- To think that Pandora can thrive in the ultra-competitive music industry over the long haul is rather optimistic.
- We think a wide range of fair value outcomes is par for the course for investors in Pandora's equity.
- There may be thousands of better-positioned firms on the market today, and we can think of 15 or so included in the Best Ideas portfolio.
Though many may like listening to free radio on the web, this doesn't mean that Pandora (NYSE:P), the largest Internet radio company, will make a good stock. In fact, shares have fallen more than 40% since their March highs, and frankly we're not surprised. The company is now resting in our fair value range, and we continue to expect shares to trade in the fair value range for the foreseeable future. To us, a long-term investment in Pandora is purely speculative. The company's ability to generate economic value (not market value) for shareholders will inevitably be challenged by competitive forces. Let's walk through our calculation of Pandora's intrinsic value with this dynamic in mind.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Pandora posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. A 3 is a relatively poor score on our index, and we prefer higher-rated entities, many of which are included in the Best Ideas portfolio. A score of a 9 or 10 on the Valuentum Buying Index is equivalent to a "we'd consider buying" rating.
Pandora's Investment Considerations
• Pandora earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. However, such economic profit performance may be short-lived as the competitive environment inevitably heats up in coming years. The company operates in a fast-changing and very dynamic industry.
• Pandora is the leader in Internet radio in the US, offering a personalized experience for each of its listeners. The firm has pioneered a new form of radio - one that uses the qualities of music to create stations and then adapts playlists based on the individual feedback of each listener.
• Pandora's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow has been negative during the past several years, much lower than the mid-single-digit range we'd expect for cash cows. The firm didn't have any debt at the end of last quarter, however, and we view this as a necessity for its high-risk operations.
• The firm has more than a 60% share of internet radio among the top 20 stations and networks. Still, competition remains fierce for both advertisers and listeners, and content costs are not cheap. Its business model remains largely unproven, in our view.
• The growth rate of the number of Pandora's active listeners should be watched closely. Apple's (NASDAQ:AAPL) iRadio, Spotify and others could pressure growth in the future and may stop it altogether. The risks are high.
• The high end of our fair value range, which we disclose below, represents what we believe to be potential take-out price of Pandora's shares should a suitor come to market.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Pandora's 3-year historical return on invested capital (without goodwill) is significantly above its estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. We disclose our calculation of the company's cost of capital below.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Pandora's free cash flow margin has averaged about -5.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Pandora, cash flow from operations dropped into negative territory from levels two years ago, while capital expenditures expanded about 41% during this time period.
Our discounted cash flow model indicates that Pandora's shares are worth between $20-$38 each. Though this is a wide range of outcomes, we think it adequately captures the risk of Pandora's equity value. For one, shares have dropped precipitously as of late, and pricing risk is evident. In many cases, the wider the margin of safety used, the wiser the investors. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
Our point fair value estimate of Pandora's shares is $29. This reflects a compound annual revenue growth rate of 29.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 121.6%. We still believe this is a robust pace of expansion, however, and is more a function of the 'law of large numbers.' Our model reflects a 5-year projected average operating margin of 11.5%, which is below Pandora's trailing 3-year average. We inevitably believe that pressures on its business model will drive margin pressure in the years ahead.
Beyond year 5, we assume free cash flow will grow at an annual rate of 15.8% for the next 15 years and 3% in perpetuity. For Pandora, we use a 11.8% weighted average cost of capital to discount future free cash flows. This is a fairly robust growth rate but a relatively punitive discount rate due to the risks inherent to its business.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Pandora to peers Saga (NYSEMKT:SGA) and SIRIUS (NASDAQ:SIRI), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $29 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Pandora. We think the firm is attractive below $20 per share (the green line), but quite expensive above $38 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Pandora's fair value at this point in time to be about $29 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Pandora's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $41 per share in Year 3 represents our existing fair value per share of $29 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Additional disclosure: AAPL is included in the actively-managed portfolios.