Pandora Media (P) Q4 2017 Results - Earnings Call Transcript

Feb. 21, 2018 10:40 PM ETPandora Media (P)7 Comments
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Pandora Media, Inc. (NYSE:P) Q4 2017 Earnings Call February 21, 2018 5:00 PM ET

Executives

Derrick Nueman - Pandora Media, Inc.

Roger J. Lynch - Pandora Media, Inc.

Naveen Chopra - Pandora Media, Inc.

Analysts

Michael Graham - Canaccord Genuity, Inc.

Richard Greenfield - BTIG LLC

Amy Yong - Macquarie Capital (USA), Inc.

Barton Crockett - B. Riley FBR, Inc.

Dylan Haber - RBC Capital Markets LLC

Ronald V. Josey - JMP Securities LLC

Matthew C. Thornton - SunTrust Robinson Humphrey, Inc.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Ashwin X. Kesireddy - JPMorgan Securities LLC

James Charles Goss - Barrington Research Associates, Inc.

John Peter Egbert - Stifel, Nicolaus & Co., Inc.

Operator

Welcome to Pandora's Fourth Quarter 2017 Financial Results Conference Call. Opening today's call is Derrick Nueman, Vice President, Pandora. Sir, you may begin your conference.

Derrick Nueman - Pandora Media, Inc.

(00:11-00:17) and welcome to Pandora's fourth quarter 2017 financial results call.

Before we begin, let me remind everyone that today's discussion will contain forward-looking statements based on our current assumptions, expectations and beliefs including projected financial results or operating metrics, business strategies, anticipated future products or services, anticipated market demand or opportunities, and other forward-looking topics. For a discussion of the specific risk factors that could cause our actual results to differ materially from today's discussion, please refer to the documents we filed with the Securities and Exchange Commission.

Also during this call, we will discuss non-GAAP measures of our performance. GAAP financial reconciliations and supplemental financial information are provided in the press release filed with the SEC and detailed financials are available on our investor relations site. Today's call is available via webcast and a replay will be available for two weeks. We will also post the full text of today's prepared remarks once they have been concluded. You can find all of the information I have just described on the Investor Relations section of pandora.com.

On today's call joining me are Roger Lynch, Pandora's President and CEO; and Naveen Chopra, Pandora's Chief Financial Officer.

With that, let me turn over the call to Roger.

Roger J. Lynch - Pandora Media, Inc.

Thanks, Derrick. And as you all know, this is his first Pandora earnings call, and we're all excited to have him here. Good afternoon, everyone. I've been at Pandora for five months now and having had a chance to dig in, I'm even more excited about the opportunity. We continue to set the standard for music discovery, and as a result, our users spend more time with Pandora than any other digital publisher as measured by comScore. With nearly 75 million monthly active users, Pandora remains the largest streaming audio provider in the United States and is the largest publisher of digital audio advertising, which all means that we are really well-positioned to enter a new era of audio.

What do I mean by this? Digital audio is on the verge of massive growth. Americans listen to an average of 4 1/2 hours of audio a day. And in the past two years alone time spent listening to music grew about 40%. This trend is going to continue upward as we see explosive growth in connected and voice activated devices and rapidly increasing consumption of other forms of content such as podcasts.

To put it in perspective, we expect one out of every two people will have a connected device in their home by 2022, and this will encourage incremental audio listening. These trends are early signs of a broader sea change in the world of audio. Just like broadcast video, newsprint and most other forms of media, audio is transitioning from a one to many broadcast experience to a one-to-one model with personalization at the core. This means the $16 billion terrestrial radio market will increasingly move to digital models where listeners enjoy a better experience and advertising can be targeted and data driven.

As I described last quarter, we are well positioned to take advantage of this transition. But first, we need to address our challenges head on. We're starting to do just that and during Q4, we began executing on many of the initiatives I outlined on the Q3 call. Q4 was an important first step towards these goals. Naveen will share more specifics about the quarter after I share some highlights on our efforts to drive users, improve monetization and create long-term operating improvements and leverage.

Starting with users, although it's too early to expect the initiatives we identified last quarter to shift the trajectory in our audience metrics, we are pleased with the launch of several important initiatives across product, marketing and partnerships that we expect will improve audience retention and engagement over the course of 2018.

On the product front, we previously highlighted the importance of adding more interactive features to our ad-supported service. In late Q4, we took a major step with the launch of Premium Access. Premium Access is a product that addresses the largest reason listeners use other services, they want to listen to a specific song or artist but can't do so without a subscription. With the launch of Premium Access, Pandora users can now unlock a window of robust on-demand music listening in exchange for viewing a short video ad. They are able to search for a specific song or artist and share direct playlist links with their friends. This not only delivers a more complete experience to our listeners but it opens new promotional opportunities for artists to feature their latest tracks and albums. And it also unlocks new rewards-based video inventory for our advertisers.

With this new product offering, we now have more compelling and complete functionality in our mobile ad-supported service than any other competitor. Premium Access also represents the simplest and easiest way to try Pandora Premium for a limited period of time, an experience that we expect to become a highly effective acquisition channel for our subscription service.

Later this quarter, we will start our marketing of Premium Access, engaging artists and creating more doorways, so that users on our ad-supported service can more easily find the new functionality and search for any artist or song they want. Nonetheless, early results are encouraging, we're seeing higher repeat sessions among Premium Access users, more use of Premium Access by younger users, and better conversion to our Pandora Premium subscription product, especially by younger listeners.

While Pandora's ad-supported service remains the biggest part of our business, our subscription products continue to perform well. We added approximately 300,000 subscribers in Q4 and grew subscription revenue 65% year-on-year, excluding Australia and New Zealand. As much as people want to paint us as either an ad-supported business or a subscription service, I am a firm believer that we need to meet consumers where they are. While we're the largest ad-supported music service and we intend to press this advantage, I do see significant opportunity to grow our subscription business and utilize the tactics I've learned from running three other subscription businesses prior to this.

Also on the product front, we have achieved spectacular listener growth through voice-activated devices. In Q4, Pandora listening on voice-activated devices was up 145% year-over-year. Given the expected growth in voice-enabled speakers, we believe this trend will continue. Our continued investment in audio experiences, voice and personalization will help drive sustained momentum in this rapidly evolving market.

During Q4, we also announced a number of device partnerships, including Comcast's Xfinity X1, Sonos, Amazon Fire TV, and Android TV. These are important because they enable our full suite of ad-supported and subscription services, as well as Premium Access in the future, on all of the devices consumers care about. This is a critical part of our plan to grow, and these announcements are a taste of what we expect will be many more during 2018.

We have spoken about our intention to expand beyond music by adding podcasts to Pandora's wealth of audio content. Podcasts are a natural first step because of Pandora's ability to address the biggest headwinds to podcast growth; discoverability and monetization. Our strengths in these areas combined with our advertising scale provide us the ability to bring podcasts to market in a way no one else has to-date.

I also believe Pandora can make more effective use of an important component of the audience equation, marketing. This past quarter, we announced that we're investing in martech tools that leverage our strength in data science, which we already use very effectively in both our consumer and advertising offerings. We're bringing in a team that can take advantage of this approach, led by our new CMO, Aimee Lapic. I look forward to seeing Aimee's analytics-driven approach and our increased capabilities improving the effectiveness of our marketing spend as we progress throughout the year.

Moving onto monetization, last quarter we spoke about our need to invest in ad tech, including increased focus on programmatic, which will leverage many of the strong capabilities we already have: scale, targeting and innovative ad formats. I am happy to report our programmatic video offering is in beta and yesterday we announced our audio programmatic pilot with Volkswagen, Omnicom Media Group and top DSPs including The Trade Desk, MediaMath and AdsWizz's AudioMatic. These offerings are expected to drive RPM growth over time by increasing sell-through and optimizing CPMs.

Of course, there are other important ad tech initiatives including new ad formats, ROI measurement, self-serve and better automated tools. We've also mentioned that we are exploring build and buy options to tackle these and we've made meaningful progress on those plans. We'll share further details as 2018 progresses.

Shifting to our organizational efforts, we recently announced we've undertaken several steps to fund the strategic priorities I just outlined. As I stated on our Q3 earnings call, we'd first focus on internally funding these investments by reallocating funds within our current cost structure, and we've done just that by identifying approximately $45 million in annualized adjusted EBITDA cost savings to put towards these efforts. We've also made changes to our org structure to drive more innovation and faster execution. And finally, we're increasing our presence in Atlanta, a city with a rich history in music that also gives us access to a wealth of talent that can be hired and retained at lower costs than in the Bay Area.

In closing, I'm confident that we're taking the right steps to reinvigorate Pandora. This means driving more listeners to our platform and a continued focus on monetization. From launching on demand for our ad-supported listeners to our programmatic efforts, we made progress on several important initiatives in the last quarter alone. I expect them to help accelerate our business as 2018 progresses and enable us to take full advantage of the rising importance of digital audio.

Thanks, and now I'll hand it over to Naveen.

Naveen Chopra - Pandora Media, Inc.

Thanks, Roger. Financially, Q4 came in significantly better than previously expected but more importantly as Roger detailed, we are excited about the progress made on several key initiatives that are critical to improving future financial performance through a return to active user growth and enhanced monetization.

I'm going to share some additional color on our Q4 results and then address guidance. Please note that for the purposes of our comments today, we will exclude Australia, New Zealand and Ticketfly from year-over-year comparisons for revenue, operating expenses, actives and hours.

Q4 total revenue was $395.3 million, growing approximately 7% year-over-year. This was driven by a 65% year-over-year increase in subscription revenue partially offset by a year-over-year decline in advertising revenue. The growth in subscription revenue was driven by subscriber growth and higher ARPUs. In the fourth quarter, we added approximately 300,000 subscribers, bringing cumulative subscribers to 5.48 million. ARPU increased to $6.08 as strong growth in Pandora Premium subscribers, which have a higher monthly ARPU, continued to offset declines, albeit a slower rate of decline than in Q3, in Plus subscribers.

Q4 advertising revenue was better than our expectations because a greater proportion of ad buys were placed later in the sales cycle than we typically see in the fourth quarter. However, ad revenue fell year-over-year primarily due to a decline in active users. Ad RPM grew 12% year-over-year to a record $75.65 in Q4. The strong ad RPM reflected a meaningful increase in blended effective CPMs and a slight increase in ad-load, offset by a modest decline in sell-through. It's also worth noting that mobile ad RPM exceeded web RPM for the first time ever. Five years ago, mobile ad RPMs were half that of web RPMs. We highlight this because it speaks to the potential of new platforms and ad formats.

Today, we have a major focus on driving listening through the new generation of CE devices like smart speakers. Those platforms don't monetize well today due to limitations in ad-tech and relatively nascent advertiser demand. But that will evolve in much the same way mobile has evolved, and we want to ensure that Pandora is positioned to benefit from continued proliferation of these devices.

Speaking of monetization gains, one of our highest priority initiatives is enabling programmatic sales, and as Roger noted, we continue to make steady progress on that front. We are excited about the potential of our programmatic efforts to enhance sell through and optimize pricing by tapping into new demand without having to rely on low priced performance based ad channels as the company did in early 2017. We believe the combination of programmatic and other ad-tech initiatives will drive continued monetization improvements over time.

Moving to the audience part of the equation, total monthly active users were 74.7 million in Q4, down 6% year-over-year. A few things worth pointing out about these metrics; first, we were more conservative with our marketing spend in the back half of 2017 as we felt it was prudent to allow time to further refine Premium Access functionality, leverage in-process martech investments, and build out our marketing ROI framework. While financially disciplined, this approach meant a 46% year-over-year reduction in Q4 paid marketing spend which had an impact on active users.

And, as I've said before, stabilizing and then growing our audience is of the utmost importance, and we have a number of initiatives underway or launching soon that are designed to both further engage our existing users and re-engage lapsed listeners. Premium Access is one of the first of these initiatives and early 233 results are encouraging. Although it won't happen overnight, we are bullish about the potential for Premium Access as well as other initiatives on our roadmap, like non-music content, to drive incremental engagement and more listeners.

Total content costs represented approximately 55% of revenue in the fourth quarter. While Q4 ad LPM was slightly lower versus Q3 at $36.77, we had anticipated a larger sequential decline. Some of the minimum guarantees we incurred in Q3 were avoided, but these benefits were unfortunately, and unexpectedly, largely offset by minimum guarantee payments to other content owners, whose music was not played as frequently as forecasted. We expect ad LPMs to continue to fluctuate a bit due to the impact of MGs and ongoing changes to our arrangements with content owners. On the subscriber side, Q4 licensing cost per subscriber or LPU, was $4.41, up from $3.12 last year. These increases are largely driven by the mix shift from Pandora Plus to Premium.

Non-GAAP gross margin was 38% compared to 36% in the year-ago quarter. The increase in margin year-over-year is driven by higher ad RPM. We continue to expect gross margins to grow over time with improvements in ad monetization, and as we achieve scale benefits in the subscription side of the business.

Turning to operating expenses, for the fourth quarter of 2017 non-GAAP operating expenses declined 6% year-over-year, driven by decreases in marketing spend and reduced G&A and sales and marketing head count. The combination of better than expected revenue and continued discipline on OpEx led to adjusted EBITDA for the fourth quarter of $5.8 million. We have and will continue to look for opportunities to improve operating leverage, while focusing investment in high-priority areas. This was the basis for the company-wide reorganization we announced in January. The reorg resulted in annualized savings of approximately $45 million in adjusted EBITDA. The savings will be reinvested in growth initiatives. The key point here is that our focus on efficiency enables us to make material growth investments without creating incremental headwinds to profitability or cash flow.

Fourth quarter 2017 GAAP net loss per share was $0.21. This is based on approximately 250 million weighted average common shares outstanding. Cash and investments ended the fourth quarter slightly up at $500.8 million, with $7.9 million of cash provided by operating activities.

Now let's move to guidance. As we've referenced there are a number of moving pieces in our business this year. The timing of ad-tech developments, label negotiations, new content launches, distribution partnerships, marketing changes, and ongoing cost-efficiency efforts, all have the potential to materially impact short-term results. Therefore, we think it's prudent to avoid specific annual guidance until we have additional data points. For now we will provide some high-level direction regarding our expectations for the year and then provide specific guidance for Q1. So for the year, we expect top line growth in 2018 to come from the subscription side of our business and we're taking actions to stabilize audience and improve monetization that will ultimately lead to growth in advertising revenue. Because we are expecting strong subscription revenue growth, subscription commissions will also grow. Other than this increase in commissions, operating expenses will represent a lower percentage of revenue in full-year 2018 than in 2017.

Our ambition is to deliver additional efficiencies beyond the $45 million of reinvested savings we previously identified. These additional efficiencies should come through tighter business processes, automation, expansion in lower-cost locations and management of content costs. And importantly, we anticipate meaningful improvement in operating cash flow in 2018 versus 2017.

With that context for the full year, I'd like to address Q1 more specifically. As noted, many of our growth initiatives are still in early stages and their impact will build over the course of 2018. This means that Q1 will incur a lot of the same ad revenue headwinds as the second half of 2017. We expect Q1 total revenue in the range of $295 million to $305 million, the midpoint of which reflects 5% growth versus the year ago period when adjusting for Ticketfly and ANZ. A couple things to note about our Q1 revenue guide. We expect typical seasonality in 2018, which means Q1 is the weakest quarter for advertising revenue with significant pick-up from Q2 through Q4. Our Q1 revenue guidance assumes continued subscription growth offset by a year-over-year decline in advertising revenue.

We expect adjusted EBITDA in Q1 of 2018 to be in the range of a loss of $100 million to a loss of $90 million, which you will notice, is lower than the year ago period. This is a function of minimum guarantees and, to a lesser extent, the year-over-year decline in ad revenue. However, we think Q1 is a relatively unique quarter and that there should be significant sequential and year-over-year improvement in adjusted EBITDA as we move into Q2. In fact, cumulative adjusted EBITDA for the Q2 through Q4 period should be meaningfully improved versus the comparable period in 2017.

Please note that adjusted EBITDA differs from GAAP net loss in that it excludes forecasted stock-based compensation expense of approximately $29 million, depreciation and amortization expense of approximately $14 million, restructuring costs of approximately $9 million, other expense of approximately $5 million and provision for income taxes of approximately $300,000 and assumes minimal cash taxes given our net loss position. Basic shares outstanding for the first quarter of 2018 are expected to be approximately 255 million.

Before we open the call for questions, I want to underscore a point that Roger made in his remarks about our long-term outlook and the growing importance of audio. We are bullish about creating value in this business by combining our existing assets, namely the scale of our audience and strength in ad-based monetization, personalization, and data with the execution plan we detailed last quarter. That plan includes a number of initiatives to reinvigorate audience metrics and restore growth in advertising revenue. I think it's a smart plan, and one which we will continue to optimize.

As we highlighted in Q3, it's not an overnight plan, meaning there will be some bumpiness as we invest for the future. But that bumpiness does not change our conviction regarding the long-term opportunity and the potential to deliver improved returns for our shareholders.

With that, I'll turn the call to the operator, who will open the line for your questions. Operator?

Question-and-Answer Session

Operator

Your first question is from Michael Graham from Canaccord.

Michael Graham - Canaccord Genuity, Inc.

Thanks a lot. Just two quick questions, one is on the CPM strength in Q4. Can you just go into a little more detail about where you were seeing was it types of ad units or was it demographically driven? And then I just wondered you're making a lot of constructive comments about subscription this quarter, which is consistent with the past and I'm just wondering if you could give us an update on sort of how you're thinking about the relative profitability between subscription and ad supported and just sort of any interplay between those two sets of listeners that you're seeing or that you're trying to engineer? Thanks.

Roger J. Lynch - Pandora Media, Inc.

Okay, thanks. It's Roger. Let me start with, I'll actually answer your second question and hand it over to Naveen to answer the first question on CPM. Yes, we are bullish on subscription. We think that clearly within music, we're seeing, across the industry, strong growth in subscription and in particular for us with Premium, which are only launched in April, strong growth, and we expect to see continued growth for that. We think we're well-positioned for it, because the scale of our listener base gives us the ability to upsell, our ad support listeners to subscription and with Premium Access that I talked about in the prepared remarks that's also proving to be a very effective upsell conversion mechanism, especially for younger listeners into Premium.

So on average, we see Premium subscribers as being higher contribution margin than an average ad supported listener, but obviously, within ad supported those listeners who listen a lot that can be quite profitable and listeners who listen less that will be less profitable. It's much more mix within our ad-supported business. Let me hand it over to Naveen to talk about the CPM.

Naveen Chopra - Pandora Media, Inc.

Yeah. Michael on CPMs, as you said, we had some positive movement on that front. Overall, CPMs were up little over 10%. I think that two particular areas of strength we would point to both audio and the display CPMs were up measurably video, which already monetizes at a premium rate held relatively consistent, but both audio and display, we saw some nice gains on CPM.

Michael Graham - Canaccord Genuity, Inc.

Okay. Thank you.

Operator

Your next question is from Anthony DiClemente with Evercore.

Unknown Speaker

Hi, guys. This is Kevin (26:34) for Anthony. I was wondering if you could talk a little bit more just about the strength we saw in the advertising revenue, was there any particular verticals or was the strength more broad-based? And the second, if you could go a little more – provide color on the opportunity in podcast, obviously, a lot of engagement there and sort of your strategy as it pertains to pursuing talent, pursuing new content anything there would be really interesting? Thanks.

Roger J. Lynch - Pandora Media, Inc.

Sure. It's Roger. So as I mentioned, we did see strength at the end of the quarter. And in terms of verticals, it was retail probably the one that stands out the most. In terms of strategy on content, we view a big opportunity for us in podcast, because we think that if you look at the podcast market today, it's growing quickly. But, yeah, in terms of revenue, it's not that meaningful yet and we think that the two big things that podcasts suffered from happened to be our two core strengths and that is discovery and monetization. So if you think about how most people discover podcasts today, they go to a chart and see what's listed on the charts and that's – there's nothing personalized about that. That's a popularity contest. Imagine if you had to discover music that way or Pandora never created Music Genome Project that enable people to discover music. So we think there's a lot that we can bring to the discovery of broadly digital audio, but in particular podcasts.

And then on the monetization front that's obviously a core strength of Pandora, we're about two thirds of the digital audio advertising marketplace and just our strength in targeting and data will be something that we think will benefit quite materially what forms a content like podcasts. So for us it's less about putting a bunch of titles into our apps, it's more about creating the discovery and monetization capabilities like we have for music, for podcasts and then once we've created that launch the content. So it's not a big bang thing that you'll see short term, it's investment that we're making now. You'll see us increase what we're doing on podcasts, we have handful of podcasts today that will increase throughout the year. But there would be a lot going on behind the scenes in terms of investments to create the experience that I just described.

Unknown Speaker

Great. Thank you.

Operator

Your next question comes from Rich Greenfield with BTIG.

Richard Greenfield - BTIG LLC

Hi. Thanks for taking the question. I guess, when you look at the decline in listening hours, Roger, how do you think about how much – first of all, where do you think those consumers are going? Are you losing to terrestrial radio, people staying with terrestrial radio, you losing to competitors like Spotify, like how do you look at that competitive landscape?

And then when you think about your plan to kind of invest marketing dollars over the year ahead, it sounds like they were down a lot in Q4. How do you look at kind of the competitive response, because it seems like a lot of your competitors are ramping their focus on music, YouTube just redid their deal with a lot of labels and just how do you – what's kind of built into that plan that you just kind of talked about for revenue and user growth over the coming year from a competitive standpoint? Thanks.

Roger J. Lynch - Pandora Media, Inc.

Yeah, Rich, the number one reason people started using other services, when I say people I mean Pandora listeners started using other services like YouTube or Spotify was actually four of the top five reasons if you looked at the surveys we have when we surveyed former listeners are all restatements of the same thing, which is I couldn't play the song or album or playlist that I wanted, because of the lean back nature of the original Pandora products. We solved that on December 19 when we launched Premium Access. So from a reason why people would go to other services, we just plugged that hole. We also created a whole new opportunity for us on the marketing side where we started to – we have to build some capabilities but if you think about really a lot of like what we did at Sling TV, what we call tune-in marketing, right, using content to drive activations.

We have that ability now, because with Premium Access, we can bring someone, market them whether it's on Facebook or Twitter, wherever it is using the data that we have. Remember, we have hundreds of millions of accounts that have been created. So we have personal preferences on hundreds of millions of people in the U.S.

We can market to them using that data about specific content, bring them on to the platform and let them play the content. That was something we couldn't do before.

So we plugged the hole in terms of why listeners leave and we also created new gateways that as we build out some of the marketing technologies that we talked about and the team, they are going to be able to pull those levers in a lot of ways that will drive engagement back to our platform. So in terms of where we're going to spend marketing, it is going to be skewed much more heavily than it has been in the past to performance-based marketing. So it's what I call doing personalized marketing at scale. So creating the technologies and the capabilities that connect our data with our new product capabilities and marketing technology tools that allow us to do outreach at scale and drive people on this platform. And so that's where we'll be spending.

In terms of competitive response to that I don't know, competitors are always going to be obviously trying to improve what they do and any move we make will be I'm sure followed by competitors. But I'm quite confident in our abilities and our growing abilities to use these capabilities in a way that change the trajectory of our listeners.

Richard Greenfield - BTIG LLC

And maybe just given your focus on Premium Access, could you give us any sense of from a cost standpoint, did that require new label agreements, is it just purely a revenue share on the ads that you've kind of put before people can click on an individual song that they specify, just how does that work financially?

Roger J. Lynch - Pandora Media, Inc.

Yeah. Let me ask Naveen to answer that question for you, Rich.

Naveen Chopra - Pandora Media, Inc.

Yeah. Hey, Rich, obviously we can't comment on all the details of arrangement with the labels on that stuff. But I think you should assume that we do pay an incremental fee, or I should say higher fee in order to provide the interactive capability, but we are taking advantage of the fact that one of the things Pandora is so good at is kind of taking the interactive experience and then allowing people to transition to more of a lean back mode where they keep listening in a radio context. And by doing that, we're able to drive the overall costs down. And in addition, the fact that we put a high value video ad at the entry point to the content creates a pretty nice equation for us in terms of the amount of revenue that we can generate relative to the cost of the content that we play during the session.

Richard Greenfield - BTIG LLC

Very helpful. Thanks.

Operator

Your next question comes from Amy Yong with Macquarie.

Amy Yong - Macquarie Capital (USA), Inc.

Thanks. I guess, two questions, so first off on active listeners, they are up nicely. What's actually resonating among your listeners and maybe if you could parse out the contribution from connected devices and how do you plan on keeping that momentum up? And then, I guess, Naveen, you spoke a lot about gross margin improvement and operating leverage. Wondering if you could help us frame how profitable you think the business can go ultimately? Thank you.

Roger J. Lynch - Pandora Media, Inc.

Okay. Yeah. Amy, let me answer the first part on active listeners. Seasonally, Pandora always sees an uptick in December due to holiday listening. So that always drives Q4 reported MAUs and 2017 was no different than prior years. I think, in terms of what's resonating with listeners that's really more to come on things that we're doing around Premium Access that I've already talked about. Let me – let Naveen answer the other question.

Naveen Chopra - Pandora Media, Inc.

Yeah. I think specific to the question on margin improvement, I think we see opportunities both for gross margin improvement and ultimately driving operating leverage in the business. I think, on the gross margin side, it's really the dynamics that we've referenced in our prepared remarks. We think that there is opportunity to continue the sales spread between RPMs and LPMs on the ad-supported side, there are also scale benefits as the subscription business grows. We qualify for lower rates where the number of our content deal, which is helpful and then as I think today, those margins are sort of artificially depressed by the fact that we are incurring MGs on a number of the content deals.

And now on the operating side, you saw some of the potential based on things that we announced in January, obviously, in this case we're reinvesting a lot of those savings, but the things that enabled us to identify that opportunity. I think, there's more to come there. We think there's a lot that we can accomplish through automation, we've talked about hiring more people in other locations, which allows us to hire more quickly, more efficiently and retain those people at lower costs.

And so I think those things will all benefit us down the road as well. We don't have any specific financial targets to give you on those things at this point, but I think we're headed in the right direction.

Operator

Your next question comes from Barton Crockett with B. Riley FBR.

Barton Crockett - B. Riley FBR, Inc.

Thanks for taking the question. I appreciate the approach to guidance here and I understand there's a lot of moving pieces, but I did want to try and understand one of the big moving pieces a little bit better and that is the gross margin view as you look through the year. I understand you're saying that that you expect improvement in, I guess, EBITDA and improvement in OpEx as a percent of revenues. But how should we think about gross margin, is that something that over the year gets better or gets worse, it seems like if ads are down that's kind of a mixed headwind? But you're renegotiating label deals. Do you expect that the constituent pieces between subscription and advertising have significant gross margin trajectories? What can you tell us about that?

Roger J. Lynch - Pandora Media, Inc.

Yeah. Hey, Barton, I think the question kind of highlighted a number of the moving pieces as you said. I think, what we can add to that is there is obviously a high degree of seasonality in our gross margins, because of the way that the advertising revenue works. And I think you'll continue to see that play out in 2018. I also would not underestimate the impact of the MG issues that we highlighted, as I said a minute ago, those really do have an impact on gross margins. And once we get to a point where we're able to kind of get into the renewal phase of a number of these deals and right size the MGs, I would expect to see some more meaningful improvement in gross margins.

Barton Crockett - B. Riley FBR, Inc.

Okay. And then, if I could just have a quick follow up. One of the things that Roger highlighted was the differential in the subscription introductory pricing for things like family and for college students and that you need some negotiations, I guess, with labels to be able to more competitive with Spotify on those kind of cheaper entry level offers. I was just wondering if you could give us an update on where you are and being able to match them competitively on pricing for that segment and how optimistic you are about something kind of breaking loose over the course of the year?

Roger J. Lynch - Pandora Media, Inc.

Yeah. Barton, it's Roger, yeah, we have what we need to launch these new plans. So they're in development now and I would expect by sometime this summer, we'll have them in market.

Barton Crockett - B. Riley FBR, Inc.

Okay. That's great. Thank you.

Operator

Your next question comes from Mark Mahaney with RBC Capital Markets.

Dylan Haber - RBC Capital Markets LLC

Hi. This is Dylan Haber on for Mark. When you think about your paid subscriber business, how much of the growth now is coming from Pandora Plus versus Pandora Premium? And then, where do you expect this mix to trend long-term? And then lastly, what percent of your current subscriber base is on a free trial? Thank you.

Naveen Chopra - Pandora Media, Inc.

Dylan, it's Naveen. I think the first question in terms of how much of the growth is coming from Plus versus Premium. Plus subs are declining in the case in Q3 or the case in Q4, they declined less in Q4 than in Q3. So the growth is really all about Premium. I think the more important take away there is that in the early days when we first launched Premium that we expected a number of those subs were coming straight from Plus meaning they were migrating to Premium, which is a balance of good thing for us, but it was not – at some point you're going to need to get subs from outside of that Plus base and we're starting to see that now, and so fewer of the subs that are coming to Premium are coming out of Plus than they were certainly in the launch. I don't have offhand for you the stat on number of listeners currently in trial, but we can get back to you on that.

Roger J. Lynch - Pandora Media, Inc.

To be clear, we report paid subscribers.

Naveen Chopra - Pandora Media, Inc.

Yes, sorry, the numbers we report do not include people in trial.

Dylan Haber - RBC Capital Markets LLC

Great. Thank you.

Operator

Your next question comes from Ron Josey with JMP Securities.

Ronald V. Josey - JMP Securities LLC

Great. Thanks for taking the question. I wanted to ask a little more about just the ad revenue. And Naveen I thought you – I think I heard you say ad revenue declining in 1Q and working to improve throughout the year. And so when you think about how that improves, I'm wondering given the strong – the strength in the RPMs, the improvement coming from ad listener growth, newer ad formats or just strength across the key verticals, and I assume the answer is yes to all three. But would it be possible to grow on just like a stabilized user base with improved ad formats like Premium Access? Thanks.

Roger J. Lynch - Pandora Media, Inc.

Yeah, look, I think that stabilizing the user base would have a dramatic impact on how we look at the ad revenue trajectory. And so that is very much our focus.

Ronald V. Josey - JMP Securities LLC

Thank you.

Operator

Your next question comes from Matthew Thornton with SunTrust.

Matthew C. Thornton - SunTrust Robinson Humphrey, Inc.

Hey, good afternoon, thanks for taking the question guys. A couple, if I could, and these are follow on to prior questions. But first on Premium Access, you talked about the benefits that you're seeing on retention engagements, upsell. I would assume this product could give you a higher – some RPM lift, but also some LPM lift. So my question is how should we think about that contribution to the margin meaning the RPM minus LPM margin? And then relatively when we think about LPM over the course of the year, Naveen, I would think that, and correct me if I'm wrong, that CRB inflation mechanism, the publisher rates those things probably step up to start the year as those Premium Access and then the renewals or any benefit from renewals might come late in the year, any color there if that's fair would be helpful? Thanks, guys.

Naveen Chopra - Pandora Media, Inc.

Yeah. Hey, Matt, so the first part of the question on Premium Access and the kind of RPM, LPM dynamics there, this is what I was trying to reference earlier and I think to put it simply, I think Premium Access gives us an opportunity to increase the margin on ad-supported listening, because we put a very high value video ad in front of the content. And that gives us the ability to absorb higher LPMs with better margins that I think we would see in more traditional ad-supported modes.

With respect to LPMs, during the rest of the year, the factors that you cited, I think, are all things that are part of our expectations over the course of the year. I think, you'll see it pump around similar levels to where we are now, could go up a little bit. But as you said, I think the longer-term kind of steady state for LPMs will be more a function of where we end up on the renewals, which we'll start to see at the end of this year.

Operator

Your next question comes from Ben Swinburne with Morgan Stanley.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Thanks. Good afternoon. Roger, could you just talk a little bit broadly about how much progress you've made and what your outlook is for improving or reducing friction to buy advertising on Pandora you talked last quarter a lot about you're not where the company needs to be in terms of generating ROI reports and making it easy to put money to work. I know you haven't been there that long, but are you seeing signs of positive movement and you think by the end of 2018 you'll be in a place that will be materially better on that front than you are today? Any color there would be helpful since obviously it's sort of critical to get the top line going, where you wanted to go?

Roger J. Lynch - Pandora Media, Inc.

Yeah, sure, Ben. I think you hit on the head. This is one of the things that we need to do really across our business, but particularly with our advertising, customers is just making it easier to transact with us and to transact in ways that our customers want to transact. And the way we reduce friction our ad buys is one, number one is by introducing programmatic and which we – which I talked about earlier and I think we're going to see continued growth there. I think that's going to be a very strategic area for us in particular audio programmatic, but also for our direct sale business, improving the automation in the systems that we have there.

So that's not something that happens overnight, because there's investments we have to make. And as I mentioned on our Q3 call, we're looking at everything from building it ourselves to maybe even acquisitions that could help accelerate our efforts across the board. So whichever path we end up on that we would expect to see some benefits from those investments over the next year. And there's a bunch of different areas that are affected by the types of investments we're talking about, but overall putting in the bucket of reducing friction I think is the right way to think about it.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

How about self-serve in the local side, is that something you guys are focused on in the next year or two?

Roger J. Lynch - Pandora Media, Inc.

It is. Yeah, yeah. So, again, self-serve is an area that it opens up new revenue opportunities for us. So smaller advertisers today it's non-economical for us to really work with them, because the...

Naveen Chopra - Pandora Media, Inc.

Yeah.'

Roger J. Lynch - Pandora Media, Inc.

...manual process of our order flow just makes it uneconomical. So self-serve tools are going to enable us to tap into whole new class of advertisers that frankly, Facebook and Google have been very effective at doing with their businesses and we just need to create similar tools that will enable us to expose those capabilities to smaller advertisers. So that's also in the works.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Great. And then just, Naveen, I don't if I got this right, but it looks like your fourth quarter subscription LP use were up quite a bit from Q3. I don't know if there were something one-off and I know you mentioned the mix to Premium, but it was up a lot from the third quarter to the fourth quarter, just curious is there any other color you could share on what drove that in the fourth quarter?

Roger J. Lynch - Pandora Media, Inc.

That should be the main driver, would just be the mix of Plus and Premium.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Okay.

Roger J. Lynch - Pandora Media, Inc.

(48:25) that should be unique.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Okay. Thanks a lot.

Roger J. Lynch - Pandora Media, Inc.

Actually, sorry, the recognition of MG expenses would impact that number as well.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Okay. So is that number – is that – the margin we see in Q4 sort of representative of how we should be thinking about subscription economics in 2018 or do you think this is – is there some volatility in the quarters that we should be aware of?

Roger J. Lynch - Pandora Media, Inc.

Yeah. Well, as mentioned earlier, I do think once we get beyond the current yields where we have MG exposure, there is material opportunity to improve margins on both LPM and LPU. So what you're seeing right now would not necessarily be or I should say the impact of MGs that you see right now would not be something, I think of as a long-term steady state.

Benjamin Daniel Swinburne - Morgan Stanley & Co. LLC

Got you. Thank you, guys.

Operator

The next question is from Doug Anmuth with JPMorgan.

Ashwin X. Kesireddy - JPMorgan Securities LLC

Yeah. Hi. Thanks for taking my question. This is Ashwin on behalf of Doug. First question is for Naveen. Is there any way you can quantify the year-end ad activity impact on revenue and any comments on profit contributions, so that we can make fair comparisons heading into Q1, will be helpful.

And one for Roger, on the products side, you talked about expanding partnership with Comcast and obviously, the new redesigned app on the X1, but I was wondering what's the likelihood that billing for your app can be integrated into something like an X1 subscription, are there any partnerships you're working on maybe on the fixed or the mobile side to launch kind of combo plans?

And finally, if you could provide, make any comments on the latest CRB ruling and its potential impact that will be great.

Roger J. Lynch - Pandora Media, Inc.

Why don't I take your second question and I'll let Naveen take the first and third. On the products side, I'm a big believer in building a business with partnerships, it's a big part of how we built Sling TV, almost half of the subscribers we added there were through partnerships. And my approach has always been with device partners to think of them not only as devices that playback your content, but as distribution partners, who can help market your service. And I think there's a lot of opportunity for us to do that in Pandora too, and that includes integrated billing like you talked about. It's something we also did at Sling TV and it's quite effective. So I view all of those as opportunities for us and there are some capabilities that we need to build internally so that we can do partnerships like the ones you described, and that's a big focus of what we're doing in 2018. So I think more to come on that front.

Naveen Chopra - Pandora Media, Inc.

And I'll take the question on Section 115 and then we may need you to repeat the first one. But I guess our comments on the Section 115 ruling, first of all, for those of you who are not familiar with this, this is the ruling on what we paid for mechanical royalties to publishers. This primarily affects the subscription part of our business. So the impact for us is a little different than a number of other streaming services that are more heavily oriented toward subscription than we are, that's obviously a meaningful part of our business, but not the largest part of the business.

The rates that were determined by the CRB ruling were higher rates than what we pay today. We expected there to be some increase, the fact that the increase escalates over time, does create something that was a little bit of a surprise to us. There is a lot of discussion, I think, in the industry right now regarding how to handle those increases, we're aware of the fact that there was a pretty significant dissenting opinion from one of the judges in that ruling. And there are a number of players in the industry who are evaluating the prospect of appealing that and we'll continue to monitor that and see how it might impact us. And I need you to repeat the first question, we didn't catch that one.

Ashwin X. Kesireddy - JPMorgan Securities LLC

Yes. I was wondering if you could talk about the or quantify the impact of – I think you mentioned like elevated activity towards late Q4 than what you typically see on the ad business has potentially contributed to better revenue here than what you're expecting for Q4?

Naveen Chopra - Pandora Media, Inc.

Yeah, I mean, I don't have a lot to quantify there per se, I mean, a quick better color we can add is, obviously, we see the ad pipeline building for the end of the prior quarter and then the beginning of the in-quarter period, particularly in Q4, a lot of those bookings come in early this quarter. As I mentioned in the prepared remarks, they came in later than expected. We don't really know whether that's a trend to expect going forward, but it was certainly the way things played out in Q4. The areas that ended up showing some strength later in the quarter, I think, as Roger mentioned retail came in much stronger than we expected. We also saw some strength on the local side, which were two areas that we did not expect to be that strong in Q4, so that was a nice outcome.

Operator

Your next question is from Jim Goss with Barrington Research.

James Charles Goss - Barrington Research Associates, Inc.

Thanks. I would like to go a little bit more on the royalty issue, you have aside from the levels you've just been charged with paying. You do have some higher royalties associated with subscription services, I assume some blended royalties with your Premium Access. And with the podcast idea, I would imagine there would be sort of a royalty free application of your services. If you looked at content acquisition costs as a trend, do you have any thoughts you might add to how that cost element of your business should trend over the next year or so?

Naveen Chopra - Pandora Media, Inc.

Yeah. Look, I think the simple answer to that is, at the end of the day we look at total content cost as a percent of revenue. And we have between reworking some of the existing deals, looking at new forms of content, we think there is an opportunity to reduce cost as a percentage of revenue in a way that makes a meaningful difference to gross margins and ultimately what we can drive in terms of operating profit. And that's I think one of the big opportunities in this business.

James Charles Goss - Barrington Research Associates, Inc.

Okay. And separately I was wondering which of your services are available on smart speakers, does it depend on what you're paying for and what is the usage shown to be so far?

Roger J. Lynch - Pandora Media, Inc.

Yeah. We are still in the process of rolling out our Premium service across our whole device ecosystem. We have made some progress in Q4 that we identified with Sonos and Comcast and Amazon Fire, there are few – still a few devices like Amazon Echo that didn't have our Premium service that will be coming later this year. But our goal this year is to have all of the major devices that we're on to have all three tiers of our service. And I think we've made quite good progress towards that.

James Charles Goss - Barrington Research Associates, Inc.

All right. Thank you.

Operator

Our last question is from John Egbert with Stifel.

John Peter Egbert - Stifel, Nicolaus & Co., Inc.

Great. Thanks. I had one follow up on the Section 115 ruling. I'm interested how the new percentage of total content costs methodology might come into play in the future, because it appears that tier could be more onerous by several percentage points depending on what you assume for how much you're paying royalties on the subscription business. Your current publisher deals for on-demand products only reference the percentage of revenue rate from the CRB ruling, which would like shield you from the total content costs formula? And also like how long do your direct publisher deals last on average, because it just seems like whenever those lapse publishers have a lot more leverage on the next time they come to the table? Thanks.

Naveen Chopra - Pandora Media, Inc.

Yeah. This is Naveen. The percentage of content cost component in the new ruling is actually it's not entirely new. There is an element of that that we have in the existing construct as well. In terms of specific timeline, we don't disclose the exact renewal dates on any of our deals. Obviously, as those do come up, there are things that both we and the publishers will be looking to update and try to optimize and I wouldn't focus on any one thing relative to what are ultimate pretty complex deals.

John Peter Egbert - Stifel, Nicolaus & Co., Inc.

Well, if I could follow-up there, if I look at the deals as we see them from the CRB, it says the minimum 22% of total content costs for the Section 115 royalties. If you assume a 70% of revenue in subscriptions is going towards content costs, which is kind of in the range of where the previous team have guided that you've tracked above that brings you to about 15% of revenue going towards publishing cost, not 11.4%. And so I just – I'm wondering if you're kind of operating under a below market rate now and I guess when we're modeling more in the next two years how should we think about that?

Naveen Chopra - Pandora Media, Inc.

I don't think we're operating on a below market rate today. And keep in mind that the percent of total content cost refers to – it's against the sound recording costs not total royalty. So I think your math is probably a little off on that basis.

John Peter Egbert - Stifel, Nicolaus & Co., Inc.

Okay. Thanks.

Operator

And that was our last question. At this time, I will now turn the call back over to the presenters.

Roger J. Lynch - Pandora Media, Inc.

Okay. Thanks very much and thanks everyone. On our Q3 call we identified a number of challenges around audience and monetization, and during the quarter, we made significant progress towards addressing many of those challenges. And while there's a lot more work to do and we're not going to bend the curve overnight, I'm confident we're on the right track. And between the large opportunity from growing digital audio market that I talked about earlier and strong execution, I really believe we will reinvigorate Pandora. So stay tuned, there's a lot more to come, and thanks again everyone.

Operator

That concludes Pandora's fourth quarter 2017 financial results conference call. We will return you to the Black History Month station.

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