Pandora Media‘s (NYSE:P) shares fell on weaker guidance after the company released its Q2 fiscal 2014 earnings last month. However, investors seem to be taking interest in the company which is evident from the stock’s recent jump. The market price has touched $24, and stands at a significant premium to our price estimate. It appears that Pandora’s strong revenue growth, a surprising jump in mobile monetization last quarter and better cost control have instilled fresh optimism in the market. Additionally, its desktop monetization is growing despite the ad dollars shifting to mobile, which indicates the demand for its ad inventory.
However, it is necessary to understand and acknowledge that Pandora is not devoid of risks. The volatile nature of the stock, efforts from intermediary bodies to raise royalty rates, expected growth in competition and more Internet outlets competing for ad dollars warrant a cautious approach. While Pandora has certainly showed some promise, the jump in monetization was abrupt and the company’s ability to sustain growth in the metric remains questionable.
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The Gap Between Revenues And Profitability Measures Is Widening
Over the last four years, Pandora has seen a surge in the number of active listeners as well as the total number of listener hours. The company grew its revenues from a mere $19.3 million in 2008 to $427.1 million in 2012, implying a compound annual growth rate of 117%. It benefited from its unique feature of customized radio stations and the surge in the usage of Internet-enabled mobile devices such as smartphones and tablets. The profitability has definitely improved over the years, but the company is still burning up its cash reserves. The gap between revenues and measures of profitability such as EBITDA (earnings before interest taxes depreciation and amortization) and free cash flows has been widening rapidly.
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The Battle For Royalty Costs Is A Risk
Given that the Internet radio royalty rates are established and intermediated by independent body SoundExchange, Pandora does not have the same leverage to negotiate favorable rates directly with the copyright owners. This implies that the costs will increase proportionally with listener hours, and the company may not become profitable unless it substantially improves its monetization.
Previously, Pandora had to pay according to the royalty rates set by the Copyright Royalty Board (CRB). However, due to the lobbying efforts by webcasters, the U.S. government passed a law that allowed them to negotiate rates directly with SoundExchange. This helped bring down the costs for Pandora as well. However, the company is also urging its users to support a bill called the “Internet Radio Fairness Act,” which was introduced last year and is aimed at bringing the Internet radio business under the same roof as terrestrial and satellite radio. There is still a lot of uncertainty around whether the royalty rates will increase as intended by the CRB and SoundExchange or they will come down, and whether the way Pandora pays royalties will change.
What About Competition?
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.
There will also be competition from Sirius XM as Pandora steps up efforts to tap the in-vehicle market which has traditionally been the territory for Sirius XM (NASDAQ:SIRI) and terrestrial radio services. In addition, 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 40% to the market price.