Pandora Improves Mobile Monetization But Faces Escalating Content Costs And Competition

Pandora’s (NYSE:P) stock dropped by roughly 20% after the company released its Q3 fiscal 2013 earnings and increased its loss forecast for the whole fiscal year. Management expects a weak fourth quarter, blaming cautious ad spending from advertisers amid concerns surrounding the fiscal cliff. ^[1] In addition, the market seems to be pessimistic regarding the rising content costs as well as the potential competition that could develop.

Our price estimate for Pandora stands at $9.75, implying a premium of about 20% to the market price. While we believe that the potential competition from companies such as Spotify, Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) can affect growth in Pandora’s listener hours as well as active users, we are hopeful that Pandora may be able to find a solution to its cost problem in a few years. This can potentially be achieved through its push for legislative action and prosecution of next arbitration aimed at setting royalty rates for the future.

See our complete analysis for Pandora

Listener Hours & Active User Growth May Slow Down, But Will Still Be Healthy

Pandora’s total listener hours grew by 67% in the quarter over the same period last year, amounting to 3.56 billion. ^[2] For the full year, we expect Pandora’s total listener hours to reach past 13.6 billion, including over 12.4 billion ad-related listener hours. Most of this growth has come from the mobile platform which constituted 77% of total listener hours in Q3 fiscal 2012. ^[1] It is not just that more users are listening to Pandora, it is also that they are listening to more songs than ever. Will this trend continue?

We forecast that growth in Pandora’s active users as well as mobile listener hours will slow down next year. Pandora has already established a large footprint in the U.S. and there is a competitive threat from other Internet-based music players who are likely to leverage high demand for Internet radio. Pandora’s stock was sharply down when reports about Apple’s plan to launch a customizable radio service emerged. Apple has dominated the online music space via its iTunes store for a long time and enjoys widely used hardware devices such as the iPhone, the iPod and the iPad. But by only launching the service on iOS devices could limit its impact on Pandora. In addition, Microsoft is also entering the business and Spotify has been expanding. Even Myspace, which boasts of a huge library with zero cost, is thinking of launching a similar service worldwide.

That said, growth will still remain healthy. Pandora has launched internationally, and with its redesigned app (Pandora 4.0), it expects to engage more users. There is still high demand for the company’s service and it crossed 1 million in-vehicle user mark. A lot of radio listening occurs during driving and Pandora is looking to tap this market.

No Respite From Rising Costs, But Pandora Could Find A Solution

Pandora is a great service but has struggled to become profitable due to the structure and pricing of its deals with the music content owners. Pandora pays high royalties for every song played. Therefore, a higher service usage leads to higher costs while mobile monetization still remains low. However, the company has been pushing hard to improve upon this. We estimate that Pandora’s mobile RPM (ad revenue per 1000 listener hours) has increased from less than $7 in 2008 to little under $22 in 2011. For 2012, this figure seems to be heading somewhere between $22 and $23. The company mentioned that its trailing 12-month RPM for mobile platform for the period ending October 31, 2012, was $22.68 and that the RPM for Q3 alone reached a record high. ^[3]  However, there could be moderation in the fourth quarter as advertisers may be cautious about spending amid concerns related to the fiscal cliff.

Pandora has also been urging its users to support a bill called the “Internet Radio Fairness Act,” which was introduced recently and is under the consideration of the U.S. Congress. This bill is aimed at bringing Internet radio under the same roof as terrestrial and satellite radio and to address concerns regarding Pandora’s high royalty payments (see Pandora’s Value Could Double If The Internet Radio Fairness Act Passes). These high costs have stood in the company’s way of becoming profitable and remain by far the biggest risk that it faces. While there has not been any substantial progress on this front, Pandora will continue to put every resource at its disposal to influence a change in the royalty structure for Internet radio.

Furthermore, the proceedings to determine the royalty rates for Internet radio that will be applied for the years from 2016 to 2020 will begin in 2014. ^[2] Pandora plans to prosecute this arbitration and may have an edge if the U.S. Congress gives some legislative guidance. There is a chance that the royalty rates could come down, or Pandora could even enter a revenue sharing model thus bringing its costs in control.

Sharp Downside If Content Costs Spiral Out Of Control

A lot of the premium of our price estimate relative to the market is based on our expectation that Pandora will find a solution to its royalty payment problem within the next 2-3 years. If that doesn’t happen, there could be substantial downside to our price estimate.

If content acquisition costs (as % of revenues) do not come down and stay around the current levels of 57% estimated for fiscal 2013 (calendar 2012), there could be downside of about 35% to our price estimate. Please note that our percentage figure differs from the reported figure due to the exclusion of non-cash items such as depreciation and stock-based compensation.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Pandora’s Q3 Fiscal 2013 Earnings Transcript [↩] [↩]
2. Pandora’s SEC Filing [↩] [↩]
3. Pandora’s Q3 Fiscal 2013 Earnings Transcript [↩]