Pandora Earnings Preview: Margins And Monetization In Focus

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 Q4 2014 results on February 5 will reflect the company’s performance for the three-month period ending December 31. Although Pandora no longer provides monthly updates for its operating metrics, we expect that steady rise in its revenues and market share continued into the fourth quarter. However, the company’s user additions and growth in listener hours might have been slow, similar to what happened in the third quarter.

Also, due to the company’s aggressive investment in sales and marketing capability, its profits likely remained under pressure. Similar to Q3 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 fourth quarter is seasonally stronger for Pandora as compared to the third quarter, which should be reflected in its Q4 RPM (revenue per member). Although the Internet radio provider has a come a long way in terms of improving its monetization, it still needs to do a lot to create a sustainable business model.

Our current price estimate for Pandora stands at $24, implying a premium of more than 40% to the current market price.

See our complete analysis for Pandora Media

Margins In Focus

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, and that pushed its sales and marketing expenses up by 54% year over year. It increased its employee headcount by 35% year over year with the addition of 80 new quota bearing sales representatives. Pandora had a total team of 1,380 employees at the end of Q3 2014, while it only had a headcount of 1,021  a year earlier.

We believe that Pandora hired a number of new sales representative in Q4 as well, which 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. However, it is worth noting that Pandora’s losses declined by 48% year over year in Q3 2014, due to strong growth in revenues and comparatively weaker rise in expenses.

Monetization Will Most Likely Improve

We expect Pandora’s ad RPM levels (revenue per 1,000 listener hours) to be up compared to the fourth 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, following relatively weaker investments in the first three quarters. In 2012, Pandora’s RPM improved from $30.30 in the third quarter to $32.33 in the fourth quarter. The company saw a similar trend in 2013, when its RPM in the fourth quarter ticked up to $40.95 from $39.68 in the third 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 positive picture of the company’s Q4 2014 RPM, which is expected to be higher than $44.35 it attained in Q3 2014.

The Impact Of Price Hike Will Finally Be Visible

Pandora has raised the monthly price of its Pandora One service by $1.00 to $4.99, making it the first price revision since the service’s launch in 2009. While this move did not have a significant impact on individual quarterly results, it 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 be reflected in Pandora’s annual figures.

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 over 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 would be  a huge improvement considering that the operating cash flow was negative in 2013, according to our calculations.

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