Pandora’s Margins Will Remain A Concern But Monetization Can Improve

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Pandora Media

At the start of the year, Pandora Media (NYSE:P) changed its fiscal year to a calender year end. We would like to point out for investors’ benefit that the upcoming Q3 2014 results on October 23 will reflect the company’s performance for the three-month period ending September 30. Although Pandora no longer provides monthly updates for its operating metrics, we expect the steady rise in its revenues and market share continued into the third quarter. However, due to the company’s aggressive investment in sales and marketing capability, its profits likely remained under pressure. Similar to Q2 2014, Pandora’s ad monetization likely grew, both sequentially and year over year, driven by a continued uptick in its mobile ad business. Generally, the third quarter is seasonally better for Pandora as compared to the second quarter, which should  be reflected in its Q3 RPM (revenue per member). The Internet radio provider has a come a long way in terms of creating a sustainable business model and we expect the Q3 results to reinforce this development.

Our current price estimate for Pandora stands at $24, implying a premium of more than 10% to the current market price.

See our complete analysis for Pandora Media

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Margins will be a Concern

Pandora has stated in the past that royalty rates it pays have increased by 53% in the last five years and will go up by another 9% in 2015. With royalty rates expected to rise each year, the company is focusing on improving its ad targeting in order to command better pricing and sell more mobile inventory slots. For this purpose, Pandora has been growing its sales force for the past several quarters. During the last quarter, the company continued to add new talent to its sales team, that pushed its sales and marketing expenses up by 50% year over year. It increased its employee headcount by 40% year over year with the addition of 15 new quota bearing sales representatives. Pandora had a total team of 343 sales representatives at the end of Q2 2014, while it only had 252 representatives a year earlier. As a result of these aggressive investments, its Q2 losses increased by a staggering 72% (on a GAAP basis) to $11.7 million. We believe that Pandora hired a number of new sales representative in Q3 as well, that will keep its expenses on the higher side. In addition, commissions on subscriptions that the company pays Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL), and soaring product development costs will also weigh on its margins.

Monetization Likely to Improve

We expect Pandora’s ad RPM levels (revenue per 1,000 listener hours) to be up compared to the third quarter of 2013. There will likely even be some sequential gain in this quarter as advertisers tend to divert a disproportionate amount of their annual budgets to the fourth quarter, followed by a lull in the first quarter, and subsequent improvement in the second and the third quarters. In 2012, Pandora’s RPM improved from $29.33 in the second quarter to $30.30 in the third quarter. The company saw a similar trend in 2013 when its RPM in the third quarter ticked up to $39.68 from $37.89 in the second quarter. Pandora has done exceptionally well in ramping up its mobile ad business, which has resulted in substantial year-over-year gains in its quarterly RPM. This paints a very pleasing picture of the company’s Q3 2014 RPM, which is expected to be higher than $40.11 (Q2 2014).

Price Hike won’t have Much Impact

Pandora has raised the monthly price of its Pandora One service by $1 to $4.99, making it the first price revision since the service’s launch in 2009. However, this move will not have a significant impact on Q3 2014 results but will have a moderate impact on the company’s full year performance. Most subscribers choose the annual billing cycle and hence, increased revenues from price hike will not be reflected in Q3 results.

Subscriber ARPU (average revenue per user) will definitely go up meaningfully next year as most subscribers migrate to the new pricing structure. The price increase will directly flow down to Pandora’s bottom line. Currently the company has about 3.3 million paying subscribers, which represents a small fraction of its overall user base. If the price increase of $1 were to be rolled out to all subscribers immediately, it will result in incremental revenues of close to $40 million. This would lead to cash flows jumping by a similar amount. This is a huge improvement considering that the operating cash flow was negative in 2013, according to our calculations. Going forward, these incremental revenues will see strong growth as we expect Pandora to continue gaining subscribers rapidly.

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