|Shares Out. (in M):||219||P/E||64||42|
|Market Cap (in $M):||3,380||P/FCF||48||31|
|Net Debt (in $M):||-459||EBIT||-69||-52|
|Borrow Cost:||General Collateral|
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Given the three business risks highlighted, which will all be discussed in more detail below, I don’t have high confidence that Pandora can achieve long-term street expectations. Expectations are for EBITDA go up 12x between 2014 and 2017 thanks to 24% topline growth over three years combined with EBITDA margins that are supposed to expand from 6.3% to 17%ish. I have reservations about both assumptions, but more reservations about the operating leverage being realized to this dramatic an extent. This long-held skepticism over the long-term final margin potential was only reinforced by the severe EBITDA margin guidance disappointment for 2015. The street was looking for margins to go from 6-7% in 2014 to 10-11% in 2015. Instead they guided to flat margins on 28% topline growth. So they can’t get any operating leverage on still dramatic topline growth this year, and after this year, content costs become more of a wild card, and topline growth could become harder to maintain, either because of increasing competition, or the law of large numbers/market share, or both. I do think revenues will grow strongly over the next few years, it’s just possible that they grow slightly below expectations or take a pause at some point due to competition before re-accelerating when connected cars really take off. Even with the stock down dramatically off the highs, it is still trading 10.5x a 2017 consensus EBITDA number that I think has a lot of risk to it. That is a high multiple given the lack of current profitability, the tail risk around Web IV, and the aggressive operating leverage and monetization assumptions underlying street estimates.
Brief Company Summary:
Pandora Media, founded in 2000, is the largest internet streaming radio company, with over 250 mm registered users and 81.5 mm monthly active users. Pandora enjoys its dominant market position as a result of a first mover advantage as well as platform ubiquity – it is available on virtually all popular consumer electronic platforms (iOS, Android, Desktop, etc.). It has also benefitted from an emphasis on an ad-supported service, as consumers have shown some meaningful price sensitivity around music subscription services. Around 80% of Pandora’s revenues come from its ad-supported free services, and the other 20% come from subscription fees on its ad-free service. Pandora offers stations in various music genres and also creates custom stations for users based on their favorite artists or songs. Users have the ability to give feedback on songs they like and don’t like, and over time this will lead to the customized stations offering them music that better suits their preferences. Pandora has made a substantial investment in the Music Genome Project, a giant database that defines songs based on a number of attributes. Cross-referencing songs that users like versus songs in the Music Genome Project database allows Pandora to help users discover music new to them that is similar to music they already know and like. Pandora has limited international presence in Australia and New Zealand, and over time would like to further its international reach, although these plans are longer-term and unlikely to be realized in the next year or two.
Bullish Investment Characteristics:
Bearish Investment Characteristics:
1. Bull Case is Heavily Reliant on Realizing Major Content Leverage over the Next Few Years but the CRB Decision is a Crap Shoot: The streaming audio industry has a very unique and particular process for determining the royalties that the streaming companies pay to the publishers. Every 5 years a 3-person arbitration board called the CRB sets the rates. That process began in 2014 and will run through 2015 with a decision expected in December. A number of webcasting companies submitted rate proposals and supporting documents arguing for modest (Pandora) to dramatic reductions in what webcasters pay to SoundExchange, an entity that represents and negotiates on behalf of the three large music publishers (Sony, Universal, and Warner). SoundExchange on the other hand proposed a near doubling of the rates that they are paid. This is the fourth such Webcasting negotiating period so it is being referred to as Web IV. The rate the CRB is supposed to come up with is supposed to reflect what a willing buyer would pay a willing seller. In past Webcasting negotiations, a dearth of deals in the non-interactive streaming audio space (which is specifically defined and P falls into – the requirements include things like not being able to request a specific song or album or artist, limits on the number of times you can hear a certain artist in a given time period, limits on number of skips, etc.) led the CRB to look at interactive/on-demand deals (for Spotify-type services, where you can request an artist, album, etc.) and then calculate and apply an interactivity discount. In past Webcasting negotiations, the CRB came out with rates that were too high, and so uneconomical as to potentially drive non-interactive webcasters out of business, so side deals were later arranged, superceding the CRB decision. This time, people expect the CRB decision to stand. There are also non-interactive deals to look at this time. The Pandora deal with Merlin (a consortium of indie labels) sets an attractive royalty precedent, but the Apple/iTunes Radio deal sets a precedent that is far less favorable to Pandora and the other webcasters. The Apple deal notably set a minimum fee of 45% of streaming revenues. Such a clause if included in the CRB decision would destroy Pandora’s earnings growth prospects because it would preclude operating leverage on the content line. There are a number of other arguments being put forth by both sides, and I could literally fill 10 pages describing them all, and the history behind all these contorted negotiations, but suffice to say this thing is a jump ball. On the one hand, there are three new people appointed to the CRB and the industry has been around longer now, and hopefully the CRB shouldn’t make any decisions so discriminatory that would be putting anyone out of business like last time. But on the other hand, there is no precedent for royalty rates ever going down, and the street bull case appears to be 100% predicated on massive leverage on content cost. If you talk to Pandora, they are sure they get some rate relief. If you talk to a record company, they are sure they get a rate increase. They are both biased. One high-ranking industry source described the likely outcome to me as completely unknowable and not analyzable. The worst case scenario – the SoundExchange proposal is adopted and rates per play double from here – is absolutely catastrophic to Pandora margins and would cause the company to go EBITDA and cash flow negative.
2. Easy Growth is Already Behind the Company as User Growth Has Slowed Considerably: After experiencing rapid growth in monthly active user – 82% in 2011, 62% in 2012, and 31% in 2013 – things have notably slowed down. In Q1 2014, active users grew 8.0%. In Q2 they grew 7.5%, and in Q3 they grew only 5.2%, ending at 76.5 mm. Things did however pick up in Q4 with user growth of 7.0%. Clearly the law of large numbers is kicking in, and the company has acknowledged that while the long-term opportunity remains 100 mm monthly active users, that is a long-term goal, and making the connected car a reality is part of getting there (so the 100 mm is indeed years away). They have shifted their focus to increasing engagement despite having to actually limit total monthly listening hours per subscriber to 40 at one point in 2013 because increasing use led to increasing royalties that in the presence of subpar monetization led to a noneconomic service. Now that monetization is better the cap is lifted, the focus is on engagement and more hours per month per user. This makes sense because more hours and engagement likely means a more loyal subscriber, and it also eventually means more inventory/impressions to sell. Unfortunately, usage gains have really slowed down in 2014 relative to prior years as well, which also accounts for some of the recent stock weakness. The normal Q1 to Q2 slowdown was a little more pronounced than usual, and Q3 did not bounce back to Q1 levels as expected. Pandora management had guided to a better usage number in Q4, but then failed to deliver on that promise. And while it makes sense that at this point in the life cycle to move from adding users to increasing engagement, this doesn’t come cheap. They have initiated consumer facing marketing efforts for the first time, geared at increasing hours and also activating lapsed users. This could be a headwind to margin expansion.
3. Opportunities for Rate Growth May be Overstated Because Internet and Terrestrial Comparisons are Not Apples to Apples: Pandora likes to talk about how they are 9% of industry listening but 2% of industry revenues. This makes a lot of sense conceptually but the inventory they are selling is not apples to apples comparable. Even taking sports and talk radio out of it, terrestrial radio rates tend to be highest during drive time, when the listener is captive and attentive in the car. Also, some of the highest priced terrestrial spots are the inline advertising, basically product placements (usually for local establishments) worked into the conversation by popular and trusted radio personalities. Pandora doesn’t really play in the drive time day part yet, nor does it offer any inline advertising spots. Pandora also says that they are monetizing around low $40s RPM now. Assuming $40 per 1000 hours and 3 minutes per hour that would be a $7 CPM per 30-second spot. This is admittedly a flawed analysis because it’s not how media buyers really price internet radio – they buy demos not total audience – but using it for comparison’s sake, the average CPM for terrestrial is only $2, and a good spot CPM is considered $9ish. It’s not clear to me that Pandora is that under the terrestrial market, although I do think they do have a far greater opportunity than just supplanting the terrestrial market if they can really harness the power of their data.
4. Growing Competition: The number of competitors participating in the streaming audio space has increased greatly. This is clearly evident just by looking at the increased number of companies participating in Web IV. The biggest threat competitively to Pandora would be the growing popularity of Spotify, particularly in the younger demo. While Spotify is still much smaller than Pandora with an estimated 60 mm subscribers (15 mm of them paid subs), it is growing users much faster, is getting linked to a lot in mainstream media because of its playlist features, and is way ahead of Pandora internationally. It has also been very aggressive on technologically innovating. While only directionally indicative, Google Trends shows search activity for Pandora falling 20% from Dec. 2012 to Dec. 2013, then another 24% from Dec. 2013 to Dec. 2014. Conversely, Google Trends shows search activity for Spotify increasing 25% from Dec. 2012 to Dec. 2013, then increasing 67% from Dec. 2013 to Dec. 2014. On the other end of the spectrum, there are a bunch of well-funded giants who have yet to make much impact but clearly have deep pockets. Much was made of the Apple iTunes Radio launch, although it hasn’t eaten into Pandora’s market share at all. Apple did however buy Beats a year ago and has yet to do anything with its small music on demand service. While Pandora has made a couple of industry hires to try to become a better promotional partner to the music publishers, it was widely thought at the time of the Apple/Beats deal that one of the motivations behind the deal might have been to bring Jimmy Iovine (and to a lesser extent Dr. Dre) in house at Apple to build a bridge to the publishers and really transform the music industry. iTunes Radio is obviously not platform agnostic (iOS only) and it’s unclear if any future Beats innovations would continue to run on Android as well as iOS (seems unlikely), which would help protect Pandora. Google, already a big force in music through YouTube, recently bought Songza. Amazon recently launched streaming music free with Amazon Prime.
5. Losing Their Cool/Problems with the Younger Demo: Anecdotally, all the younger people seem to be on Spotify. There is some feeling that Pandora is your parents’ internet radio service, although the conventional wisdom of a service’s imminent demise because teens are abandoning it seems perennially overdone (see FB in the $20s). That said, the media buyer I spoke to said they specifically use Pandora to buy the 18-24 demo, so if that demo is leaving for Spotify, that will be a problem for Pandora monetization.,
6. Not Enough Songs?: Pandora Catalog is 900,000 songs versus Spotify catalog is 20 million songs.
7. Potential for One-Time Negative Event Concerning pre-1972 Royalty State Lawsuits: Due to pre-1972 recordings falling under state laws and not federal statutes, they have not fallen under the Webcasting agreements for minimum royalties and they have been played free for some time. There are a number of cases challenging this moving through the state courts, and so far the music publishers have been winning. Eventually Pandora will run out of appeals. If they lose, they may have to start paying royalties on pre-1972 recordings, which constitute 8-10% of plays, and have been played for free up to now. Assuming the current rate structure stands, this could be a several hundred bp margin headwind, not insignificant to a company with a 6-7% EBITDA margin. Additionally, they could be liable for 3 years of damages, which I estimate could run somewhere between $20 mm on the low end to $140 mm on the high end. On the low end, the damages are immaterial. On the high end, it’s a third of their cash. I think the interesting thing is no one is talking about this issue. I am not certain when these cases wrap up.
8. International Opportunity May Be Limited: Spotify has a big lead already, and the royalty rates have been hard enough to work out just in the US. If Pandora management thought it would be easily tackled, why would they be pushing off even framing the opportunity to 2016?
9. General Macroeconomic Risks: Advertising is highly cyclical, and even when the economy is doing OK, can be lumpy and surprise people (as it did over the summer in both the television and terrestrial radio markets). While Pandora is a story of secular growth, if the overall advertising pie shrinks, it will be harder for them to grow. This has never been considered a risk factor for them before because of their secular growth, although this may have changed some with the Q4 report.
1. Despite terrible trailing twelve month performance and this very bimodal risk in the December Web IV decision, the street remained near uniformly bullish until the Q4 blow up. There were over 20 buys and 5 holds going into the miss and bad guidance. Three firms did downgrade to neutral after the quarter, and almost everyone cut their price target, but most analysts stuck with the buy, and Pandora still has 19 buy ratings on it. It’s unusual to see a stock down over 50% in a year and the sellside stick by it like this.
2. Short interest which was once insane here (>70% of float I think a couple of years ago) is now down to 14%.
3. Stock based compensation levels were already high here and are increasing dramatically in the face of poor performance. It is egregious.
Price Target and rationale:
Price Target of $11 with a bias, acknowledging there is a chance it is worth a lot less
25% chance the street is right: They get flat or slightly down rates at Web IV, monetization continues to improve, and increasing competition doesn’t eat into their market share. P makes a high teens EBITDA margin and $1.20 eps in 2017 (untaxed), a generous 20x EBITDA multiple, discounted back 2 years at 10%, yields $20
65% chance the street is being a little aggressive: The CRB comes back with modest increases in the royalty rate, which curtails their ability to get all the leverage the street is looking for. The benefit of RPM (revenue per thousand listening hours) growth that exceeds LPM (licensing fees per thousand plays) growth is partially offset by having to start paying royalties on pre-1972 music, which constitute about 10% of plays, and which they currently don’t pay for. Leverage on the content line is still there but more muted and EBITDA margins go from 6.3% in 2014 to 11.5% in 2017. Sales growth compounds around the recently lowered consensus numbers, as the street has woken up a bit to the law of large numbers, and I do acknowledge the very real opportunities for better monetization with the increased investment in the local sales force. P makes an untaxed 55c in 2017, and 10x 2017 EBITDA is around $9.
10% chance they are screwed by the CRB in December: The CRB comes back with an adverse decision – accepting the SoundExchange proposal or something close to it. P also loses the pre-1972 cases and experiences negative operating leverage on the content line. They need to throttle usage again to stay profitable. Growth rates are lowered as a result. Marketing is cut back to 2013-2014 levels through severe cost cutting to minimize cash burn. Company will be approaching EPS and EBITDA breakeven in 2017, having burned through most of its cash balance. This scenario may be too generous because RPM growth may not come through as I have modeled it in this scenario, as marketing investment will grind to halt, and the company will irritate its users by bringing back usage caps at the same time it is under threat from new competitors. The company is really near worthless in this scenario, and will probably have been forced to do a dilutive secondary to shore up its balance sheet. I will give it the benefit of the doubt and say it is worth $2 in this scenario. I do think this is an unlikely scenario, but it is catastrophic if it happens so it can’t be ignored.
(25% X $20) + (65% X $9) + (10% X $2) = $11.05
They already lowered the year so much, it's kind of a sandbag, so that sets them up for possible squeezes.
They can sign favorable royalty deals with small, meaningless content owners which lulls people into complacency about their bargaining position with the Big 3 publishers.
Dream scenario happens where CRB cuts rate for them and margins explode.
Key Upcoming Events:
· 2/17/15 Written rebuttal testimony die for Web IV proceedings
· 3/5/15 Company will hold an Investor Day (announced on 2/5/15 with earnings)
· 3/20/15 Conclusion second discovery period of Web IV
· 4/7/15 Due date for amended written rebuttals
· 4/27/15 Hearings to cover rebuttals (should last one month)
· Late April 2015 1Q Earnings Release
· 6/3/15 Closing arguments made to CRB
· December 2015 Web IV Decision
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