Much has been written about Pandora (P) leading up to its IPO this week and it seems more has been negative than positive.
The negative commentary became quite voluminous following Pandora's filings that indicated a price range and number of shares offered that would result in a total market capitalization of over $1 billion. There have been some valid arguments presented, mainly that the company's content costs are rising, that the company does not control its content costs beyond 2015 and that a significant portion of the shares being offered are from existing shareholders. Each of these factors should be at least a yellow flag indicating to investors that they should proceed with caution. However, we believe that there are several factors that could justify what we expect to be a $2 billion-plus market cap, if not now then later this year or early next year when the company has had a couple of quarters to operate without the major cash constraints it operated under prior to this offering.
Given the implications of the three major issues mentioned above, we should put this potentially positive outlook into context, which is our belief that we are at the beginning of a wave of innovation in music delivery where consumption of music will increase significantly as consumers gain access to the music they want anytime, anywhere and on just about any device. We see Pandora as the early leader in the push to get its program pre-installed on home consumer electronics products (ie TVs, DVD players, audio receivers) and in automobiles, which along with its already near ubiquitous presence (it's a top 5 app on all four major smart phone platforms, #1 on the iPad and #2 on the iPhone) on the ever expanding number of smart phones will essentially make it the first service to be truly available anytime and anywhere. This has the potential to make Pandora the "Netflix (NFLX) of music" where consumers expect to have the Pandora option on any device or platform that delivers music and manufacturers risk decreased relevance if they fail to offer it. This phenomenon is at the same time enormously valuable and difficult to quantify.
We see three factors that could drive Pandora's valuation to $2 billion-plus and two of them (if they materialize) could wholly justify such a valuation and then some. The first factor is what should initially drive the $2 billion-plus valuation for Pandora - investor recognition of the revolution occurring in the delivery and consumption of music and a desire to gain portfolio exposure to the mobile/streaming music space. Scarcity is the key word here and it almost seems that the bankers bringing Pandora to market appreciate and are playing on this theme by offering such a small percentage (approximately 10%) of the company in its IPO. There simply aren't very many ways for a retail investor to buy in to the revolution they see taking place. While Apple (AAPL), Microsoft (MSFT), Amazon.com (AMZN), Best Buy (BBY) (ownership of Napster), Viacom (VIA) (through MTV's stake in Rhapsody) and Google (GOOG) all have or likely will have significant streaming music service offerings, it is difficult to imagine a scenario where one of these services will have a large enough impact to "move the needle" in terms of direct contribution to the top or bottom line. When it begins trading on Wednesday, Pandora will be one of only two "pure play" publicly traded streaming music options available, with the other being a tiny Nasdaq listed company called Atrinsic (ATRN).
Atrinsic entered the streaming music business through its recent acquisition of the iconic Kazaa brand and is much smaller than Pandora with a market cap a little below $20 million. However, it is much like Pandora in that very few of its shares are available to the public, with over 85% of its six million shares held by executives, directors, the "Big Four" music labels and other registered 5% holders.
Thus, retail investors who want to invest in a company whose shares will be significantly and directly impacted by the streaming/mobile music revolution have the option of buying some of the 14.8 million shares of Pandora that will be available come Wednesday or the 1.1 million or so shares of Atrinsic/Kazaa that are available to the public. When you consider that close to 100 million people have downloaded Pandora and that the original version of Kazaa was downloaded close to 800 million times, you get a feel for the broad and wide reaching appeal of these kinds of services and at least a general notion that there would be quite a few investors who might want a piece of the action. In summary, we think there will be great demand for pure play streaming/mobile music offerings and until Spotify and/or Rhapsody goes public, there will only be 16 million (14.8m Pandora & 1.1m Atrinsic/Kazaa) or so shares available to the investing public. What we expect to be great demand for the small supply of shares available will likely drive Pandora's share price much higher when they begin trading - possibly even well beyond a $2 billion market cap.
The second and third factors will be key to driving Pandora's long term valuation and we believe that either (if they materialize) would go a long way toward addressing the biggest issues Pandora faces and could even justify/expand on Pandora's $2 billion-plus valuation.
The second factor is the increased monetization of listener hours. We believe that the ads run by Pandora at this stage are unlikely to reflect their true value. The targeting technologies and the marketing of this inventory are new to Pandora and advertisers. We believe this market has yet to evolve to reflect their potential value, not unlike the place where Internet pay per click ads were around the time of the dot com bust.
Pay per click ads of the kind that the Google juggernaut was built upon were just beginning to be offered by Google in 2000 - 2001, a time when many businesses seemed to lump all online advertising into the same basket - too expensive to be justified. Much of this perception was based upon the prices being charged for those banner and other non targeted display ads that were so popular in the early days of the Internet boom. Many failed to appreciate the value distinction between a display ad that would be displayed to all visitors to a website vs. an ad that would only be offered to a very specific segment of the visitors to that site - in this case the people who entered a search query that matched the terms the advertiser viewed as being a good fit for his product.
I started an online specialty lodging marketing company in a spare bedroom in early 2000 (and sold it to a Nasdaq listed company in 2006) when I realized that I could be the top bidder for search terms related to my products that would show up at the top of searches on AOL, Yahoo, MSN and Google. For 10 to 20 cents per click I could be the top ad shown for a product that would generate commissions averaging over $75 that converted on average one of every 40 times it was clicked. As one might expect, over the next few years the prices of those ads rose substantially (to over $2 per click) as other advertisers realized the value of those placements and began competing to take those top spots. Some competitors figured out ways to drive even more value from each conversion and others simply kept bidding up the prices for search terms even beyond levels that could be profitable. This same scenario began to play out for most all commercially viable keywords, as the the understanding of the value proposition of keyword bidding through Google Adwords reached a critical mass of advertisers who drove the prices for each ad much higher than they were in the first couple of years of the service.
We believe that internet radio/streaming music advertising is at that same kind of early stage juncture. We believe that Pandora's early ad sales have been characterized by the value of radio ads, which are much more like the old run of site banner ads that deliver the advertiser's message to all users. However, Pandora's highly customizable ad offerings are actually much more like the pay per click ads in their ability to target a message to a very specific audience. On the Pandora platform, an advertiser can have its message directed to a very specific segment of listeners with targeting by age, gender and zip code. There are even taste factors that could be entered into the equation, for instance the ad could be targeted to just the 32-year-old females in a certain zip code who like Michael Buble. This ability to target a customized marketing message to a very specific target market is new and currently unique. When more market specific local advertisers begin to be introduced to the advertising mix, Pandora will be able to monetize more of the millions of listener hours with customized ads and the competition that will emerge for these customized placements will increasingly allow Pandora to monetize those hours at higher rates. We note that Pandora only started targeting ads in local markets just a few months ago and expect that revenues going forward will be impacted much more heavily by this factor.
A third major factor could allow Pandora to grow into that multi billion dollar valuation. We believe that Pandora management will begin to put more emphasis on growing the subscription side of the business both organically and through acquisitions. We will be shocked if management does not put its "freshly minted" acquisition currency to work and it is possible that it might look to acquire one of the smaller on demand streaming services to ramp subscriber revenue by the addition of a higher value added product line.
There are only five companies that currently have the U.S. licenses that will allow on demand streaming and two of them (Napster and Rhapsody) are owned by large organizations that would be unlikely to sell them. That leaves three prime targets that the company might be able to scoop up now at prices that could look ridiculously cheap two years out, namely the aforementioned Kazaa or the VC backed MOG. We would also include Rdio in that list, but wonder if MSFT's acquisition of a significant stake in Rdio through its purchase of Skype might make overtures toward Rdio a little more complicated.
We believe such a move could jump start the subscription revenue side of its business and we ponder how quickly Pandora might be able to scale such a business by offering such services to its 100 million strong "warm" prospect base of radio style streaming music program downloaders. If it could get one third of the converters (freemium to paid subscribers) from that user base that the on demand service Spotify has achieved (7.5%), it would instantly make Pandora the largest player in the "on demand" streaming space. The resulting subscription revenue stream (at the going industry rate of $9.99 per month) would become its largest revenue source, exceeding Pandora's current advertising revenue run rate of approximately $210m per year.
Pandora wannabe upstart Slacker is a Pandora style streaming radio service that just began to offer an on demand streaming service earlier this month. Slacker is making a "de novo" attempt, but we think it's more likely that Pandora will go the acquisition route to ramp the subscriber side more quickly and take advantage of the disparity in its valuation vs. the largely under-appreciated on demand services. Assuming it can beat Amazon, Sirius XM (SIRI) and Google to the punch, it appears that Pandora might be able to acquire one of the three aforementioned streaming on demand players for prices that might be less than the cost of getting licenses from the Big Four music labels (Apple reportedly paid $100 - $150m, Spotify is reportedly raising $100m+ to cover US license fees, and Kazaa paid $115m in fees to obtain the necessary licenses). While most of the on demand streaming music services are not yet publicly traded, we note that the largest (ATRN/Kazaa) of the three mentioned above as the best targets has a market cap in the $20m range, substantially below the $100m - $150m going rate to get U.S. licenses from the four major music labels and only about 1% of our projected $2 billion market cap for Pandora.
In summary, we strongly believe that Pandora will achieve a $2 billion-plus market cap this week due to the scarcity of options for investors to get exposure to the evolving mobile/streaming music revolution. And while we do not dispute many commentator's reasons for taking caution, we think this valuation could be justified if the company is able to significantly increase its monetization of listener hours and/or materially ramp its subscriber revenue through acquisitions.