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Pandora Media, Inc. (NYSE:P)

Q2 2014 Results Earnings Conference Call

July 24, 2014; 05:00 p.m. ET

Executives

Brian McAndrews - Chairman & Chief Executive Officer

Mike Herring - Chief Financial Officer

Dominic Paschel - Vice President

Analysts

Nat Schindler - Bank of America Merrill Lynch

Michael Graham - Canaccord

Laura Martin - Needham

Peter Stabler - Wells Fargo

Edward Williams - BMO Capital Markets

Jason Helfstein - Oppenheimer

James Marsh - Piper Jaffray

Douglas Anmuth - JPMorgan

Matt Callahan - SunTrust

Heath Terry - Goldman Sachs

Thomas Champion - Cowen & Co.

Corey Barrett - Pacific Crest Securities

Ben Swinburne - Morgan Stanley

Sameet Sinha - B. Riley

Rob Sanderson - MKM Partners

Operator

Welcome to Pandora’s Second Quarter 2014 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

Take you Angela. Good afternoon and welcome to Pandora’s second quarter 2014 financial results call for the period ended June 30, 2014.

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 materially. For a discussion of the risks that could cause our results to 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 directly comparable GAAP financial measures are provided in the tables in 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 Relations 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’m excited to share details with you regarding a very strong second quarter, primarily due to the momentum we are building in local and mobile, where our investments are paying off. Today I’ll review our second quarter financial highlights and share more details about our activities over the quarter and then turn the call over to Mike Herring, our Chief Financial Officer.

Let me begin with a couple of financial highlights. Second quarter revenue reached $218.9 million, an increase of 38% based on non-GAAP revenue of $158.4 million in the second quarter of 2013.

As we have grown revenue, we are driving increased gross profits and we have been reinvesting those dollars back into the business, building out our sales team and expanding our product development capability, as we look to capitalize on the short and long-term opportunities available to us.

Despite those significant investments we are operating the company profitably with non-GAAP second quarter 2014 net income of $9.1 million or diluted EPS of $0.04, compared to non-GAAP net income of $8.6 million or diluted EPS of $0.04 for the second quarter of 2013.

Our better than expected financial results were driven by continued increases in user engagement, rising listener hours and our focus on local and mobile monetization. As of the end of June, a traditionally seasonal low point, active users increased 7.5% year-over-year from 71.1 million to 76.4 million.

At the same time listeners are increasingly engaged as listener hours rose 5% quarter-to-quarter in 2014 from 4.8 billion in Q1 to 5.04 billion this quarter. On an annual basis listening hours grew 29%, increasing from 3.91 billion in Q2, 2013 to 5.04 billion in Q2, 2014.

As you may recall, we began limiting free mobile listening to 40 hours per month in March of last year, making year-over-year comparisons less relevant than the increasing engagement momentum we see in the near-term, and in that respect, this quarters hours were a milestone, as we served over 5 billion hours of music in a quarter for the first time.

For the month of June specifically, we had more than 25 million daily unique listeners every Friday, an all-time high for the seasonally slower summer period. For context, last year the high watermark for a Friday in June was 22.6 million daily uniques. Importantly, listeners are using Pandora more frequently and for longer periods of time, consuming an average of 21.1 hours per active user in June, up 20% over the last year.

Pandora began measuring market share on our own, because no third-party measurement firm could provide accurate market share numbers across web and connected devices. Our estimates, which include third party data show our share of total U.S. radio listening increased from 7.04% a year ago to 8.9%. We are pleased to say that now several third-party measurement sources are available. Specifically, Triton, comScore and Edison published estimates of Pandora’s audience.

Edison Research’s inaugural share of the year report estimated Pandora’s overall radio market share at 9.2% of total broadcast satellite and Internet radio listening, slightly above our own estimates. The most recent comScore multiplatform top 100 properties report has Pandora at 81.8 million monthly uniques; and finally Triton Digital top 20 U.S. ranker has Pandora at an all-time high market share for U.S. Internet radio at 77.6% of the top 20 properties.

While all of these pieces of research have slightly different methodologies and objectives, they all lead back to the central theme, that Pandora is the clear market leader in Internet radio and a growing force in radio overall.

As our market share and hours streamed have grown, our focus on monetizing listening hours has continued to drive strong results and as a result RPMs are on the rise despite much higher volumes of hours to monetize.

Total RPMs on a non-GAAP basis reached $43.41 in the second quarter of 2014, up 7% from $40.53 a year ago. Advertising RPMs rose due to strong sell-through in pricing, increasing 6% from $37.89 in the second quarter last year to $40.11 this year. And mobile monetization continues to increase as we narrow the gap between mobile usage and mobile revenue with mobile advertising RPMs reaching $36 in the second quarter of 2014, up 11% from $32.56 in the same quarter last year.

Mobile advertising now accounts for 76% of total ad revenue, a record share. Continuing to close the gap with consumption, where 83% of total hours are consumed on those platforms.

Our investments in local advertising are also paying off, with local revenue up 144% from the second quarter last year. We are constantly developing innovative programs for advertisers to drive further monetization. During the quarter we beta launched a new advertising solution called Promoted Stations with 10% of listeners. Despite this limited rollout, we have already seen one in eight of all brand station additions coming from that ad unit.

Promoted stations are native ad units based on the listening experience brands want to create for their respective audiences, which may include custom content from an artist or a mix of songs powered by Pandora’s Music Genome Project.

Notably, this is the first time that Pandora has natively integrated an add product within a listener station list. Advertisers in the beta launch include Kleenex Brand, SKECHERS USA, StubHub, Taco Bell, and Toyota Motor Sales.

To further engage listeners, provide new opportunities for advertisers and extend our presence in the music community, this quarter we introduced Pandora’s Discovery Den to Miami as part of the hottest week in Latin music. Here we produced the program in partnership with State Farm, P&G Orgullosa, and Sprint. Also we continue to host Pandora Presents, a series of personalized concerts designed to connect fans with artists they love in a live setting.

This quarter we announced that Pandora presents partnership with StubHub, as part of StubHub’s next stage concert series, the company’s biggest music initiative yet to discover and support emerging artists, while giving exclusive access to the true music fan. Something we seek to do every day in a digital environment at Pandora.

The Discovery Den and Pandora Presents are natural environments for brands to partner with Pandora, to connect authentically with engaged users, much as they do online. To help manage this increasing complexity and scale of our advertising operations, I’m pleased to report that David Gerbitz has joint us earlier this month as EVP of Revenue Operations. David has extensive experience in managing complex and fast-growing sales operations at scale and we’ll be responsible for the implementation of Pandora’s advertising products, working closely with our Chief Revenue Officer, John Trimble. We are thrilled to have him onboard.

Subscription and other revenue was $41.6 million, an increase of 35% over $30.9 million on a non-GAAP basis in the same period in 2013. For context, as noted earlier, in March of 2013 Pandora instituted a mobile free listening limit of 40 hours, which had the effect at that time of driving accelerated subscription conversions, and with that accelerated subscription revenues, which impacts some of the year-over-year comparisons.

The second quarter Pandora successfully implemented a price increase, in which the lowest cost, $36 annual plan was eliminated, and the $3.99 monthly plan was raised to $4.99 for all new subscribers.

Existing subscriber at the time of the price increase were set at a discounted loyalty price of $3.99 monthly if they remained an active paying subscriber. So the full impact of the price increase will play out over many months. So far the program is performing as anticipated. To-date we have seen an increase in average revenue per subscriber, and net subscribers continue to grow now surpassing 3.5 million of approximately 100,000 net new from the prior quarter.

While our biggest market opportunity is that of the $50 billion combined in U.S. digital enriched media, mobile and broadcast radio markets, subscription growth continues to be very important to our overall monetization strategies.

As I approach my one-year anniversary since joining Pandora, I continue to be impressed by our strong culture and incredibly talented team. To ensure we preserve the essential elements of what makes Pandora unique and guide our future strategy and business priorities, I work closely with the executive team to hone Pandora’s long-term vision, which is to be the effortless source of personalized music and discovery for billions around the world. Clearly that is ambitious, but I have every reason to believe we are up to the challenge.

Pandora’s future success is deeply rooted in the strength of our unparallel platform, which connects over 250 million registered users and more than 75 million active listeners a month, with over 125,000 artists and more than 1.5 million carefully curated tracks. And because of this tremendous value our platform delivers, we’ve created strong and lasting relationships with our listeners, resulting in more than 6 billion stations created, 40 billion pieces of some feedback and countless interactions with our advertisers.

This provides an immense pool of data and insights for our team of world-class data scientists, engineers and other experts, to further enhance the listener experience, strengthen connections between artists and fans and help marketers in the music industry grow well into the future.

For our listeners, this unparallel data pool, combined with our investment and expertise over the past 15 years have given us a formidable lead in creating the optimal listening experience and provided us with an incredible competitive advantage. But there is more to be done and we will continue to invest as we work to ensure that every listener hears exactly the right song at precisely the right time.

For marketers who also continue to invest and optimize our platform; to help achieve their business objectives and make it as easy efficient and effective as possible to advertise on Pandora, as we strive to ensure that marketers can deliver their advertising message to the right listener at the right time.

We leave the industry today in this area and we will continue to differentiate Pandora from our competitors. As for artists in the music industry, this is an area of immense opportunity for Pandora. To be sure, we are proud of the contributions that Pandora has made to the artist and music community.

In addition to paying over $1 billion, yes $1 billion in all-time royalties to artists, publishers and labels, Pandora has provided additional exposure and a wonderful environment for artists with large followings, as well as a platform for countless artists who otherwise would have had little to no exposure at all.

At events like Pandora Presents, Pandora Discovery Den and Pandora Premieres, all represent great examples of where Pandora has worked closely with the music community to create great venues for artist to connect with their fans. But in our view this is only scratching the surface of Pandora’s opportunity to partner with artists in the music industry. Up to now we have utilized proprietary data very well to help enhance our listener and advertise experience, and we will continue to do so. But we see tremendous opportunity to broaden our energy and focus, working more close to with artists in the music industry to harness the power of Pandora’s platform.

As we look to the future, we are eager to collaborate to grow our collective businesses and reach larger audiences. This is a significant priority and over the coming months and into 2015, you can expect to see us take important steps in this direction.

As one recent example of just such an important step, earlier this week we announced that Lars Murray has joined Pandora as Vice President of Industry Relations. Lars joins us from Columbia Records, where he led a highly regarded digital marketing operation focused on helping artists grow their fan base and exposure through the use of digital platforms.

His past notable successes in aligning music industry objectives with new media potential includes the launch of Daft Punk's market leading album, the execution of Pharrell’s 24 Hours of Happiness campaign and Jack White’s record breaking album release.

Lars brings more than 20 years of industry relationships and experience to this key leadership role, in driving our efforts to build stronger relationships with artists, labels and other industry stakeholders, helping us meet our goal of providing nothing short of the best experience for both artists and our listeners.

So to sum up, Pandora’s building off of our strong foundation, adapting to change and investing in our future. While the environment we operate in is both competitive and dynamic, I’m highly confident in our future, excited about our team and focused on advancing our vision. I look forward to the rest of the year and many years ahead as we redefine radio for a connected world.

And now I’d like to turn the call over to Mike Herring, our Chief Financial Officer for more details regarding our financials.

Mike Herring

Thank you, Brian. I’ll walk through our second quarter financials, discuss our business strategy and then finish with some thoughts regarding guidance for the third quarter and full-year 2014.

Starting with revenue, we ended the second quarter of 2014 with total revenue of $218.9 million, representing 38% growth on a non-GAAP basis from the year ago quarter, above the high-end of our guidance range.

Advertising revenue increased 39% in the second quarter of 2014 to $177.3 million compared to $127.6 million in revenue in the same quarter last year. Strong execution in mobile continues to drive ad revenue and for the second quarter, mobile ad revenue was $134.4 million, an increase of 54% over the same period last year, accounting for a record high 76% of total ad revenue as we continue to close the mobile monetization gap.

Our investment in penetrating the local radio advertising market is paying off, as local advertising revenue in the second quarter reached approximately 20% of total ad revenue to $35.3 million, an increase of 144% from approximately $14.5 million in the same period last year. We now have 109 local sellers in 37 markets and an inside sales force that addresses another 150 DMAs and we intend to invest to extend our market share for the foreseeable future.

Turning to subscription revenue, subscription and other revenue was $41.6 million, an increase of 35% over $30.9 million on a non-GAAP basis in the same period of 2013. Second quarter GAAP basic and diluted loss per share was $0.06. Basic and diluted non-GAAP earnings-per-share was $0.04, which excludes approximately $20.6 million in stock-based compensation expense and $200,000 in amortization of intangible assets and what’s better than guidance of breakeven to $0.03.

GAAP, basic and diluted EPS and non-GAAP basic EPS were based on 205.7 million weighted average shares outstanding and non-GAAP diluted EPS was based on 218.6 million weighted average shares outstanding.

EPS performance above guidance was driven by better than expected advertising revenue, as the sales team ramps and continues to execute ahead of expectations in local and mobile. Our ability to improve our bottom line is largely dependent on leverage we can realize on content costs, which are significant. This quarter Pandora again paid more than $100 million in content royalties to rights holders and in its history Pandora has now paid more than $1 billion in total royalties.

As we’ve mentioned repeatedly, our ability to drive leverage on these costs is driven by a central financial dynamic. The ability to drive increased RPMs in excess of LPM or licensing costs per thousand hours.

LPMs are largely fixed with annual increases, and thus to the extent RPMs expand, we are able to commensurately expand our gross margin. Given last year’s listening hour limit and significant user hour growth in 2014, leading to our first 5 billion hour quarter, RPM continued to grow but slowed on a year-over-year basis. Due to this dynamic, second quarter gross margin was essentially flat year-over-year. However, we expect gross margins to expand over the long-term towards our target of 60%.

Our strength and confidence in monetization in 2014 has allowed us to let user hours grow. Philosophically we prefer to maintain strong listener hour growth, which we consider a foundational economic force, driving long-term revenue, gross profit and ultimately earnings and shareholder value.

On an absolute basis we continue to increase monetization across the board. Total RPMs for the quarter grew 7% year-over-year to $43.41, compared to $40.53 on a non-GAAP basis for the second quarter 2013. Mobile monetization continues to show strong momentum, with total mobile RPMs for the second quarter increasing 11% to $39.88, compared to $36.01 on a non-GAAP basis in the same period last year. Total web RPMs for the quarter increased 7% to $61.01 from $57.09 on a non-GAAP basis in the second quarter last year.

Turning to operating expenses, as discussed in our first quarter call, we will continue to add sales people during the second quarter, adding 15 additional quota bearing sales reps to bring the total team to 343 feet on the street, a 109 of which are and 37 local markets.

We increased headcount 40% year-over-year to 1,305 employees in the second quarter of calendar year 2014 from 935 employees in the same period last year. Primarily the result of new additions to our sales team where we’ve added 91 sales people year-over-year.

For the second quarter of 2014, non-GAAP sales and marketing expense $56.3 million or 26% of total revenue, an increase of 43% compared to $39.3 million in the second quarter of 2013. Included in the result sales and marketing expense, our commissions on subscription that we pay Google and Apple. In the second quarter these commissions totaled $7.5 million and 13% of sales and marketing.

Non-GAAP product development expense was $8.7 million or 4% of total revenue, an increase of 57% compared to $5.5 million in the prior year. Our non-GAAP G&A expense was $20.5 million or 9% of non-GAAP revenue, an increase of 39% compared to $14.7 million in the prior year.

Turning to the balance sheet, Pandora ended the second quarter with $437.9 million in cash and investments compared to $445.9 million at the end of the prior quarter. Cash used in operating activities was $7.1 million for the second quarter of calendar year 2014, compared to $4.6 million in the year ago quarter. Capital expenditures were $4.5 million in the quarter.

Now, I’ll wrap up with thoughts regarding guidance for the calendar year 2014 and the third quarter 2014. Starting with the full-year 2014, we estimate non-GAAP total revenues in the range of $895 million to $915 million or year-over-year growth at the midpoint of 40%, up $15 million from the prior range of $880 million to $900 million given on our Q1 earnings call.

We expect non-GAAP diluted earnings per share between $0.16 and $0.19, up from the prior range of $0.14 to $0.18. Full-year non-GAAP 2014 earnings per share 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 219 million diluted shares outstanding.

For the third quarter 2014, we estimate total revenue in the range of $235 million to $240 million or a year-over-year growth at the midpoint of 39%. We estimate third quarter 2014 non-GAAP diluted earnings per share to be between $0.05 and $0.08. The third quarter 2014 non-GAAP earnings per share excludes stock-based compensation expense and amortization of intangibles, assumes minimal tax expense given our net operating loss position, and is based on 221 million diluted shares outstanding.

In summary, we continue to execute well across our strategic initiative and are building momentum in mobile and local in particular. We are starting to see return on those investments and look forward to increased contribution from our sales team as they ramp throughout the year. The growth in our top-line is driving expanding gross profits and we are reinvesting aggressively in our strategic opportunities, while maintaining non-GAAP profitability.

And with that, we are ready to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Nat Schindler with Bank of America.

Nat Schindler - Bank of America Merrill Lynch

Yes, great, thanks. I have one question in two parts that are unrelated. The first part, could you talk a little bit about your opportunities internationally and any efforts that you have had recently to expand your international efforts outside of obviously what’s been going on in New Zealand and Australia and also if any information about those was well and how you’ve done down there?

Additionally, could you talk a little bit about what has happened to active user growth at this point? With 250 million radio listeners in the U.S. your growth seems to be coming, stabilizing here at sub 80 million or not quite stabilizing, still growing, but still growing relatively slowly. Why can’t you close that gap a lot further? Thanks.

Brian McAndrews

Sure. On the first one, international, just a quick mention; Australia and New Zealand just recently passed 2 million registered users and that’s in less than two years. They are signing about two new registered users every second and so we’ve seen great growth there and we are also ramping up advertising there and seeing revenue coming in. So we feel good about that, and we think there’s great learnings to be had there as we think about other countries.

We have nothing to announce in terms of other countries. We are spending time internally thinking about what are the other attractive markets that we might go into and planning longer-term we don’t have anything to announce at this point, but we do see longer-term. Our vision as I mentioned is to reach billions of people around the world. So clearly we want to expand outside the countries we are currently in.

In terms of the growth, we expected to see some seasonality in June that’s typical for us, that we see pickup more in September and relative slowdown in the summer as people go on vacation and leave school. Over time, one of the things that people do of course in summer is go on vacation; many people drive. As we become more and more prominent in cars, maybe we will see some tempering of that or maybe even lose some of that seasonality, but for now it was expected.

Even within that we still grew 7.5% in terms of actives versus last year and average hours were up 20%. So clearly there’s a cap on the number of people who can listen to us in certain geographies. We feel we are not there yet in our current geographies, but we also are investing in features and in the playlist etc., to try to view more, to get people to listen more.

Here we mentioned in the past call that we did mobile notifications. One of the fruits of that was we saw some benefit on Cinco de Mayo on Memorial Day when we did notifications and encouraged people to listen to certain stations and we got nice bumps out of that. You could argue that it hurt us relatively to June compared to May, because those were in May and not in June. But actually we are starting to see results of some of the experiments and things that we are doing on the front end listener experience, in addition to what we’ve always done on the back end.

Operator

Your next question comes from Michael Graham with Canaccord.

Michael Graham - Canaccord

Thanks. I just want to follow-up on the listener decline if I could. And you touched on this for a minute, but it seems as if the company with such strong hours growth in the quarter would have been hesitant and has been hesitant to really go after expanding the active listener base proactively, just given that you are still up against trying to sell all the supply, all the inventory that you’re generating.

I’m just wondering, are we likely to see later on this year as the sales force gets up to a bigger productivity ramp, are we likely to see you guys being more aggressive on advertising, promoting, going after the, at least 100 million sort of latent Pandora accounts that are out there that are not monthly active listeners? Thanks a lot.

Brian McAndrews

We are investing more in marketing than we ever have before. Having said that we are not talking about a massive budget, but we’ve historically done really word-of-mouth and been really successful with that and we are investing more in marketing in terms of Internet and even some brand marketing in the second half.

Having said that, we feel we have very robust uniques and we’d like to see that number continue to grow, but at the end of the day we are also very, very interested in hours growth and continuing to monetize as we grow the hours. So it’s both that are important and once you hit that certain critical mass, arguably the hours have even more up-side over time.

Operator

Your next question comes from Laura Martin with Needham.

Laura Martin - Needham

Hey Brian. I was particularly interested, I want to follow-up on Nat’s international question. When you think about international monetization could you talk about the relative margins that you’re seeing and costs, offshore versus onshore?

And then how aggressive should we expect to see you international. Would that be expansion in 2015 or is it more of a 2016 expansion theory for international. Also new revenue streams, have you thought about any other revenue streams other than advertising or you’re pretty much going to be a non-advertising subscription business, model business for the foreseeable future. Thanks.

Brian McAndrews

Yes, I’ll take the latter part and I’ll let Mike talk about the margin piece. I think international is something that we do feel there will be opportunities in the medium to longer term. We have no specific plans at this time or announcements, so I would say that we can’t say specifically what will happen in 2015. I think as we get closer to that, we’ll share our plans towards the end of the year if we have specific plans.

And in terms of revenue streams I would say at this point we think we have a great growth opportunity where we are continuing to invest in the ad supported business and the sales force getting higher RPMs, shifting more and more towards mobile when taking advantage of that opportunity. Shifting more and more towards local you heard. Some of the metrics there were up nearly 150% year-over-year, so we see tremendous opportunity there.

I think in general we have a platform as I talked about in my closing remarks that has great potential to go beyond into areas we haven’t yet contemplated. So I think other revenue streams are certainly a possibility down the road, but I would not say in the near term.

Mike Herring

And Laura, thank you for your question on margins. That’s going to really depend on a market by market basis. When you look at the only international markets we’re in outside the United States today Australia, New Zealand, monetization there is in its infancy. We just started selling advertising in January, although it’s tracking very strongly alongside the user engagement that we have in those countries.

But despite the fact that the advertising market is smaller there, the cost structure from a content licensing in royalty perspective is better than in the United States, so we expect that we’d eventually see a better overall margin profile in that specific market. I think every market is going to look a little differently.

We have seen some early indications that the content cost in Canada and specifically may be attractive enough for us to be participating in that market, but it remains to be seen. So it depends a lot, because content cost and royalties are such a large percentage of our revenue and our cost structure, that is the biggest determinant as to what margins are possible in various markets and we’ll look at those as a big driver, as to what markets we choose to address.

Operator

Your next question comes from Peter Stabler with Wells Fargo.

Peter Stabler - Wells Fargo

Good afternoon. Thanks for taking the question. So I wanted to shift the conversation a little bit in terms of competition. There is no shortage of discussion of course about your competition for listening hours.

I was wonder if you can comment on the competition for local advertising from your digital competitors that have launched. Who else has scale, data, sales force integrations? Would you worry about perhaps excluding IR radio, who has an installed sales force. If you could just comment on the competitive dynamics and digital players in local advertising that would be great. Thank you.

Brian McAndrews

I would say Peter, we're always aware of the competitive situation and taking into account in how we think about our business and the landscape. Having said that, we focus more on our own strength and how to execute for our listeners and advertisers. I would say there are not a lot of players of scale.

As I mentioned in my remarks, our share of Internet radio is 77.6%. So we really have a tremendous share of the connected universe in that respect in radio and we are ahead of everybody in terms of building out a sales force design and focused on this area.

So there will be other players and I think each one has to make a decision as you know a lot of the noise in the music streaming space has been around subscription models and while those are a different business area that people can obviously choose to pursue and maybe very attractive, it's not where our focus is and that was our core strength and where our big opportunity is or where we see the big opportunity, and so we feel like we are well ahead of other players in the market in that respect.

Operator

Your next question comes from Edward Williams with BMO Capital Markets.

Edward Williams - BMO Capital Markets

Good afternoon. Just wanted to talk to you a little bit about the auto experience, what sort of feedback have you gotten from the advertisers who’ve been focusing on the auto market, and also what sort of usage are you getting from users who are using Pandora in the car? How much more hours are they generating per month versus the kind of typical Pandora user?

Brian McAndrews

Edward, so we’ve seen some great growth in the auto business in terms of our native integrations. We now have 7 million unique users who’ve activated Pandora through their native automotive integrations and that’s up from 2.5 million a year ago. So we are seeing momentum there, which we feel good about, and on average at this point, people in the car are listening about six a hours a month per listener and that compares to the 21.1 number for the average Pandora listener I mentioned earlier.

So we are definitely seeing momentum, albeit it's going to take a while, but now we are at 145 models of cars, including ten of the ten best-selling vehicles and so we are at about a third or a little more of every new car that comes off a lot.

So we are very encouraged about the long-term trajectory. We know it will take time, but we are feeling very positive. Just as an aside, if you were seeing more and more automobile advertisers come to Pandora. In fact, that category is up 85% over last year for the first half. So to the extent that automobile advertisers or any kind of proxy for wanting to advertise the people driving, certainly we are starting to see a lot more – we're seeing a lot of strength there.

Operator

Your next question comes from Jason Helfstein with Oppenheimer.

Jason Helfstein - Oppenheimer

Thanks. I wanted to go back to something. So you talked about working with the music industry and prior to that you talked about building the people around the world and clearly the music industry holds the key to you being able to do that. So can you just talk about some of the initiatives you are thinking about, broadly working with the music industry so that they understand that the only way that your interests are aligned with theirs, which is to help them monetize music, and ultimately that allows you to potentially go into more markets. Thanks.

Brian McAndrews

Sure Jason. Some of the things that we hope to do over time are still in the early stages and also we are not going to necessarily talk about a lot of specifics, but I will say that we have historically made a lot of artist on Pandora, and written very large checks relative to obviously Terrestrial Radio and other areas. We’ve written very large checks. As I mentioned in my remarks, we’ve in the history of the company now written royalty payments of over $1 billion. So we certainly are aligned in that respect, and as we grow, and as we work with labels and publishers and artist to grow more, there's no reason my that number can continue to grow.

But the other thing is, you mentioned alignment in terms of royalties and that definitely is alignment, but there’s other objectives that artists and labels have as well in terms of breaking new artists, thinking about promoting tours for artist and some of the data that we have, that frankly could be very useful to labels in terms of how they think about certain artists, how they think about promoting certain artists and the artists themselves, how they think about structuring their career.

So we want to work with the industry and again, Lars is a key part in helping us do this, although we have other folks on the team here as well. To figure out what are those ways, we just feel we have this platform that up to now has been relatively closed in that respect to the artist and music community in terms of the data and we feel like there's opportunities to work more closely and leverage that data for a mutual benefit.

Operator

Your next question comes from James Marsh with Piper Jaffray.

James Marsh - Piper Jaffray

Thanks very much. I guess as you look at all the competitors that have kind of come into the market recently, a lot of them kind of mimicking some of the things that you offer. Do you see any features that competitors are providing today, that you might consider kind of building off of? I mean do see anything that you might want to mimic yourself?

Brian McAndrews

I wouldn’t say specifically, no. I mean I think we feel that we’ve really been very differentiated with the Music Genome and then the 50 plus algorithms we’ve now built on top of that. That's not to say that there won't be things. We’re opened to ideas from all sorts of places, but I think we are really focused on what we believe is best for our listener and best for our advertiser and ultimately also what is really good for the artist and the music industry.

So we’re a pioneer if anything. There’s probably been a lot more people who have tried to imitate us than the other way around.

Having said that, again, if there are good ideas and there are things we are – we are open to ideas wherever they come from and so if we do see things and I think to the earlier question, to Jason’s question, there may be things that there are some other players in terrestrial radio or other areas that worked with the industry to do things that we may learn from as we go further in that direction.

Operator

Your next question comes from Douglas Anmuth with JPMorgan.

Douglas Anmuth - JPMorgan

Thank you. Brian, can you just talk about the conditions you think that really need to be in place to drive a tipping point here for terrestrial radio ad buyers and as part of that, how important is Nielson Measure? And then also Mike, can you just comment on how much political revenue might be in the back half you guided here, Q3 and Q4? Thanks.

Brian McAndrews

Sure. I would say that in terms of terrestrial radio, we are in some ways I think – I don't want to say we’ve hit the tipping point. I don't know exactly when that is, but I would say certainly a critical factor for us was getting integrated with STRATA and Mediaocean with having Triton come onboard and get now MRC Accredited, not just nationally, but also in their local market.

So we feel like, while there’s still always work to do in evangelizing the new offering and the new space to buyers in both the digital world and the broadcast world, so there's always work to be done and actually other players coming into the space help in that respect. I’d say that there is a lot of major milestones that we've hit with those.

Nielsen, our feeling is that their client should probably want them to be in the space as it becomes more and more critical. Our feeling now is the way that we are set up with Triton in their MRC accreditation in local markets, which is actually far deeper and better than what Nielsen has at this point.

The Nielsen would be a nice to have for us, but it’s certainly not a must-have and a must Nielsen does make a decision to go apples-to-apples for us, it makes more sense for us to work with players where we are providing the most value to the buyer, so they can actually compare us apples-to-apples with terrestrial radio and that's what Triton does. And now with Edison out there and comScore, people are having more and more ways to measure us, which is only a positive.

Mike Herring

And to answer the question on political, it definitely is factored into some of the pipeline build for the back half of the year. They give us confidence in raising our overall annual number. We’ve definitely seen over the last few years in major political cycles a lot of dollars flowing into radio generally and certainly now that Pandora has a reasonable market share and it’s gaining market share there, we expect it to definitely play in that space, particularly with the local nature of a lot of radio advertising and the targeting abilities that we’ve been developing over time.

So I think it will be a meaningful number. It's been six, high single digits, millions of spend in major election cycle before in prior years. This is shaping up to be higher than that, but it's not going to change the business, but we think it's going to be a nice piece of business for us in the back half.

Operator

Your next question comes from Robert Peck with SunTrust.

Matt Callahan - SunTrust

Yes hi, it’s Matt in for Bob, thanks for taking the question. There's been a lot of talk around the international piece, which is obviously a nice new potential significant tan there, but I was also wondering if you had any other things on the whiteboard, and particularly spoken word or proprietary content or radio ad exchange, any thoughts you might have along those lines.

And then one follow-up question on the competitive landscape, looking at the June numbers again, active users were a little light in June and obviously Apple made the big announcement with Beats. Beats offers a seven-day trial there. I would assume there’s probably some drummed up interest given the announcement. Did you see any impact from that announcement and perhaps people giving the Beats a trial there? Thanks.

Brian McAndrews

Sure. The first one Matt, I would say that we’re really focused right now on the music business. Obviously we also have comedy. We think there’s huge opportunity there and that's really where our strength is. In terms of other opportunities, we won't take other things off the table and I think those are things that we can consider over time. But there is certainly nothing that we’re immediately focused on. We feel like we've got just a great opportunity in front of us in terms of what most people listen to radio for and it's about 80% of the market is people listening to music on radio.

And then in terms of the listener side, we don't detect anything in particular from any particular player. June everyone in our space we believe is down. As a mentioned before, it’s got a natural seasonality we see, and particularly again in the connected world where there's a lot less in cars which might mitigate some of that. It's not surprising that we see it and we’ve seen it with other players in the space as well.

Operator

Your next question comes from Heath Terry with Goldman Sachs.

Heath Terry - Goldman Sachs

Great, thanks. Brian, curious if you can give us an idea of what you're – we’ve seen you increase the amount of sort of device targeting that you seem to be doing for your inventory, moving from ZIP code to a more direct location. When you look at the opportunity in terms of leveraging some of the more advanced targeting that’s being done out there, where is Pandora now, and what kind of impact do you think – taking advantage of what other companies are doing in advertising technology and buying for customers could do for monetization of the, not just the remnant inventory that you have, but even broader.

Brian McAndrews

Heath, I think we see that we've done a fair amount there, but we still see there’s tremendous opportunity, both with our own data working with third parties. We now have over 100 segment target listeners using our own data and third-party data, and we've announced in the past that we found ways and through those combinations to target really well on things like Hispanic, targeting. The question before about political, we’ve actually found ways to help target political advertising.

And so we think that starting with the core that we have, we have an identifier across devices is a huge benefit in a world where cookies are a threat and things like that. We are able to reach people and star right off the back with obviously the DIAGEO information, and building on top of that in terms of their music interest and life stage and income and occupation, there’s just lots of different things that we can do, both ourselves and third-party.

So, I think we would say we are seeing increasing in CPMs and RPMs. We expect those to continue and it's a combination of course of sell-through and CPM and we have every reason to believe we can be incredibly competitive in terms of targeting, given the data we have and that connected and direct connection with the user and the scale we have in the audio and digital display world.

Operator

Your next question comes from John Blackledge with Cowen and Company.

Thomas Champion - Cowen & Co.

Hi guys, its Tom for John. Curious if you could comment on audio spot loads on average in the quarter and max number of ad spots. And second, if you could comment on what the full-year guide implies for free cash flow. Thanks very much.

Mike Herring

Sure. This is Mike. So the max at load hasn't changed since September of last year. It is up. The maximum we’ll do is around six and we do get north of five in certain markets. Overall, in Q1 when we had was kind of a seasonally down quarter, the average load was below 2.5 per hour. Even with the number of hours peaking over 5 billion in Q2 we saw that average ads per hour increase pretty significantly because the sell-through rate increased pretty significantly and so I think our add average was close to three ads per hour for the second quarter.

And since we only do 15 and 32 second ads, it's important to note that that doesn't translate to three minutes an ad, three minutes an hour on average. It translates to a minute to a minute and a half of ads an hour, which is one of the reasons why we have such strong engagement listeners. We balance the listening experience with the advertising experience, higher advertiser ROI results as well.

Operator

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

Corey Barrett - Pacific Crest Securities

Hi, thanks for taking my questions; I've got a couple. First, as you think about sort of the next legs of user growth, material user growth, both in auto and international, how do you think about that in terms of timeline and prioritization?

And then secondly, on the international piece, how do you balance sort of waiting for favorable rates for international launches, potentially at the expense of a first-mover advantage versus potentially making director deals, which would potentially cost you margin, but would allow you to roll out internationally sooner?

Brian McAndrews

Hey Corey, I would say auto is certainly a high priority for us. Obviously we can only control the timing of that so much, but we've invested a lot of energy and timing in getting into, it’s now in145 models, and we’ll continue to invest and we’ll be in the first connected car with Volvo. So we see a big opportunity there. We are investing a lot; we’ll continue to and that timeline will come to a degree with our help, but also just as people turnover cars over time.

And international, yes it’s a good question. I mean I think we want to work with the rights holders to do deals that ideally are win-win deals and so we are going to do things that we think makes sense economically. That doesn't mean we wouldn't be willing to make investments to launch in countries where we won’t get a return immediately.

Certainly we are open to that type of opportunity. We are not going to do things where we don't feel we can never get a return, but if we feel that there is a reasonable horizon, we do see benefit to doing it sooner rather than later.

Having said that, we also do believe we have a really strong product and if we’re not the first player in some markets, we still have a great opportunity to grow the significant business in this Internet radio space.

Operator

Your next question comes from Ben Swinburne with Morgan Stanley.

Ben Swinburne - Morgan Stanley

Thank you. Good afternoon. I have two. I wanted to ask about selling drive time day parts at this point if that's a big part of what's driving your business or is that something that’s going to come as you get more in-dash integrations done since drive time is as you guys know, is the highest priced pay part on the advertising front.

And then second, on daily listener hours, it looked like it moderated from April, May into June. Is that seasonality as well? And would you expect hours per active user to start growing again as in-car listening picks up? Thanks.

Brian McAndrews

Sure. In terms of the drive time piece, we actually don't hate it. The amount we know that is the actual hours in the auto is relatively small compared to our overall hours. So that, although we can segment it by time and day part, and do so that way, and we essentially sold out the auto portion of our hours, which we know is delivered in our car.

It's not a big mover in terms of our current revenue, although we do believe in the future that can really become material as we penetrate autos and we do get a 20% lift on average like we do today on listening because of those auto integrations. That would add a lot of listener hours to address your second question, as well as high-value hours under today's advertisers goals and understanding.

From a listener hour per user, that is pretty much – I think we're at 21 and change this quarter. We’re just shy of 22 last quarter. That's been pretty consistent. It doesn't change a lot in the short term. It's very high engagement relative to any other property out there. We don't think there's any trend that we are concerned about.

If you go back just two or three years ago, we’ve seen significant growth in that engagement. It is impacted somewhat by the seasonality of the summer. The same thing that has a small percentage of users, not able to connect to Pandora or connecting less would apply in June as it did in every other connected form of radio. Frankly, it's one of the reasons we’re moving to third party measurement. Al least third party measurement puts it in context.

If you look at comScore or Edison or Triton’s measurements, they all show all connected sources of listening declining May to June. It's just the way, an artifact of the way the market exists right now. When we distribute metrics on an island, they can be interpreted a lot of different ways. In the context of an industry report I think it makes a lot more sense.

Operator

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

Sameet Sinha - B. Riley

Yes, thank you very much. Mike, I wanted to speak to you about the gross margin comment that you made, saying that the gross margin should start to expand in the longer term. But the way I look at it, as you reach year end, you have higher pricing on subscription services; your listener outgrowth should normalize; your local sales team should start kicking and generating higher RPM local revenue; in-auto advertising, promoted stations, all these should give higher RPMs. So I would think that your gross margin should start to expand again starting in the fourth quarter. Can you comment on that?

Brian McAndrews

Actually, I think it’s natural for us to see gross margin expand as you move through the year. In fact, it expanded pretty dramatically Q1 to Q2. Q1 of 2014 to Q2 2014, almost 1,000 basis points I think. We expect that to continue to happen and peak in Q4 has then reset in Q1, higher than last year or higher than this year, next year, but the commentary made there was really an artifact of the denominator of RPMs, indicates hours.

I mean hours were 3.9 billion to a little over 5 billion year-over-year. So the denominator in that RPM factor was much, much higher and in those hours we are paying 9% more than we did last year and it's directly linearly associated with those costs. The costs were up directly with that increased hours and revenue per 1,000 hours, that was the much bigger hurdle.

Now two Pandora’s credit, we absolutely achieved that. Revenue growth outstripped costs growth, even with much higher hours, much higher inventory, resulting in nice RPM growth year-over-year, and I think well, even though the expansion of gross margin in the quarter was only a fraction of a percentage point, we do expect that to continue through the year as RPMs continue to grow and LPMs remain essentially flat.

Operator

And your final question comes from Rob Sanderson with MKM Partners.

Rob Sanderson - MKM Partners

I just made it under the wire. Thanks for taking the question. Your local ad sales is about 20% ad revenue. Was that flat from last quarter and how much of your ad visits can think local can be by the end of ’15?

And a follow-on to that, local sales productivity, how much more productive were your last year’s hires be this year, another way to ask that, how much of your local growth you expect to be driven by new hires compared to a ramp in sales productivity?

Brian McAndrews

Bob, thanks for the question and thanks for hanging in there. Yes, it was up I think something like 80 basis points sequentially in terms of percentage of ad revenue Q1 to Q2 from a local ad sales perspective, and I think that reflects the fact that most of the revenue driven in local ad sales in Q1 and Q2 is driven by sales people that began the year at full capacity and we are seeing that and the same thing with the rest of revenues that’s kind of consistent at sort of the last year’s fully baked quarters.

As we go into the back half of the year, we expect that local revenue will continue to accelerate. Part of that addresses one of the things you also asked us about productivity. This year we’ve seen the local advertising team really hit the ground running. I think we are better and we’ve learned a lot over the last two years of the first 27 markets. What to do? How to make them productive? How they get them up and running. I think we've been in Mediaocean and STRATA now for more than a year.

So they are walking in on day one with these tools and with now Telmar on the planning side, already operational and being used by agencies largely, so lots of benefits are increasing. Its increasing productivity and improving that ramp to fill productivity. It’s one of the reasons we are getting bullish about the back half of the year and raised our top line revenue target significantly for the year, but in the second quarter’s call.

Lastly, like how much do we think we could get to by the end of 2015, which was your last question. I think it is going to steadily increase. Two-thirds of all the radio ad buying in the United States is local. We think that not only can we achieve that over time, that split, but it could be even greater, because access advertisers that are currently shut out of the radio world, because they can't afford to reach over the air broadcast, rest of the radio, because we can segment much more granular and sell much smaller radio buys. I think we can actually expand the radio advertising market, connect it to radio overall. It could really be a growth area in general for local advertising.

Brian McAndrews

With that we’ll close out the call. Angelo if you can take us back to talk about B2B, we’ll continue on our conversations throughout the quarter. Thank you.

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Source: Pandora Media's (P) CEO Brian McAndrews on Q2 2014 Results - Earnings Call Transcript
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