Two Scenarios That Can Impact Pandora’s Valuation Significantly

Pandora Media‘s (NYSE:P) honeymoon period is over. After runaway growth in its advertising revenues and user base, concerns of profitability have finally taken over. The Internet radio company has been unable to generate enough revenues from advertising to offset its huge expenses and hence, it still remains a loss making business. Within Pandora’s expenses, content acquisition cost is the largest contributor, accounting for about 47% of total “costs and expenses” and 48% of net revenues. Pandora pays royalties on per performance basis, and the rates have been set by the Copyright Royalty Board (CRB).

For some time now, the music industry has been complaining that free streaming services such as Pandora are not paying them fairly. Through independent bodies such as SoundExchange, they have often raised this concern with the CRB. However, since CRB had already set Pandora’s royalty rates til 2015, it did not pay much heed to SoundExchange’s proposal until last year. In early 2014, SoundExchange proposed that Pandora’s per performance royalty rates should be increased from $0.0015 in 2015 to $0.0025 in 2016 with $0.0001 addition in rates every year thereafter. The ‘Webcasting-IV’ rate setting proceedings have gone on for about a year without much information about where it is heading, and the final decision will not be out until the end of the year. It is almost certain that Pandora’s royalty rates will increase at a faster rate 2016 on-wards than they have increased in the past, but what if it is able to negotiate a better deal?

Another question we look to answer here is what could be the impact on Pandora, if Spotify with its relatively better content and rapid user growth takes away some listener hour share from the company. Such a scenario would discourage advertisers from spending a higher amount for their adds on Pandora’s platform, negatively impacting its mobile and desktop ad revenues.

Our price estimate for Pandora at $20.48, is about 10% premium to the current market price.

See our complete analysis for Pandora Media

Smaller-Than-Expected Rise In Pandora’s Royalty Rates (+15%)

Pandora is not profitable with the royalty rates it pays currently, which the music industry feels are too low. To make this worse, SoundExchange has proposed a significant increase in royalty rates from 2016 on-wards, that will likely increase Pandora’s content acquisition costs, making it more difficult for the Internet radio company to generate profits. The more plausible scenario is that the Copyright Royalty Board will set Pandora’s royalty rates for 2016 and beyond closer to SoundExchange’s proposal. Therefore, we expect Pandora’s “content acquisition costs as percentage of revenues” to decline this year with better topline growth, with only a moderate rise in royalty rates.  However, we expect them to rise significantly in 2016 and 2017 with a considerable increase in royalty rates. Thereafter, we expect the figure to decline gradually and reach 44% over the next four-five years, as the company generates higher revenues through advertisements and the year-over-year royalty rate increase remains at $0.0001, as it has been before.

However, Pandora is trying hard to convince the CRB to keep the increase in royalty rates at the historic levels. Earlier this year, Pandora issued a press release stating that it has submitted a rebuttal statement in the ‘Webcasting IV’ rate-setting proceedings. 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. ^[1] Final statements from both the parties have to be submitted by June and if Pandora manages to bend the decision (due year end) in its favor, it may not have to face such significant increase in content acquisition costs. In fact, the company can even strike direct deals with music labels and artists on a larger scale to negotiate a better overall price rather than the per-performance payment. If the aforementioned scenario turns into a reality, resulting in only a moderate rise in “content acquisition costs as percentage of revenues” in 2016 and 2017, which could later come down to 40% over the next four-five years, there can be about 15% upside to our price estimate for the company.

Pandora being able to convince the CRB to set royalty rates as per its proposal is a little unlikely, but it isn’t out of question. Considering the fact that the company’s future is somewhat dependent on this decision, it will try to put forth the best possible argument as to why a significant rise in royalty rates would be bad for the company as well as the artists. The Copyright Royalty Board will look to find a balance between the proposals of both the parties. On the other hand, Pandora has a better ability of negotiating direct deals with artists and labels, and it will look to pursue the same extensively, if CRB’s decision goes against it.

Growing Competition From Spotify (-15%)

Spotify is quickly catching up with Pandora. Earlier this year, the company reported 60 million registered users, narrowing the gap between itself and Pandora. In December 2013, 27% of the total Internet users in the U.S. were using Pandora, while the figure for Spotify was at 6%. Eleven months later, around 51% of Internet users were listening to music on Pandora and 14% were using Spotify. Although improvement for both the players was significant, Pandora is likely to reach a saturation point soon, but Spotify still has a lot terrain to cover. This makes it a formidable threat for Pandora. In fact, just a month back, Spotify raised $350 million, reportedly valuing itself at $8 billion, which is more than twice the current market cap of Pandora. ^[2]   Considering that Pandora has a higher market share in terms of listener hours and has a significantly higher number of registered users, Spotify is obviously doing something much better than Pandora.

In fact, Spotify has a larger music library as compared to Pandora and has the ability to offer better content, since it pays higher royalty rates and hence, is the more preferred choice of artists, labels and songwriters. It has over 1.5 billion playlists created so far and it adds over 20,000 songs to its library every day. Spotify’s continued rapid growth can have a negative impact on Pandora’s listener hours and subsequently, advertisers’ spending on the Internet radio company’s platform.

Consider a scenario where Pandora’s monthly mobile listener hours per active user increase to only 19 over the next five-six years instead of our current forecast of 21.7. Lack of growth in listener hours can prompt advertisers to spend less at Pandora and more on Spotify. In such a case, Pandora’s monthly ad revenue per 100 listener hours would grow at a slower-than-expected pace. Consider that this figure increases to only $5.50 (long term) instead of our current forecast of $6.23. Something similar would happen for the desktop platform as well, though it is not a very significant segment for Pandora. Monthly desktop listener hours are falling rapidly due to the industry-wide mobile shift and they are likely to continue this trend forward. For the scenario, we estimate that the figure reaches 1.93 by the end of our forecast period instead of 2.04. For desktop ad revenues per 100 listener hours, we lower the long term forecast to $6.85 from the current $7.33.

The cumulative impact of these changes brings about a 15% downside to our price estimate for Pandora. This scenario may as well turn into a reality, if Pandora fails to monetize its listener base effectively and Spotify takes away some listener hour share with better content on offer and rapid user growth.

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1. Pandora Files Its Writter Rebuttal Statements in ‘Webcasting IV’, Pandora, Feb 23 2015 [↩]
2. Spotify raises $350M at $8B valuation:sources, CNBC, May 1 2015 [↩]