Pandora Earnings Preview: What We’re Watching

Internet radio company  Pandora Media (NYSE:P) is scheduled to release its Q1 fiscal 2015 earnings on April 23rd. We are expecting a robust increase in the company’s revenues on account of a steady rise in its mobile and desktop ad monetization, as well as growth in number of active users. However, rapidly increasing sales and marketing expenses along with high content acquisition costs are likely to pummel Pandora’s bottomline yet again. Although the company mentioned in its previous quarterly earnings call that it was well positioned to reduce its content acquisition costs relative to revenues in 2015, they still stand big at around 45% of total revenues. A marginal reduction in  this ratio will not have any material impact on the Internet radio company’s losses. In fact, this improvement wouldn’t even please investors much, given that royalty rates are set to increase significantly from 2016 on-wards, and a slight improvement this year would prove insignificant from long term perspective. To this end, we are awaiting an update on the ongoing ‘Webcasting IV’ royalty rate-setting proceeding, that was commenced by the U.S. Copyright Royalty Board (CRB) early in 2014.

Our current price estimate for Pandora stands at $20.22, implying a premium of more than 15% to the current market price.

See our complete analysis for Pandora Media

Continued Uptrend In Monetization Expected

We expect Pandora’s ad RPM levels (revenue per 1,000 listener hours) to be up compared to the first quarter of 2014. However, there will not be any sequential gain since 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 Q1 2013, Pandora’s overall RPM improved to $24.85 from $22.45 in the same quarter of the prior year. In Q1 2014, this figure had jumped to $33.40, clearly implying that the company’s monetization had gained substantial momentum. The primary driver for the increase was ‘mobile and other connected devices’, ad RPM for which increased to $29.46 in Q1 2014 from $20.45 in Q1 2013 and just $15.73 in Q1 2012. Desktop ad RPM had also reported positive gains during the period, but its increase wasn’t as intense. In Q1 this year, we expect ad RPM to continue its strong momentum, especially across ‘mobile and other connected devices’, given that Pandora has been very aggressive with the sales and marketing of its ad inventory. Hence, we expect the company’s overall ad RPM for Q1 2015 to be much higher than $33.40, but lower than $48.19 (Q4 2014), because Q1 is seasonally weak.

Expenses Likely To Increase

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. Last year, sales and marketing expenses as percentage of revenues was around 30.1%, while it was 28.5% a year earlier. The net increase in selling and marketing expenses for the period was over 52%, which is mainly attributable to the addition of new quota bearing sales representatives and other employees in these areas. We believe that Pandora likely continued to bolster its sales team in Q1 2015 as well, which would have pushed its sales and marketing expenses relative to revenues higher, negatively impacting operating income. 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.

Active Listeners May Grow

Pandora has often said that it can grow its active listener count to close to 100 million by targeting under-penetrated market segments. The company has been focusing aggressively on the used and new car market for the purpose. Last year, active listener count increased around 7% from 76 million to 81.5 million. There may not be any drastic increase in this figure in Q1 2015 given that it is nearing saturation, but there will be some gains nonetheless. More importantly, Pandora seeks a faster increase in the number paid subscribers, who still do not contribute much to the company’s overall value. In 2014, paying subscribers increased 9% year over year to 3.6 million and the subscription segment contributed just 20% to overall revenues. The subscription segment is the most productive one for the company for obvious reasons, but Pandora is finding it hard to convince free users to pay for ad-free services. For long term sustainability, Pandora needs the proportion of its paying subscribers in its overall active user base to be much higher than the current level of 5%. It will be interesting to see if there is any notable improvement in this figure in Q1 2015.

Awaiting Updates On The Royalty Rate-Setting Proceedings

It has been almost a year since the Copyright Royalty Board began proceedings on SoundExchange’s proposal to increase Pandora’s royalty rates considerably. However, there has been little update since. (Read: Pandora’s Price Estimate Revised to $20.22 On Expected Rise In Royalty Rates) While it is almost certain that Pandora’s royalty rates 2016 onwards will increase by a higher amount than they have increased in the past, it is unclear whether the CRB will uphold SoundExchange’s proposal or will revise it to a slightly smaller value. Going by the current proposal, SoundExchange wants Pandora to pay $0.0025 per performance in 2016, while it will be paying just $0.0015 this year. Earlier this year, Pandora issued a press release stating that it has submitted a rebuttal statement in the ‘Webcasting IV’ rate-setting proceedings. ^[1] The company is making the argument that such significant increase in royalty rates would substantially reduce music-right holders exposure on its platform, as it would offer less-diverse content favoring music of artists and labels that have a direct deal with Pandora. Though the final statements have to be submitted by June and the decision will not be taken until the end of 2015, we will continue to keep an eye out for updates on the proceedings.

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1. Pandora Files Its Writter Rebuttal Statements in ‘Webcasting IV’, Pandora, Feb 23 2015 [↩]