Pandora: Strong Market Opportunity, Thin IPO Float Could Amplify Investor Demand

| About: Pandora Media (P)

Backed by a slate of notable VCs, Pandora Media (NYSE:P) launched its free internet radio service in 2005 and has quickly scaled to take a commanding 58% share of the market with 34 million active users. After increasing its deal terms last Friday, Pandora now plans to raise $162 million by offering 14.7 million shares at a price range of $10 to $12.

The company had previously filed to offer 13.7 million at a range of $7 to $9. At the midpoint of the proposed range, the proceeds raised should exceed the original terms by nearly 50%, valuing the company at $2.1 billion.

Pandora plans to price Tuesday evening and list on the NYSE on Wednesday under the ticker symbol P. Morgan Stanley, J.P. Morgan, and Citi are the lead underwriters on the deal, which is one of the three deals scheduled to price on this week's US IPO calendar.

Background

Pandora was designed to personalize the online radio listening experience. The company maintains a music catalog of over 800,000 songs spanning 240 genres, with each piece being categorized on up to 450 fundamental attributes in order to craft individualized radio stations based on user preferences. The company began by streaming its ad-supported services to desktops and laptops, however, Pandora has seen strong adoption in mobile devices (currently 60% of listener hours) and maintains partnerships with makers of over 200 "smart" consumer electronic devices.

Beyond consumer electronics, the company has hosted negotiations several auto manufacturers, including Mercedes-Benz and Ford, as well as aftermarket audio system suppliers in order to enter the automotive market. The service is expanding beyond current musical offerings, with the company preparing more varied programs including comedy (launched in May 11), news, sports, and talk.

Financials

Pandora generates revenues from online display video and audio ads (87% of 2010 revenue) and through the sale of ad-free subscriptions (13%). For the fiscal 1Q ended April, sales grew 136% to $51 million as a result of 137% growth in advertising and 134% growth in subscriptions. Listener hours were up 129% to 1.6 billion on active user growth of 89%. Operating loss widened to $5 million as a result of investments in advertisement sales and general operations. The company remains unprofitable, with operating losses expected to continue into FY12, but management targets 20% operating margins at scale.

Risks

Pandora's content costs currently represent 50% of sales and are driven by listener hours, which may limit the scalability of the business model. A key licensing agreement with SoundExchange expires in 2015, which may result in higher royalty rates. There are low barriers to entry, and the market already has several competitors including Slacker Radio, Groove Shark, and traditional media giants such as Clear Channel, CBS (NYSE:CBS), and Sirius Radio (NASDAQ:SIRI). Regulatory framework outside the US makes content licensing prohibitively expensive at present and the process for securing international licensing rights could take several years.

Outlook

Given Pandora's rapid growth in user listener hours and its experienced management team, Pandora appears to be well positioned to expand advertising in a $24 billion addressable ad market. Usage-based content costs are the key concern for this story, as they have contributed to a track record of operating losses and may limit long-term margin upside.

Nonetheless, Pandora can leverage its market dominance and "Music Genome" to increase revenue penetration through higher ad inventory sell-through and ad load. This market opportunity and very thin IPO float could amplify strong investor demand for this innovative, high-growth internet story.