Pandora: Not A Sound Buy
Intense competition and rising media content acquisition costs spell uncertainty for Pandora’s future, and this is why Bidness Etc is neutral on the stock
The revolutionary iTunes Store, introduced by Apple Inc. (AAPL) in April 2003, commercialized digital music like never before. It took only five years for the store to become the largest music vendor in the US, and another two years for the service to become the largest music vendor in the world. Its success marked a significant shift in consumer preferences in terms of content consumption, and redefined how users interacted with digital content.
One of the reasons for the phenomenal success of iTunes was its a la carte pricing plan, which allowed consumers to purchase individual songs at a flat rate without having to pay a subscription fee. For the first time, users had the option of paying only for the music they wanted to listen to, instead of having to purchase entire music records for the sake of one or two hit songs.
But that simply isn’t good enough anymore.
Internet radio, which is rapidly overtaking download-based music services, is fast, free, and automatically offers listeners choices that are surprisingly well-tailored to their individual music preferences.
Pandora Media Inc. (P) is the current leader in internet radio services in the US with a 70% market share, according to Triton Research. Pandora Internet Radio, its music recommendation service, employs data analytic tools to provide a highly-personalized music experiences to listeners. The service, which is based on the Music Genome Project, recommends music based on the artist preferences drawn from different users by assessing the songs played. This is based on around 450 subjective and objective attributes of each song. Users provide feedback on Pandora’s recommendations, which the service incorporates to further refine future recommendations.
Pandora’s Business Model:
Pandora had a user base of around 200 million on July 31, 2013 – a big jump from the 80 million users who used its services in June 2011. Pandora had a 7.5% market share in the US radio market (internet and traditional) in the second quarter of its 2014 fiscal year (2QFY14), up 4.1% since its initial public offering in 2011. It currently provides two different services: the Free Service and Pandora One.
Like other internet media and services companies, Pandora’s primary source of earnings is advertisements, not content sales. Pandora’s Free Service is an ad-based model which allows listeners to enjoy a personalized music experience free of charge. However, the free service restricts users to 320 listening hours per month for traditional platforms like desktops and notebooks. Users need to pay $0.99 for unlimited hours for one month if they wish to increase this cap. Users can also purchase a monthly or annual subscription for Pandora One.
Pandora’s free service carries audio, video and displays ads. Advertisers place banner ads on Pandora’s use interface, while audio advertisements deliver audio messages between songs. Video advertisements are packaged as in-banner videos initiated by mouse clicks, or videos that start automatically when a listener switches to other stations or songs.
Pandora One, on the other hand, is an ad-free service which gives users access to unlimited hours of music listening, higher quality streaming (192 kbps bitrate) and a dedicated music player. However, to access this service, users must pay a monthly $4 charge, or an annual fee of $36.
Stock Price Drivers:
Movements in Pandora’s stock price depend on the company’s reported figures for number of active users, the number of listener hours, and ad RPM (revenues per 1,000 listener hours).
Number of Active Users:
The number of active users is used to gauge increases in traffic to Pandora’s services. Pandora has more than 200 million registered users, out of which around 71 million are classified as “active”. The number of active users is measured using a 30-day timeframe before the date on which the metric is reported. In 2QFY14, it recorded 29.7% more active users compared to the same period of the preceding year.
Listener hours represent the total number of hours of music streamed by users, and allow the company to measure increases in audience activity. The number of listener hours is also an important revenue driver as it is used to negotiate higher rates for advertisement deals. Pandora recorded a total of 3.88 billion listener hours in 2QFY14, up 17.6% over the previous year.
In industry usage, RPM refers to revenues generated by the company for every 1,000 hours of content streamed by users. It is a useful metric when gauging the effectiveness of monetizing growth in the user base through the company’s advertisement inventory – which is the amount of ad space or number of advertisements a publisher has available to sell to advertisers.
75% of Pandora’s current user base accesses the service via smartphones and tablets. Pandora has been able to generate higher RPM from different devices, which has resulted in accelerated topline growth.
Future Growth Drivers:
The total US radio advertising industry was worth $15.4 billion in 2012, and is expected to grow to around $18 billion by 2017. Pandora is heavily reliant on advertisement revenues for growth, and its ability to monetize its mobile user base will be a crucial revenue driver, as mobile and connected devices already account for 79% of its total listening hours.
Mobile display advertising, in which Pandora has the third-largest share at 13%, has had a historic five-year compound annual growth rate (CAGR) of 48%, while online display, video and rich media advertising has grown 13.2%. In 2QFY14, Pandora generated $116 million in mobile revenues, 92% higher over the same period of the preceding year. It also earned 58% more in mobile RPM over the same period of the previous year at $37.59.
Pandora is focusing on localized marketing techniques to capitalize on new growth opportunities and earn higher CPMs (cost per 1,000 impressions) for local ads. The local ad market currently accounts for 74% of total US radio advertising, and in the company’s latest earnings call, the management noted that CPMs for ads aired on a national level ranged from low to middle single-digits, whereas CPMs for local ads ranged in the high teens.
Pandora’s mobile app, when it was initially introduced, limited users to 40 hours of listening, but the limit has been eliminated from September 1, 2013. This will increase its advertising inventory, allowing Pandora to monetize the opportunity presented by growth in mobile users of its Free Service.
Source: IDC & Veronis Suhler Stevenson Communications Industry Forecast
Risks for Pandora:
andora incurs higher costs than its competitors in acquiring new content, as it pays providers based on the number of times the content is streamed. This means that an increase in listener hours, which Pandora uses to negotiate better advertising rates, also raises the costs it pays for using artists’ content. Pandora’s profitability therefore hinges upon its ability to monetize the increase in listener hours, while reducing content acquisition costs as a percentage of revenues.
The ‘per performance rate’, which is the industry term for the rates paid to content owners for their content based on the number of hours for which it is accessed, is set under the Pureplay webcasters agreement at an incremental rate every year.
*The applicable per performance rate used is either the given rate or 25% of Pandora’s US gross revenues, whichever is higher.
Apple has recently launched iTunes Radio and it will pose a direct challenge to Pandora’s dominance. Pandora’s management has called it a “credible threat”, and they may have sufficient reason to feel threatened: iTunes Radio attracted more than 11 million trial users within the first five days of its launch.
What is more worrying for Pandora is that iTunes has been able to secure deals with several major record labels that will significantly lower its content acquisition costs. To really seal the deal, Apple has also bagged advertisement deals with major corporations, including PepsiCo Inc. (PEP), Nissan Motor Co., Ltd. (NSANY) and the Procter & Gamble Company (PG).
Pandora’s Financial Performance:
Although Pandora recorded a $7.7 million net loss in 2QFY14 due to high royalty fee payments, it was nonetheless a tremendous improvement over the preceding quarter, in which it lost $28 million. Despite these losses, the company has recorded strong growth in its topline, and has brought its content costs down from 59% of revenues in 2QFY13 to 51% in 2Q14.
Pandora stock’s performance year-to-date (YTD) has been nearly seven times higher than the returns posted by the NASDAQ 100, primarily due to the growth in its topline.
Currently, the stock is trading at a one-year forward price to earnings (P/E) multiple of 830x, with a price to earnings growth (PEG) ratio of 3.86. Its price to sales multiple is 9.1x, significantly lower than other consumer-facing internet companies like LinkedIn Corp (LNKD), Facebook Inc (FB) and Yelp Inc (YELP), whose prices are trading at an average multiple of 20x sales.
Pandora has been leading the internet radio industry with its unique products and ability to handle and utilize big data better than its competitors. For example, it has employed the Music Genome Project to great effect in its personalized music recommendation service. With growth in its mobile segment, and Pandora’s ability to monetize this growth, it seems poised to take advantage of the opportunities presented by this segment.
However, Pandora’s faces higher media content acquisition costs and a formidable competitor in iTunes Radio. Although iTunes Radio still has not deployed a service that can replicate or refine the highly-popular personalized experience offered by Pandora , it still remains a potential threat as the company has secured better content acquisition and advertising deals with its partners.
Pandora is already operating at a loss due to its investments in growing its user base, and increased costs and competition may further dent its profitability. Due to the uncertainty surrounding its future, Bidness Etc is neutral on the stock.