During a recent investor conference, Pandora Media’s (NYSE:P) management stated that the company expects to lower its content acquisition costs (as % of revenues) from 60% currently to 40% over the next few years.  Our price estimate for Pandora stands at $9.75, implying a discount of about 30% to the market price. This price estimate is based on our expectation that Pandora’s content acquisition costs (as % of revenues) will continue to remain high and decline to just 55% by the end of our forecast period.
However, if what Pandora is expecting is in fact possible, there could be a massive upside of close to 80% to our price estimate. In other words, Pandora could be a $17 stock if the company can deliver on its promise of reducing these costs to 40% of revenues. What is Pandora doing to achieve this?
The company recently decided to put a cap on free listening on mobile. Users will now be able to listen up to 40 hours of free music every month and will need to pay 99 cents to continue listening for the remainder of the month.  The only way that the company can reduce its costs (as % of revenues) substantially is by making its mobile platform as profitable as desktop. The best way to do this is to increase direct sell-through of the mobile ad inventory. Currently, there is a huge gap between the levels of monetization on the two platforms, but the company seems to be headed in the right direction. Mobile RPM (revenue per 1000 listener hours) has been increasing over the last few years.
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Path To Higher Monetization
(1) Higher sell through of mobile inventory
Mobile listener hours have grown tremendously over the past few years leading to an increase in mobile inventory. Close to 75-80% of total listener hours now come from the mobile platform for Pandora. However, the company currently does not have a large enough sales force in many regional radio ad markets to sell inventory and establishing this sales force will be key to higher sell-through rates for its ad inventory. Over time, as the mobile listener hours growth slows, Pandora should continue pushing sales of its mobile ad inventory and eventually mobile monetization levels should catch up with current desktop levels.
Radio ad buyers are for the most part are indifferent about placing their ads on the mobile or desktop platforms since traditional radio has forever been a mobile platform. Therefore, the company is confident about its ability to improve mobile monetization to sustainable levels in the future.
(2) Long-term potential for increase in ad frequency
Pandora serves about 8 to 12 ads per hour which can consist of 7 to 8 interaction-based display ads and 3 to 4 audio ads. In comparison, traditional radio serves around 13 minutes of advertising each hour or about 25 ad spots with each ~30 seconds in duration.  Given that Pandora is monetizing its 8-12 hourly ads on the desktop at a rate of $57 per 1,000 listener hours, it implies that Pandora is monetizing better than traditional radio on a per ad basis.
What this also means is that Pandora has a significant opportunity to increase its hourly ad frequency. We believe that this has a great potential in in-vehicle platforms where users are accustomed to higher ad frequency. The traditional radio market is ~$15+ billion. The in-vehicle market accounts for about 47% of the traditional radio market and therefore presents a big, untapped opportunity for Pandora.Notes:
- Pandora Forecasts Music Costs to Shrink to 40% of Revenue, Bloomberg, Mar 20 2013 [↩] [↩]
- Pandora caps free mobile listening at 40 hours a month, CNET News, Feb 27 2013 [↩]