Pandora Media (NYSE:P) is doing well in its quest of creating a profitable business, even as the growth in the number of active listeners is slowing down. The company seems to have a found a solution to its mobile woes, as its mobile ad RPM (revenue per 1,000 listener hours) reached a record high during the third quarter of 2013. In addition to this, content acquisition costs declined significantly as a percentage of revenues. Given that these costs are tied to the number of instances played for a particular song and have predefined annual increase, improving monetization will be additive to profits and will continue to push these costs down as a proportion of revenues. As a result, we have updated our price estimate for Pandora from $14.50 to $24. Almost 75% of this increase can be attributed to our updated forecast for content acquisition costs as % of revenues. We now expect this figure to decline to about 38% by the end of our forecast period as compared to our previous expectation of 47.50%.
Our price estimate for Pandora stands at $24, implying a discount of more than 15% to the market price. While things are certainly going the company’s way, the current market valuation implies very aggressive cash flow growth which may be difficult to achieve. It must be noted that beginning next quarter, Pandora will adjust its fiscal year to coincide with the calendar year.
Mobile RPMs Hit Record High
Pandora’s RPM (revenue per 1,000 listener hours) has seen a substantial jump in the last two quarters. The company’s focus on increasing audio ads and expanding its ad business among local clients, along with the continued ramp up of its sales force, are fueling this growth. Mobile ad revenues stood at $104.9 million in Q3 2013, growing 58% over the same period last year and accounting for more than 70% of overall advertising revenues.  That’s encouraging and comparable to Twitter which earns more than 75% of its revenues from mobile. The mobile ad RPM for the quarter stood at $36, up from $33.90 in Q2 2013 and $25.59 in Q3 2012. 
The market opportunity is big as the annual radio advertising sales in the U.S. are in the vicinity of $15 billion, while U.S. digital advertising stands at more than $40 billion.  Compared to this, Pandora’s annual revenues are around just $659 million (2013 estimate). We expect the company’s mobile monetization to approach that of the desktop over the course of next six to seven years as it continues to attract advertisers looking to reach a more relevant audience.
Improving Mobile RPM Will Aid Margin
Unlike Sirius XM, Pandora pays fixed dollar amount for each song played. On a per listener hour basis, this cost has gone up marginally over the last few years as a result of predefined annual royalty rate increases and changing content mix. The figure has increased from an estimated $17.5 per 1,000 listener hours in 2008 to $18.5 per 1,000 listener hours in 2012. Going forward, we expect Pandora’s content acquisition cost per 1,000 listener hours to gradually inch up, and reach $20.8 by the end of our forecast period. This will imply that these costs as a percentage of revenue will go down to 38%, as opposed to our previous forecast of 47.5%.
Given that these expenses are tied to the number of times a song is played, better monetizing each instance of play will help Pandora expand its margins. This is where the company has shown significant improvement in the last few quarters.
Competition Will Weigh On Active Listener Growth
For Q3 2013, the average active listener count stood at 71.9 million, which represents a healthy jump of 24% over the same period a year ago.  However, the sequential growth tells a completely different story. The active listener count increased from 72.1 million in August 2013 to just 72.7 million in September, registering growth of merely 0.8%.  In October, the figure actually declined to 70.9 million, which suggests that the company may be nearing the ceiling for the active listener base in the U.S.  This can be attributed to some less sticky customers trying out new services including Apple’s iTunes radio. Although Pandora stated that the growth was back on track by the end of October, we believe the competing services will make it difficult for the company to continue growing its active listener base at the current pace.
In addition to Apple, Pandora will also face competition from Sirius XM as it steps up efforts to tap the in-vehicle market which has traditionally been the territory for Sirius XM (NASDAQ:SIRI) and terrestrial radio services. We also expect Spotify to 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.Notes: