- Pandora has entered into a transitional quarter in which content costs have increased, but will remain constant over the next five years.
- I anticipate that expectations on long-term revenue are too conservative by both Pandora's management team and analyst consensus.
- However, estimates by sell-side analysts on valuation seem too high given market dynamics and risk assumptions by the buy side. As such I value Pandora at $11.97/share, which implies a 49% upside.
Okay, I’m not going to lie, I did say that Pandora Media (NYSE:P) looked like an interesting play going into its earnings report. What I did not anticipate was such a massive reduction in adjusted EBITDA, which was guided to a negative margin for the first time in quite a while. Adjusted EBITDA margin will decline from 4.43% to (5.3%) year-over-year between the FY’15 and FY’16 reporting period. This implies that the cumulative cost of ramping up marketing, incremental increases in licensing costs in conjunction with heightened spending into the premium music service will suppress profitability for the foreseeable two to three-year window. As such, investors have sold the stock in after-hours trade.
Going into earnings I was optimistic on revenue and pessimistic on adjusted EPS, which proved to be the case. However, I did not anticipate the company’s profitability outlook to erode so significantly. Whenever visibility drops volatility increases. No one likes bad surprises. The extent to which the company’s financial performance was going to be negatively affected as a result of the Copyright Royalty Board ruling was unprecedented.
The analyst consensus revised price targets lower:
Slashing Estimates; PT from $20 to $13: We have materially lowered our estimates, with our 2016 EBITDA cut from $82MM to a negative $75MM, in-line with guidance. Our PT goes to $13 based on a combined 2X P/Sales and 20X EV/EBITDA on our ’17 estimates. – RBC Capital Markets
Maintaining our outperform rating but lowering our price target from $26 to $15. We had previously valued Pandora on a per listener basis, but now that the company intends to expand internationally at a high investment rate and intends to roll out an on-demand service, the valuation framework has shifted. Instead, we value Pandora at a EV/revenue multiple of 1x 2018 levels, discounted back two years at a 10% discount rate. – Wedbush Securities
The company reported revenue of $336 million, which was above my estimate of $333.27 million. Active listener figures recovered from 78.1 million to 81.1 million in Q4’15, which was well above my own expectations, as active listener figures grew by 3.8% q-o-q. It’s not yet clear whether this growth rate is sustainable, but assuming the incremental advertising spend continues to produce results, the active listener figure may grow by 16% over the next year.
It’s not exactly clear if the growth in engagement was due to pre-existing account owners engaging with the app more, or acceleration of user growth as a result of the promotional activity. Total listener hours increased by 3% Y/Y in Q4’15, but some of the growth in active users could be due to pre-existing accounts engaging with the app, which converts inactive accounts to active accounts. Therefore, the source of active listener growth is somewhat difficult to pinpoint, but sustained marketing spend should result in active listener growth of 5% over the course of FY’16.
According to Pandora's management, the cost of licensing per thousand hours will increase from $25 to $32 between FY’15 to FY’16, which explains why gross margins will compress to 20.8% over the near-term. However, the CRB ruling sets licensing pricing for the next five years, so the costs will remain constant over the timeframe. Pandora anticipates that margins will improve due to sustained revenue growth.
Quoted from Pandora's earnings conference call:
Yeah. In terms of the question about driving RPMs I mean, at the current ad loads we're at now, so averaging in this high-value demos and areas, 5, 5.5 ads at the most on a per hour basis, it will grow well into the $70, $80, $90 RPMs. So we're very confident we can do that, it's a matter of both penetrating markets, driving budgets from terrestrial radio to Pandora, and it's about expanding into new sources of demand where we can under-monetize demographics and geographics.
Based on Pandora's management commentary, I anticipate RPMs (revenue per thousand listening hours) to increase at a 20% CAGR over the next five years, which implies that Pandora’s gross margin will increase considerably over the timeframe. This is driven by penetration of digital ad formats relative to analog and the rapid improvement of mobile CPMs relative to desktop on aggregate. Sustaining ad-price improvement with modest increases to ad load should equate to an RPM figure of $151.16 by 2020 from the current base of $60.75. If we assume a conservative 5% growth rate to active listeners, the listener hours should also sustain at a 5% CAGR over the foreseeable five-years i.e. 26.94 billion listener hours. Therefore, I’m anticipating that revenue from the core radio product to reach $4.07 billion by the end of FY’20. Furthermore, I anticipate the subscription service to generate $1.3 billion and events and sponsorships to generate $300 million in revenue (figure on subscription and events are derived from long-term management outlook).
It's worth noting that in a relatively realistic scenario, Pandora can eventually reach $5.67 billion in annual revenue. At the end of those five years, I’m anticipating a net profit rate of 10% based on management guidance, which implies that net income could potentially reach $567 million. To arrive at my intrinsic estimate, I assign an end of five-year valuation of $19.33 billion at 34.08x net income. Because the company has a negative weighted average cost of capital (WACC) I input the S&P 500 average WACC of 8.9% for the trailing 12-year period, and then add a 41% risk premium (as my forecast on revenue is substantially larger than the management's long-term outlook). So my discount rate against the $19.33 billion valuation is 49.9%, which results in a $11.97 present valuation or $2.55 billion market cap for the company.
Since the risk-to-reward still seems compelling based on my long-term value estimate, I still feel compelled to recommend the stock. Yes, I acknowledge that near-term market sentiment around Pandora could worsen, but I still anticipate a relatively predictable path to improving sales and margins.
Therefore, assuming Pandora's management is able to execute and grow sales at its forecasted rate, visibility on fundamentals will likely improve, which will result in mean value reversion. Of course, I’m extremely conservative on my discount rate, which is a result of my aggressive growth estimate. Furthermore, I come away with the impression that investors are aggressively discounting the Pandora stock, which demonstrates near zero conviction in the business model due in part to competitive risk factors. I take the opposing stance to broad investor consensus as Pandora has demonstrated that it can sustain active listener growth despite a more bloated cost structure. In other words, the stock is extremely undervalued when excluding the possibility of an end of Pandora scenario.
As such, I reiterate my buy recommendation and initiate a $11.97 price target for Pandora stock.