Description

Business:

Pandora is an internet-based streaming music service with ~80mm active monthly users who stream over 20 billion hours of music annually or about 24 hours each per month.  After Facebook and its related properties, Pandora’s mobile app was the 2nd most downloaded in 2015 and despite competitive threats, it ranked first at the end of 2Q for time spent across all music apps.  More impressively, users spent 33% more time on the Pandora app than Facebook in 2015, and more than 4x as much time than on Snapchat, Netflix, and YouTube according to ComScore.  The stock near $14 represents a ~$3bn market cap company which trades ~$50mm/day and has a clean balance sheet.  Today, the main product is free ad-supported radio that represents ~80% of the business, with an ad-free product and a ticketing business rounding the balance.

Thesis:

The reason why the stock is interesting is they are finally about to launch an on-demand product which will leverage the existing asset base in a new addressable market with higher quality recurring subscription revenue.  It will also put them in a stronger competitive position against Spotify and Apple by being a one-stop music shop for traditional ‘lean back’ radio, on demand active consumption, and live event ticketing.  Management is finalizing the content licensing deals and has guided to ~$1.3bn of revenue by 2020 based upon 11mm subscribers (converting ~10% of projected active users).  At the 30% expected gross margin on recent guidance, this new on-demand business would be worth the entire market cap alone, leaving you the core ad-based radio business and the ticketing business for free.  For context, Spotify last raised equity at a $8.5bn valuation representing 4x its 2015 revenues.  In terms of feasibility, the US has about ~20mm paid music subscribers today where Pandora’s ~80mm MAU’s reside and the market is growing toward ~40mm+ by 2020 (a little shy of the Netflix’s ~50mm).  Not only is the 11mm subs achievable in the US alone, but the on-demand licensing deal is expected to give Pandora international rights as well.  However, if for whatever reason the on-demand product flops, the Company will likely be shopped to strategics with Liberty rumored to have expressed interest circa $15.     

Key Controversies:

The stock has been controversial for a host of reasons but the crux of the bear case resides with 1) profitability constraints associated with music content licensing as well as potential saturation in advertising monetization, and 2) obsolesce risk with competition primarily from Spotify and Apple which currently offer on-demand subscription products. 

This first overhang on profitability was cleared by a ruling of the CRB last December that ties Pandora’s content costs to CPI going forward which leaves a healthy 40%+ gross margin on their free ad-supported radio product.  They are monetizing their listening hours today at ~$55 RPM (revenue per 1000 hours), but this represents an ad load that averages only 3.3 ads or under 2 minutes per hour.  Terrestrial radio on the other hand bombards listeners with 12-16 minutes of ads per hour.  There is admittedly varying quality of ad supply and Pandora has no intention of burdening users with terrestrial radio’s levels of distraction, but there still is plenty of room both on inventory available to sell and ad load capacity.  Specifically, as both local and national advertisers continue to migrate their advertising toward venues that offer better targeting capabilities, the Company’s average load could easily approach a still non-invasive 7 per hour or 3.5 minutes (which is the current max today in the best sold demographics).  The Company sees a $1bn+ opportunity in achieving their fair listenership share of local radio ad spend and now have local sales reps in 39 markets to chase it.  This gap vs terrestrial is due to the fact that local advertisers prefer the captive in-car audience, but today only 6% of Pandora hours are in-car vs ~40% for terrestrial radio.  However, the playing field will continue to level over the coming years as Pandora is a major participant in the connected car where it is now spec’d in to 190 new car models. 

The other major overhang has been the continuing threat of competition from Spotify, Apple, Google, and a host of other players including Tidal and Amazon.  The main disadvantage for Pandora was the lack of an on-demand product which Spotify (~30mm+ global subs) and Apple (15mm+ global subs) have been offering and currently adding users at over 1mm per month.  The first key thing to understand is that this on-demand race is not compromising Pandora’s core ad-based radio product as listener hours have grown despite these competitive threats in the background.  More importantly, Pandora is finally getting involved with an expected on-demand launch before yearend which management has described as more than a ‘me too’ product.  Not only is there a large pie of potential users evidenced by the rapid uptake of Apple Music (estimates range from 10-15% of the US population, to 40mm+ US subscribers approaching Netflix, to 5% of smartphone users long-term globally), but Pandora will also be able to market to existing radio users with no acquisition cost.  The end result is a new subscription revenue stream of ~$10 monthly per user (compared to their ~$5 ad-free product today) as well as a protected and growing core ad-based radio product that will only get stronger over time in the car.

Differentiated View:

Consensus currently expects ~$2bn of revenue in 2018 which assumes little from this on-demand business.  Management’s recent projections are 11mm on-demand subs by 2020 (representing 10% of projected active users) which would be worth an additive ~$1.3bn of revenue, but looking at the 1mm+ clip per month of users joining Spotify and Apple, it’s not inconceivable that they could hit 11mm much sooner.  Even if the on-demand uptake is just on pace, top line estimates by 2018 are at least 20%+ too low. 

Valuation & Risk:

Spotify last took an equity round in 2015 at $8.5bn or ~4x revenue and they have roughly the same total user base (~80mm subs of which ~30mm are paying).  Pandora trades for just north of 2x revenue today and could ultimately have more attractive margins and a sizeable advantage for growth in the car.  On that basis, if management were to come anywhere close to their recently laid out $4bn 2020 revenue aspiration, the bull case could take the stock north of $35.  Using the Spotify comp, a 3.5x multiple on just the guided ~$1.3bn of on-demand revenue is worth $15-$20 (with the low-end using a 15x EBITDA multiple in-line with SIRI).  Given there is a $16bn radio advertising market for their core business (as well as general digital advertising allocations) and an estimated ~$20bn+ global market for purchased music content in which Pandora can now join Spotify and Apple as a participant, this $4bn aspirational TAM in is not terribly egregious.  On the downside, with ~20%+ of the float sold short, there’s healthy skepticism for management’s plan given the competitive situation and profitability challenges with ad-based businesses.  If the on-demand product flops and you are stuck with just core radio + tickets, the stock could initially trade toward $10.  However, at this point the Company would likely be shopped and there seems to be strategic interest with Liberty rumored to have bid $15 earlier this year. Further, while management reiterated its intention and ability to execute on a standalone basis, there is now an activist involved to apply pressure if better alternatives arise.  The most important catalyst near-term is the timing and receptiveness of the on-demand product.  There’s potentially a call on political ad spend to help the quarter, but that is less relevant in context.  It has not been a smooth ride for Pandora, but going forward the combination of brand, scale, network effects, negotiated content costs, integration in vehicles and devices, and a host of secular tailwinds has created a unique asset in the public domain that should ultimately reprice higher. 

Catalyst

 The most important catalyst near-term is the timing and receptiveness of the on-demand product.  There’s potentially a call on political ad spend to help the quarter, but that is less relevant in context.