners

Yes. Thanks. Good afternoon. A question on content cost. Your dollar per listening hour actually ticked down sequentially and given the strength in subscription growth versus advertising growth, I think listening hours is also attuned to subscription with going back to (inaudible). Given how exchange rates are so much than higher subscription, basically cost to listeners is (inaudible). Can you talk about some efforts you are taking to manage cost per listening hours (inaudible)?

Mike Herring

So (inaudible), small things, Rob. You are right. That we do but the macro reason why that happened between Q2 and Q3 is that the shift in hours actually shifted back somewhat to advertising hours versus subscriber hours. So in the first half of this year, we saw that as we were converting 1.2 million subscribers, we saw a big shift in hours percentage, big relative shift from ad supported dollars to subscription supported dollars and because the subscription supported dollars have an 80% higher licensing rate, you saw that dollars per thousand hours increase disproportionately because of that mix change. Going from Q2 to Q3, it shifted back some and we actually saw that number come down quarter-over-quarter, not so materially that it moves the huge levers but it is a good demonstration of how disconnected the licensing rates are. They disproportionately incentivize us to drive the advertising dollars over the subscription business to drive back towards Laura's comment. Right now, the licensing actually incentivize the subscription from a pure cost per hour basis versus advertising. We look at that as an opportunity and we optimize our business based upon it.

Operator

Your final question come from Brian Nowak with Susquehanna.

Brian Nowak - Susquehanna

I just had two just a follow-up on the back-to-back ad load. Can you talk to any user engagement trends or negative feedback you had from that? Then as a corollary to that, subscription revenue switching users continue to come through strongly. I am just curious, Brian, how do you think about managing the potential long-term risk of more users switching to subscription products over the higher lifetime value advertising products? Thanks.

Mike Herring

So, on a back-to-back, even at a macro level, you can see that the advertising did not hurt user engagement. If you look at hours, per user are up significantly, even September to October and by October, we really were running in a pretty high percentage of back-to-back ads. We really didn't see any negative impact, depending on how you cut the data, the switch to back-to-back even with the higher number of ads per hour, actually improved listener engagement.

So we actually think about that that was a real positive and a win-win both from a monetization perspective and engagement perspective.

Brian McAndrews

I would just say and my concern is on the subscription balance and I think that's probably a good problem to have as people are going, more people want to become subscribers as those are obviously among our most loyal listeners and it would be our job to make sure that we have the optimal pricing over time that makes the most sense there. Again, our model is leading with free and we believe that that's where the biggest opportunity is and our monetization, as you have heard, continues to increase significantly there but if there are people who want the ad-free environment on Pandora, then that's again a good problem to have, from our standpoint. Anything to add, Mike?

Mike Herring

Yes. It's not that we discourage people to be subscribers. Who would think that converting them to be subscribers is a lot harder than anything is generally believed in the marketplace. We encourage it. We market it to people and we believe that the subscription business and subscription product is a viable product and that there is a core market amount our 70 million users currently about 3 million people inside that value what we can offer from the subscription product at the unit $3, $4 a month, right. So that's an important subset of our user base but it's a subset and there is a reason why we have 70 million people who have the idea that radio is free and that we can provide a high quality product with the trade-off of providing advertising. It fits perfectly into the market opportunity and I think that's one of the reasons why we have been so successful. So you want to close on it?

Brian McAndrews

Yes, thank you. Again, we are very pleased with our growth this quarter and we look forward to finish our healthy year strong and talking to you again in a few months. Looking forward to calendar year '14.

Dominic Paschel

Angela, if you can take us back to Elton John radio, please.

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