Description

I think Pandora is a compelling long.  I will pause here to let that sink in and I realize half the VIC community will get squeamish just thinking about a tech name down (hopefully the other half is excited about a tech name down so much in one of the most epic tech bull markets).  Yes I think a stock that is down 43% YTD and has a 39% short interest is compelling.  But before I get into the meat of the pitch let me set the tone:

I don't know where I'm goin

but I sure know where I've been

hanging on the promises in songs of yesterday.

An' I've made up my mind, I ain't wasting no more time

but here I go again, here I go again.

Tho' I keep searching for an answer

I never seem to find what I'm looking for.

Oh Lord, I pray you give me strength to carry on

'cos I know what it means to walk along the lonely street of dreams.

Here I go again on my own goin' down the only road I've ever known.

Like a drifter I was born to walk alone.

An' I've made up my mind, I ain't wasting no more time.

I think the great bards David Coverdale and Bernie Marsden really nailed it with this one.  It perfectly summarizes the Pandora pitch.  On the off chance anyone needs more I guess I can explain more below.

Pandora is a high tension tech stock that has had multiple historical missteps.  Pandora has had years of mismanagement and now with Liberty backing (via Sirius) has a highly favorable risk/reward skew. Liberty owns ~16% of Pandora via a convertible preferred stock that converts 25% out of the money.  The upside in Pandora is driven by three main factors:

1.       Growth in listener hours driven by stabilizing user numbers and increasing hours per user that will be generated as streaming uptake accelerates

2.       Higher RPMs generated by a combination of higher ad load and effective use of higher value ad formats and programmatic advertising

3.       Cost rationalization driven by a solid management team under Liberty Media’s close watch

Pandora has 76M active users in the US, of which, 71M of them listen to Pandora’s “lean-back” ad-supported product at over 23 hours per month on average.  Pandora has been poorly mismanaged and has undergone three CEO changes in the past two year.  Some lowlights: 

1.       Buying Ticketfly for $400M and then selling it 18 months later for $230M.

2.       Spending $150M to create an on-demand service to compete with Spotify & Apple despite both having a multi-year lead

3.       Neglecting its core ad business to first try and compete with Apple/Spotify and then because they wanted to pivot and become a label themselves

4.       Proactively capping ad-load for now rational reason

5.       Building two “Taj-Mahal” like HQs and hiring an insane amount of people – i.e. one of the more awe inspiring collections of “corporate fat”

After this ill-fated entry into on-demand streaming Pandora fired its old management team and BoD, received a capital injection from SIRI, and re-focused on its core advertising product.  Pandora announced their new CEO on August 14^th.  Roger Lynch has a good background and was the former CEO of Sling Media.  He has a strong tech background, knows how to run both an ad supported and subscription business, and most importantly knows how to run a lean ship.  He has already made some good hires for the ad-tech group.  

To butcher a quote – great artists steal.  We have definitely heard this song from the Liberty playbook before.  In Jan 2009 Sirius was near bankruptcy and Liberty outbid DISH to put $530M in Sirius via convertible preferred.  They did this in two tranches ($280M and a follow on tranche later).  Within a quarter of Liberty investing Sirius was able to get to FCF positive and from there it was a rocket ship.  Pandora is oddly similar – it’s the exact same instrument (convertible preferred with a tiered investment – they accelerated the 2^nd tier faster than anyone anticipated which is normally not a bad sign).  As previously mentioned Liberty also replaced the CEO and the BoD.  While I can’t be sure – this does feel like I am listening to Robin Thicke’s song “Blurred Lines” which we all know was just lifted from Marvin Gaye’s :Got to Give it Up”  - net-net we have heard this song before, and it worked really great the last time.

Management changes and Liberty don’t matter unless users stay around as that is the core of Pandora’s value.  People are concerned that users are starting to churn off. What they are missing is that Pandora’s core value is the Mom & Pops out there that will never change.  Out of their 71M lean-back US listeners there is a core cohort that will continue to use Pandora for years to come irrespective of ad-load.  If it isn’t broke don’t fix it!  People mistakenly think this competes with Apple and Spotify and it does not.  It is an entirely different use case.  The cohorts that uses this isn’t looking to create playlists or listen to cutting edge stuff – they just want lean-back streaming radio to play music for them for long periods of time.  There is also something to be said about connected car and how that is just taking off now (wasn’t easy for Mom & Pop Main Street to use prior to the latest few models of cars) and there is a massive untapped potential in spoken word which Pandora is now getting into with podcasts, etc. (genome project will be expanded at the podcast level – which in my own humble opinion as a podcast consumer is pretty cool). 

Pandora has a near-monopoly on the online local audio ad market which is ~$15B.  And right now their ad-load is 1/6^th that of terrestrial radio.  They can easily increase ad-load to 8 to 9 30 second spots up from ~5 today (terrestrial radio is at ~15 min per hour or 30 ad spots) – and if they do that this thing is a home run.   Pandora will be able to both increase ad-load and increase CPMs as they can better target customers than terrestrial radio can.  As Pandora further shifts its ad mix from national down to local it will naturally increase their RPM (aka Pandora will naturally make more money!).   The prior management team also proactively capped ad-load, so just bringing it up to where it naturally should be let alone ever trying to compete with terrestrial (which it won’t get to that level) results in dramatic financial results.

Additionally we are witnessing a big change in audio ads via the introduction of programmatic audio.  Unlike the programmatic introduction to display, audio will not experience CPM deflation as there is limited ad space (you can always make another blog on the internet with ad space, but we only have two ears and can listen to one song at a time).  The added kicker to this is programmatic audio will make Pandora dramatically more efficient in delivering ads.  Right now 8-10 people touch every ad served on Pandora (each sales person has 3 assistants helping them).  This number should be closer to 3-5.  So Pandora can actually cut their SG&A by something like 25% just getting their headcount numbers in line with industry averages.  Once they fully embrace programmatic this number can go even lower.  In speaking with former employees they universally said that Pandora was a bloated and inefficient sales team – and it’s not like the results have hidden this fact. 

So you have a new team (CEO and BoD), a product people have loved for years but  has gotten muddied due to mismanagement, a cost base that is about to dramatically cut, and a revenue stream that is about to massively inflect.  Seems like a good set up.  You take all these together and I get to something like $1 in FCF by 2020.  While I am not sure what multiple it deservers I have a feeling Mr. Market won’t be valuing this business at 7x FCF.

Further – I also think you have limited downside risk as Pandora is trading close to liquidation value. You can break Pandora up into three component pieces:

1.       The NOL – Sirius’s NOL will be used up soon and John Malone doesn’t exactly love paying taxes so he is on the NOL prowl.  Luckily Pandora has a nice fact NOL and even using Section 382 limitations we can take the NPV of this to find some value.

2.       The subscription business – not much has been said on this, but Pandora has recently raised prices on this – they are clearly no longer running this as a charity operation and instead intend to run it for profit.  I assume they just run it for cash and take a CLV based valuation approach based on an elevated churn.

3.       AD business – I assume 30% of users walk overnight and the other piece they push ad-load up to a staging 1/3 of terrestrial radio ad load.

You take all these and sum them and cash and ne out debt and compounded PIK on the preferred and get to something like $6.70 per share.  Given that this thing is trading at $7.20 now.  I will take $0.50 of downside for probably $7+ of upside any day.  

If management even and Liberty media are even marginally competent this is one of the most favorable risk/rewards I have seen in a while.  The stock has been hit extra hard lately due to a large shareholder liquidating their position – I suspect this was a forced liquidation due to redemptions making the opportunity that much more interesting.  To paraphrase the great band Ratt this one is dangerous but worth the risk.    

Catalyst

This quarter will mark the first earnings call for the new CEO.  As revenue starts to inflect from higher ad-load / CPMs, and cost cutting begins the financials will massively inflect.  Further there is also a free option on an eventual SIRI merger which is in the cards as SIRI's NOLs expire and Pandora inflects given SIRI's convertible preferred stake.