Pandora’s Monetization Jumps But Risks Still Not Fully Priced In

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Pandora Media

Pandora Media‘s (NYSE:P) Q2 fiscal 2014 earnings showed strong revenue growth, a surprising jump in mobile monetization and better cost controls that encouraged the company to end the 40-hour monthly listening cap on the mobile platform. Pandora introduced this cap towards the end of February, and discontinuing this reflects its confidence that improving mobile ad sales are sufficient to offset the rising content costs. Additionally, desktop monetization grew despite the ad dollars shifting to mobile, which indicates the demand for Pandora’s ad inventory. Overall, the quarter showed a lot of promise for Pandora’s future growth.

Despite this, the stock slumped 10% on weaker guidance. Pandora expects full year EPS (earnings per share) to be between 0 and 5 cents per share against analysts’ previous expectation of 5 cents per share. [1] The market’s reaction is a classic example of overoptimism while potentially overlooking certain key risks.

We recently raised our price estimate for Pandora to 14.50, which still stands at a discount of about 25% to the market price. While we raised our forecast for monetization and overall margins, we remain cautious around the possibility of strong competition developing from Apple (NASDAQ:AAPL) and others who can bid up the content prices.

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See our complete analysis for Pandora Media

Focus On Local & Audio Advertisements Will Help Monetization Growth

Pandora’s mobile revenues grew by 92% during Q2 fiscal 2014, amounting to $116 million. [2] In comparison, the total listener hours growth stood at just 18%, indicating slower active user base growth and the impact of 40-hour listening cap on the mobile platform, which accounts for over 80% of Pandora’s listening. [2] That’s not necessarily bad because Pandora has a significant opportunity to grow its revenues and profits by simply focusing on mobile RPM rates (revenue per 1,000 listener hours). Although there is still a huge gap between the figures for mobile and desktop, the company’s progress is very encouraging. The chart below shows how Pandora’s mobile RPM has trended over the last few quarters. The intermediate decline reflects seasonality as RPM tends to go down in the first quarter of the fiscal year.

Although Pandora’s mobile RPM has been growing gradually, it saw an unusual jump in the second quarter which can be attributed to the company’s focus on increasing audio ads, expanding its ad business among local clients and the continued ramp up of its sales force. Radio ad buyers are for the most part indifferent about placing their ads on the mobile or desktop platforms since traditional radio has forever been mobile. Therefore, the company is confident about its ability to improve mobile monetization to sustainable levels in the future.

Pandora has acknowledged that local advertising is a big opportunity and radio services have an edge in this area. The revenue generated by local ads increased four-fold in Q2 fiscal 2014 compared to Q2 fiscal 2013. [3] The company is also building momentum in audio ads which accounted for more than 60% of the total ad revenue during the quarter. [3] 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. [4] In comparison, traditional radio serves around 13 minutes of advertising each hour or about 25 ad spots with each ~30 seconds in duration. [4] There is a clear opportunity to increase the number of audio ads, and we believe that this has the most 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 thus presents a big, untapped opportunity for Pandora. The company is making significant stride on this front and expects one-third of the vehicles sold in the U.S. in 2013 to have Pandora integration. [3]

The fact that the graphs for ‘mobile ad RPM’ and ‘total mobile RPM’ run parallel suggests that the jump in RPM is not due to the surge in the number of subscriptions for Pandora One service. The company is clearly selling a lot more ad inventory than before. If mobile RPM increases to desktop RPM levels by the end of our forecast period, there can be 20% upside to our current price estimate.

Future Competition Cannot Be Ignored

Apple has 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 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 a good chance that other big names such as Microsoft (NASDAQ:MSFT) might 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 sustain its rapid growth.

Our price estimate for Pandora stands at $14.50, implying a discount of about 25% to the market price.

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Notes:
  1. Survey conducted by Thomson Reuters []
  2. Pandora Media’s SEC Filings [] []
  3. Pandora’s Q2 fiscal 2014 Earnings Transcript [] [] []
  4. Pandora’s Corporate Presentation [] []