Pandora Earnings Preview: Soaring Expenses To Overshadow Strong Topline Improvement

Pandora Media (NYSE:P) shares have fallen sharply since the report of third quarter results in late October. Not only did the company issue weaker-than-expected Q4 guidance, but there were significant concerns over the pending ruling of the Copyright Royalty Board’s (CRB) regarding the company’s royalty costs. The Internet radio company is scheduled to release its Q4 and full year results on February 11, and even though we expect a steady rise in its revenues, a faster increase in expenses is likely to keep the company deep in losses. Pandora expects to report revenues in the $325-$330 million range with adjusted EBITDA at ~$27 million.

While the prior guidance had missed analysts expectation, it reflects a year-over-year top-line growth of almost 56%, which is indeed strong. A consistent improvement in the mobile and desktop ad monetization, thanks to its inroads in the local ad industry, likely drove Pandora’s revenues during the  fourth quarter. However, the strong increase in net sales is likely to have been countered by rapidly increasing sales and marketing expenses, and higher content acquisition costs. In fact, the company’s EBITDA projections for the fourth quarter are 48% below what it achieved in the year ago period.

With content acquisition costs expected to increase significantly next year, Pandora desperately needs to beat its guidance to create some positive vibe around its stock in the market. We believe that investors did overreact on the CRB’s decision, because it could have turned out worse. With rates increasing just 15%, Pandora has the opportunity to generate profits in the near term by leveraging its recent acquisitions and direct licensing deals.

Our current price estimate for Pandora stands at $19, implying a significant premium to the current market price.

See our complete analysis for Pandora Media

Improving Monetization To Drive Revenue

Pandora’s ad RPM levels (revenue per 1,000 listener hours) are likely to be up compared to the third quarter of 2015. Also, there will be some sequential gain since advertisers tend to divert a disproportionate amount of their annual budgets to the fourth quarter, following relatively weaker investment in the first quarter, with gradual improvement in the subsequent quarters. In Q4 2014, Pandora’s overall RPM improved to $48.19 from $40.95 in the same quarter of the prior year. A similar trend was visible when comparing Q4 2013 and Q4 2012. The primary driver for the increase in ad RPM last year was ‘mobile and other connected devices’, ad RPM for which increased to $44.37 in Q4 2014 from $36.20 in Q4 2013. ^[1] Desktop ad RPM had also reported positive gains during the period, growing from $61.92 to $68.83. In Q4 this year, we expect ad RPM to be up notably, especially across ‘mobile and other connected devices’, given that Pandora has been very aggressive with the sales and marketing of its ad inventory. In fact, local ad revenues had increased 52% year over year in the prior quarter and we expect this strong growth momentum to have continued in Q4 2015.

Expenses Expected To Be Up

With royalty rates rising every 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. In Q3 2015, sales and marketing expenses increased 50%, much faster than growth in overall revenues, settling at 34% of net revenues.

We believe that Pandora likely continued to bolster its sales team in Q4 2015 as well, given that its local ad business is flourishing, which could only 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.

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1. Pandora Reports Q4 2014 Financial Results, Pandora, Feb 5 2015 [↩]