Pandora Media’s (NYSE:P) stock continued its downtrend in 2012, albeit at a slower pace. The Internet radio company became public in 2011, and has lost approximately 40% of its market value since then. Who’s to blame?
There is no doubt that Pandora is a great service, but it has struggled so far with its business model and is still not churning out profits. The royalty rates are expected to rise, which will further put cost pressure in the future. Even though the company has come a long way in terms of improving its monetization, the costs continue to increase as a proportion of revenues. In 2012, the company saw a slowdown in listener hours growth. The company also made its international debut in Australia and New Zealand as well as intensified its efforts to push for certain legislative changes to control royalty rates.
Overall, the year was quite eventful, and we expect the company to focus on further improving its mobile monetization in 2013, by pushing direct sales of its mobile ad inventory. We don’t expect any significant improvement in Pandora’s content cost management anytime soon. We believe that this is more of a long-term objective, and it will take a while before the service can become profitable.
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Listener Hours & Active User Growth Slowed Down, Expect The Trend To Continue In 2013
Although Pandora’s total listener hours grew by a healthy rate in 2012, the growth slowed down sequentially as well compared to 2011. For instance, Pandora’s total listener hours grew by 67% in Q3 2012 over the same period in the prior year, amounting to 3.56 billion.  For the full year, we expect Pandora’s total listener hours to pass 13.6 billion, including over 12.4 billion ad-related listener hours. This implies a growth of roughly 62% over 2011. Most of this growth is coming from the mobile platform, which constituted 77% of total listener hours in Q3 fiscal 2012. It is not just that more users are listening to Pandora, it is also that they are listening to more songs than before.
We forecast that growth in Pandora’s active users as well as mobile listener hours will slow down in 2013. 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. Also Myspace, which boasts a huge library with zero cost, is thinking of launching a similar service worldwide.
Pandora marked its international debut by launching its service in Australia and New Zealand towards the end of the year. The company’s expansion into international markets is not only a growth initiative but also a strategic one. Given the increasing competition in the U.S., it makes sense for the company to diversify its geographic exposure. Furthermore, there is no doubt that the potential for subscriber growth in international markets is quite large as Internet penetration continues to rise, and Internet-enabled device adoption increases. Though the populations of Australia and New Zealand are much lower than that of the U.S., the low penetration of Internet radio presents a good opportunity for Pandora.
Australia has a population of over 22 million residents and fewer than 1 million Australians listened to Internet radio in 2011.  Also, as of 2011, less than 9% of the population aged 14 and over in Australia used their smartphones to listen to the radio.  This is in stark contrast to the U.S. where, out of a population of 310 million, Pandora has more than 150 million registered users and close to 60 million active users.
This suggests that there is an opportunity for Internet radio penetration to increase significantly in Australia. Negotiating royalty rates with artists and music labels is going to be an important element of the company’s international expansion strategy. As far as Australia and New Zealand are concerned, we think that Pandora can leverage a lot of content (English songs) that it already has. This wouldn’t be true in case of emerging markets, which makes us think that Pandora may not enter another international market in 2013, and instead try and focus on making its core U.S. business profitable. That’s what Netflix (NASDAQ:NFLX) has done and that’s how it is able to afford its costly international expansion.
Push To Improve Profitability
In 2012, Pandora’s efforts to improve its profitability included improving mobile monetization and push for legislative changes regarding royalty rates for internet radio. 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 31 October, 2012, was $22.68 and that the RPM for Q3 alone reached a record high.  However, there could be moderation in 2013 as the advertisers may be cautious about spending amid concerns related to the fiscal cliff.
In addition to this, the company has been urging its users to support a bill called the “Internet Radio Fairness Act,” which was introduced recently and was under the consideration of the U.S. Congress. This bill is aimed at bringing Internet radio business under the same regulations as terrestrial and satellite radio. The basic issue is that Pandora pays much higher royalties (as a % of revenues) for music compared to traditional radio companies such as Sirius XM (NASDAQ:SIRI). Part of this has to do with higher rates and partly with the fact that Pandora is an under-monetized service due to its almost sole dependence on advertising revenues. It appears that in the near term, Pandora will continue to suffer losses. The Internet Radio Fairness Act aims to address the latter. If the bill is passed, we believe it could add significant upside to Pandora’s stock.
Our price estimate for Pandora Media stands at $9.75, implying a premium of less than 10% to the market price.Notes: