Pandora Proves Business Model, Non-GAAP Profitable In 2Q14

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Pandora Media, Inc. (NYSE:P) management forecasted Non-GAAP (loss) earnings per share is between $(0.02) and $0.01 for 2Q14 and $(0.02) and $0.08 for the FYE14. At first glance, when this earnings release was published, it seemed quite a stretch that Pandora could generate a GAAP or Non-GAAP profit but after some analysis, included below, a Non-GAAP profit appears to actually be possible in 2Q14.

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The forecast was developed using the assumptions listed below but is limited in many ways as a result of the author's inability to consult with management during the process of developing the forecast. As a result, the forecast may be wrong and any reader of this article should not rely on it to trade Pandora shares. All figures are in millions, except per share data.

1. Pandora's revenues and major costs are seasonal. Therefore the only reasonable way to estimate future quarterly figures is to consider management forecasts and the seasonal historical results available. Revenues for 2Q14 are assumed to be in the middle of the range forecasted ($155.0-$160.0) by management, or $157.5. This represents current quarter (2Q14) over prior quarter (1Q14) growth of 25.5% and is consistent with the prior year current quarter over prior quarter growth of 25.4%.

2. Revenues for 3Q14 and 4Q14 will grow at 9.3% and 2.1% (current quarter over prior quarter) respectively, representing a 50% growth rate decrease as compared the prior year, FYE13, current quarter over prior quarter growth rates. FYE13 current quarter over prior quarter growth for 3Q13 and 4Q13 was 18.5% and 4.2% respectively. This 50% cut in growth, though arbitrary in nature, was necessary in order for the forecasted revenues to fall within the FYE14 revenue forecast of $615.0-$635.0 supplied by management in its 1Q14 earnings release. This forecast confirms that Pandora management see the revenue growth rates slowing this fiscal year beginning in either 3Q14 or 4Q14. Actual 1Q14 revenue was $125.5. Forecasted 2Q14 revenue is $155.0-$160.0. Together, these figures therefore represent revenue of $280.5-$285.5 that management anticipates will be generated for the first six months of FYE14. If $615.0-$635.0 in revenues are expected for all of FYE14 then only $334.5-$349.5 in revenues are therefore anticipated by management for the second half of FYE14. Although this does represent growth, the growth rate is expected to slow.

3. Costs of revenues, marketing and sales and other operating expenses are estimated to be equal to the costs incurred in each quarter of FYE13 on a percentage of revenue basis. This is considered a reasonable approach given the significant impact of seasonality on both revenues and costs. A review of current quarter over prior quarter figures, on a percentage of revenues basis, supports the fact that seasonality does exist but on a percentage of revenue basis, the percentages have not varied considerably, except for perhaps costs of sales in 2Q13, which had a current quarter over prior quarter percentage of revenues decrease of 10.5%. It is worth noting that over the next three quarters, this percentage changed in the opposite direction, increasing a total of 6.6% and further supporting the assumption that these percentages do not vary so substantially from quarter to quarter that they cannot be relied upon to some degree for forecasting purposes.

4. Other income (expenses) and provision for income taxes are immaterial. Prior year figures were assumed for each reporting period presented.

5. The subscription return reserve was 2.4% of 1Q14 revenues. This percentage was used to estimate the subscription return reserve for 2Q14, 3Q14 and 4Q14, respectively.

6. Stock based compensation is estimated to remain stagnant for each of the remaining quarters of FYE14. According to Pandora's 10-K, stock compensation that was deferred as of January 31, 2013 will be expensed in future periods, and represents approximately $2.5 per month on a going forward basis. This is consistent with the estimate of stock compensation of $7.4 for each period presented herein. Additional issuances of stock to employees or others could result in additional stock compensation expense. However, this was not considered in this forecast due to a lack of understanding of management's intentions with regard to this subject.

7. The shares used to compute the Non-GAAP earnings per share for 2Q14 and FYE14, 175,000 and 176,000, respectively, were provided by management in the 1Q14 earnings release. The figures used in the calculation for 3Q14 and 4Q14 were estimated within the range provided by management for those two periods.

8. All historical data was derived from Pandora's annual and quarterly reports found at and earnings releases published for each historical quarterly reporting period referenced herein.

It is important to remember that this is Non-GAAP profit and any or all of these assumptions could be wrong. It is an encouraging analysis but as most investors will agree, free cashflow is what really matters. What is important here though is that this does seem to show that Pandora's business model, criticized by many, may actually be possible of producing GAAP profits one day. Many who have spoken out against investing in Pandora are also not aware of the fact that Pandora's management has clearly focused on customer experience initiatives rather than trying to fully monetize their listening base. It is entirely likely that once Pandora believes it has successfully entrenched itself within the internet radio sector as the leader or one of a few primary leaders, then ads within Pandora broadcasts will increase in number. On June 24, 2013, Cracker's David Lowery alluded to the potential of Pandora serving more ads and increasing revenues "Right now Pandora plays one minute of commercials an hour on their free service. Here's an idea! Play two minutes of commercials and double your revenue! [Sirius XM (NASDAQ:SIRI) often plays 13 minutes and charges a subscription)." Pandora will also likely seek out technology innovation internally and perhaps externally through M&A in order to increase monetization. Yes competition and massive royalties are major issues and neither can be discounted. I think those topics have been discussed at length by others and do not need to be reiterated here. With all of this in mind, it will be very interesting to see how internet radio plays out in the next few years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. If any reader would like a copy of the spreadsheet used to make these calculations I would be happy to share the document with them. Please email me at requesting a copy.