Seeking Alpha
Long/short equity, growth at reasonable price, research analyst, deep value
Profile| Send Message| ()  

According to a report by eMarketer, Pandora Media (P) is a leader in the mobile ad war, currently ranking second only behind Google (GOOG). Considering it has already surpassed companies such as Apple (AAPL) and Facebook (FB), this is a very impressive accomplishment. Unfortunately in the process, the company is losing the content costs war.

The company is a leader in custom-radio internet services. Prior to Friday, the stock surged nearly 25% over the last week. Investors were impressed with the revenue growth for Q2 2013 that ended in July. The big gains from mobile ads helped push revenue up 51% over last year. Apparently though this growth has attracted the attention of Apple, which according to published reports is planning a similar internet radio service to compete directly with Pandora.

Q2 2013 Highlights

Pandora reported the following highlights for Q2:

  • 2Q13 total revenue of $101.3 million grew 51% year-over-year
  • 2Q13 total mobile revenue of $59.2 million grew 86% year-over-year
  • 2Q13 total listener hours of 3.30 billion grew 80% year-over-year
  • Active users reach 54.9 million growing 48% year-over-year

Pandora continues to report impressive growth, yet it has very little to show on the bottom line. With revenue surpassing the $100M level, investors have to question when the company will finally have enough scale to reach the bottom line.

Mobile Ads

The eMarketer report is surprising in that it shows Pandora as a clear leader in the mobile ad space. Amazing that the report is forecasting more mobile revenue for Pandora than Facebook and Twitter combined. A prime example of how inept Facebook has been at developing a mobile strategy.

The 2014 forecast is also interesting in that the report sees Facebook finally gaining a strong share of the mobile market. While entirely possible that the sheer size of Facebook will lead to a dramatic leap forward in revenue, it still remains a question whether users will continue using the service if it becomes cluttered with ads.

Pandora is expected to jump to nearly $500M in mobile revenue by 2014 from a forecast of $226M in 2012. That amounts to a 123% gain over the two years. Considering the jump in Q2 mobile revenue, Pandora is already at a nearly $240M run rate, placing the 2012 estimates as very conservative.

Apple Details

Per the Wall Street Journal on Thursday, Apple is in talks with the music industry to license content for a custom-radio service similar to Pandora. This news of Apple entering the space sent Pandora down nearly 17% on Friday. Was the move justified?

Look at the take from Peter Kafka of AllThingsD. He summarizes the plan as following:

  • Apple could launch a Pandora clone tomorrow without the labels' permission, because if it wanted to do a straightforward "Web radio" service, it could use the same compulsory licenses that Pandora and other Web radio services use.
  • Apple will want more flexibility than those licenses provide, so it will need the labels' permission for that. That's not a slam dunk, but it's quite doable, because the music industry has become a lot more flexible in the past few years. That's what happens to an industry after a decade-plus of staggering decline.
  • And in any case, the labels are happy to cut deals with Apple. Label chiefs used to blame Apple and its iTunes store for part of their decline, but they've gotten over that. And they like generating additional revenue streams.

Peter shares some similar questions about the service. Sure Apple could sell ads better than Pandora, but that doesn't seem likely, considering the iAd platform has been a major failure. Not to mention, a new iOS radio service would share the same flaw of being tied to Apple products, while users want the freedom of mobility to other platforms.

The only apparent benefit might be a tie-in with iTunes, but even that seems late to the game as Pandora already controls the internet radio market. Will users convert to Apple just because it has a similar service? Something tells me that the early adopters on Pandora might just stick around.

Valuation

While the eMarketer report momentarily changed my opinion on the stock after being very negative back in May, the details of the Q2 costs slapped me back to reality.

Though the company had impressive revenue growth overall and especially in the mobile sector, the content costs continue to leave little to desire in the valuation. Content costs hit $60M for Q2 or roughly 60% of total costs. On top of that, the company also spent $23M or roughly 23% of total costs on Marketing and Sales. The combined two expenses leave very little in the way of margin to offset any product development and administration costs with a gross margin of around $94M.

After the sell-off Friday, the market value dropped to just under $2B using the 194M diluted shares expected for Q3. That appears expensive for a stock that is unable to generate revenue beyond the cost of providing the service.

Conclusion

While the company might soon face competition from Apple, the bigger problem remains that higher growth only leads to higher costs. Until the company is as inventive with reducing the content costs as with creating a desirable service, this stock just doesn't provide much value.

With the advancement and scale of Pandora, Sirius XM (SIRI), and Spotify, it seems unlikely that Apple will make much headway with the music labels on any advantageous licenses. Pandora remains a good way to play the sector if only the fundamentals matched the growth.

Disclaimer: Please consult your financial advisor before making any investment decisions.

Source: Pandora: Winning The Mobile Ad Battle, But Losing The War