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Back in March, after Pandora (P) filed its S-1, we published a research note positioning the postives and negatives of the story along with a preliminary Intrinsic Valuation estimate (IV).

Pandora has updated its filings and is now in active marketing, just as Apple (AAPL) unveils its iCloud strategy. Despite the name, the Apple iCloud strategy appears to be more focused on making users' own Apple devices and content work together so the user can have his own private cloud rather than a personalized public cloud offering like Pandora. Besides, Pandora's "Internet radio" will continue to be a different use type than iTunes.

We've updated our note with the new numbers and added one negative factor, which is the increasing consumer concerns around bandwidth use and costs. Overall, our conclusion is that we'd be cautious on this one. Pandora is a big success, but its business model is unlikely to generate double digit operating margins, even in the long term. That doesn't make it a bad investment, but it does mean that the price matters.

Positives, Neutrals and Negatives

+ Pandora is a very easy to use service. This is critically important in the consumer technology market and can hardly be emphasized enough.

+ Although the “Music Genome” approach that Pandora has pioneered has its critics, it does make it very simple for new users to declare some of the music they like and then enjoy a listening experience that includes both favorite music and new discoveries.

+ The market is large with some rapidly growing segments like iTunes and advertising-supported digital radio.

+ Pandora is the market leader in the streaming, advertising supported segment.

+ Getting the user experience right takes some doing. Pandora has executed well so far and has the resources to develop the necessary technology and services that keep users engaged and happy.

+ Music has been in the cloud for a long time (radio!) and is an ideal application for true cloud-based offerings. Pandora’s architecture and approach is more cloud-focused than many others’.

+ The management team has an excellent mix of backgrounds and experience, including: consumer marketing, cloud computing, online commerce, Internet business, legal affairs and music.

= Fees paid for content are still a fairly high percentage of sales and are basically going up on a per performance rate. Pandora may still have the ability to bring the costs down as a percentage of sales as they scale. The rates are set through 2015 after which point a new agreement will be needed.

- The obvious one here is competition, especially with Apple and Google (GOOG) controlling much of the mobile internet consumer market. If they launched strong offerings for iOS and/or Android respectively, it would take away some market opportunity for Pandora.

- Making matters worse, the competitive barriers in the business are basically nil. Pandora has strong technology but virtually no lock-in. Although it has some advantages to being included in consumer devices it’s not a lock-in like iTunes.

- Consumers are increasingly worried about bandwidth limits and costs. This makes them wary of streaming services like Pandora, especially when mobile or roaming.

Background & Context

What was previously known as the “music business” is shifting radically into consumer business. The transition is causing established players to suffer and scramble to cope with the changes. The market has been shifting more quickly than their ability to move.

Music has been delivered via an “analog cloud” called radio for a long time. Even today, most music is consumed this way but the “radio” is shifting from analog to digital.

Pandora is generally recognized as a pioneer and leader in streamed music content; or, as the company calls it, “Internet radio.” The company has 80 million registered users and a 50% share of internet radio listening in the U.S. Pandora started in 2000 with an innovative idea called the “Music Genome Project,” which is an algorithmic analysis of music to enhance the listening and discovery experiences of music. In 2005, the company launched its free service for consumers.

The company strategy has been to deliver its value as a service and allow consumers to access its Pandora stations on any platform, including computing devices such as tablets and smartphones, and in cars and consumer audio systems. Pandora is accessible on virtually any connected device.

By leveraging digital delivery and the internet, Pandora has been able to deliver a more effective audience for advertisers and a better ratio of content to advertising for listeners. The situation is analogous to how digital content-based advertising has impacted newspapers. This advertising model is driving major revenue growth. Revenue grew from $19m in fiscal 2009 to $55m in fiscal 2010 and should exceed $100m for fiscal 2011.

The Pandora IPO will help catalyze an intense battle for online music in 2011. Apple stands in the strongest position, but Google, Amazon (AMZN), the music industry and even consumers may be eager to see successful alternatives. In addition to Pandora, companies like Spotify, Sirius/XM, Radio (SIRI), MOG, Kazaa, Last.fm, RealNetworks (RNWK), Beyond Oblivion and dozens of smaller companies are vying for a piece of the action. Individual and syndicated stations are also implementing their own digital strategies. Recently Bob Pittman of Clear Channel noted that the company would push into the digital space and had the advantage of over 200m listeners.

This topic deserves a full-length report, but for now what follows is a short take on the Pandora IPO and some notes on industry dynamics and the other players. Indeed, the royalty structure and economics alone could occupy an entire report, if not a book. We’ll touch on them and of course they are incorporated into our financial models through 2015, at which point most existing licensing terms and agreements end.

Stock and Valuation

In updating our preliminary IV model from March, we note that the company has grown faster than our original projections so we have been able to increase our revenue estimates, which also allows us to give the company a slightly higher multiple (40x) to drive the IV.

Our IV model puts Pandora shares at $8. For comparison purposes, a peer analysis is attached as well as the IV model.

click to enlarge image

Revenues are growing fast so $8 represents just over 9x trailing sales; it drops to 5x current year estimated sales. Probably the most direct comparable companies are Sirius XM Radio and Netflix (NFLX), which trade at 4x and 6x current sales respectively. It’s also worth noting that Sirius and Netflix have both seen major increases in their stock prices of 128% and 147% over the last 12 months, respectively.

Conclusion

Many investors, particularly institutions, remain wary of investments in entertainment companies. But at the same time, Pandora is a real disruptor and a very rapidly growing company that is using technology and the internet to innovate and reinvent a large segment of the music industry.

Pandora has some key advantages over competition in the consumer experience and in monetization. This puts them in a good position in terms of the ad-supported streaming business. Early enthusiasm might push the shares beyond our IV estimates.

We would stick very closely to our IV estimate of $8 when looking at Pandora because we find its business model a little constricted. On the revenue side, it faces consumer concerns over bandwidth constraints and potentially increasing costs; on the expense side of the business, it is beholden to the content owners who might raise prices in the future. These margin pressures will make it difficult for the shares to sustain prices above our IV estimates.

Source: Positives and Negatives of the Pandora Story: Our Intrinsic Valuation Estimate