Pandora Media’s (NYSE:P) stock has been inching higher for the past couple of weeks thanks to some analyst upgrades that forecast improving profitability on mobile and Pandora’s growing presence in new vehicles. While there is definitely some truth to these claims, Pandora is not devoid of some significant risks that need to be considered before investing in the stock. The company’s radio service is immensely popular in the U.S., but is still not profitable due to low monetization on mobile. Even though Pandora has made notable strides in this area, the gap between the levels of monetization on mobile and desktop is too big to ignore. In addition to this, the company is going to face tough competition from Apple (NASDAQ:AAPL) and others as the market for Internet radio attracts more suitors over time. Let’s take a look at what’s working for Pandora and what’s not.
What’s Going Well For Pandora?
Strong User Base Growth
At the end of January 2013, Pandora had close to 175 million registered users covering more than 55% of the U.S. population. However, the company’s active user base stood at 65.6 million, implying that close to 37% of the total registered users were actively using Pandora’s Internet radio service. The company defines active users as the number of unique registered users that have used its service within the trailing 30 days from the end of each calendar month. It is these active users that are generating revenues for the company, and it is important to understand their growth trajectory. From 7 million in 2008, the number of active users rose to to 65.6 million in 2012, implying a whopping average annual growth rate of 78%.
Pandora’s radio service has gained immense popularity in the U.S. due to its personalization algorithm, and the increased usage of mobile devices. However, we believe that the growth will slowdown as the company has already covered most of the addressable market in the U.S. and is likely to face increased competition in future. Besides this, we expect Pandora to shift its focus towards profitability instead of user base growth. Overall, we expect Pandora’s active user base to reach close to 125 million by the end of our forecast period.
Growing Smartphone Market
Pandora’s mobile platform now accounts for close to 80% of its listener hours. The proliferation of smartphones and other connected devices is one of the reasons why Pandora has gained such immense popularity in the U.S. These devices make it convenient for users to access the Internet radio service anytime and anywhere. According to Gartner’s estimates, about 172 million smartphones were sold in 2009, implying a growth of 24% over 2008. The growth accelerated in 2011, when Gartner reported that Q3 2011 smartphone sales amounted to 115 million units, registering an increase of 42% over Q3 2010. For the full year 2011, smartphone sales stood at over 430 million units. The growth continued in 2012 as smartphone sales rose by 47% and 38% in the third and fourth quarter respectively. We expect the global smartphone market to continue to grow at a healthy pace. Pandora’s music app, which is available on iPhone, Blackberry, Android and Windows Mobile, is already one of the most popular apps. As the smartphone market grows, Pandora will expand its active user base.
The company’s push in the vehicle market is also aiding its growth. In January 2010, Pandora joined hands with electronics manufacturer Pioneer to provide Internet radio enabled music systems for cars. The device can detect Pandora settings when a phone is connected with the system. Since then, Pandora has struck several deals with world’s leading automotive manufacturers like BMW, Ford, Mercedez-Benz and Toyota. Pandora availability on PCs, smartphones and automobiles, hereby provides full connectivity to users.
But What Are The Key Risks?
Inadequate Mobile Monetization
There is significant gap between Pandora’s monetization on mobile and desktop platforms. The company is profitable on dektop, but hasn’t been able to do the same for mobile where the bulk of the growth is coming from. Pandora’s mobile listener hours have grown tremendously over the past few years leading to an increase in the mobile ad inventory. Close to 75-80% of the company’s total listener hours now come from the mobile platform. However, Pandora currently does not have a large enough sales force in many regional radio ad markets and establishing this sales force will be key to higher sell-through rates for its ad inventory.
Pandora serves about 8 to 12 ads per hour that 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 $50+ per 1,000 listener hours, it implies that the company 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 good 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.
Apple recently announced its Internet radio service that will directly compete with Pandora.  Under the name iTunes Radio, Apple will offer many features similar to that of Pandora, including personalized radio stations, free ad-supported service as well as the ad-free subscription option. While Pandora has over 1 million songs in its library, Apple’s service will give its users access to its entire iTunes catalog which boasts of over 26 million songs. In addition, the subscription fee for iTunes Radio (at $24.99 per year) is lower than that for Pandora, which charges $36 per year for its Pandora One service. 
The competition will not just come from Apple but also from Sirius XM as Pandora steps up its effort to tap the in-vehicle market, which has traditionally been the territory for Sirius XM (NASDAQ:SIRI) and terrestrial radio services. In addition to this, we expect Spotify to further expand its Internet radio service and Clear Channel’s iHeartRadio to gradually entice users. There is good chance that other big names such as Microsoft (NASDAQ:MSFT) can jump on the Internet radio bandwagon if Apple is successful. The market is going to get crowded, which will make it difficult for Pandora to become profitable.
Our price estimate for Pandora stands at $11.85, implying a discount of 40% to the market price.Notes: