Pandora's Make or Break February


According to Greek legend, Pandora was the first woman on Earth, and was given to Epimetheus as a gift by Zeus, with a jar that contained all the evils of the world. Out of curiosity, she opened the jar, unintentionally releasing these evils. The only thing left inside the jar was the Spirit of Hope. Seeing something remained, Pandora closed the jar, quickly trapping Hope inside and keeping it safe. Shareholders reviewing Pandora's quarterly results are likely debating hope as well. They are hoping the recent slowdown in active listeners is only seasonal, that revenue per thousand listening hours will continue to grow, and that the cost of acquiring content doesn't accelerate.

Revenue and profit are beating estimates today
Pandora reported December quarterly results of $201 million and $0.12 per share. This handily beat consensus of $175.6 million and $0.08. Despite the revenue and earnings performance, guidance was below expectations and listening metrics for the month of January showed a slowdown. However, a closer look at the numbers shows that pricing for advertising remains strong, which should sustain the company's top line growth, at least for now.

Pandora's profit comes from capturing the spread between revenue from advertising, and from the cost of the music it distributes. Either a slowdown in advertising, revenue growth, or increasing content costs could bring down profit estimates for 2014. Because Pandora hasn't turned a material profit yet, reduced long-term expectations would crush the share price.

Listener growth faltering, but not showing a sustained decline
Despite the headlines, the drop in listener growth appears to be only seasonal at this point. Competition in this sector has been heating up as Apple introduced iTunes Radio in the September quarter. Initially, there appeared to be an impact on the number of active listeners as the month of October showed a decline.

However, it rebounded in November and held up in December. There was a decline in January as well, and the question has come up again in February. January's decline wasn't a new phenomenon, as this could have been simply a seasonal decline that was slightly larger than last year's. The percentages were similar, with a 2.2% decline last January and a 3.6% decline this year. This isn't ideal for a growth company, but it isn't a disaster either. This one-off weakness makes the next data point more important, though, and that will come in the first week in March when listener metrics are released.

Apple is the biggest competitive threat now
Until recently, Spotify was considered to be Pandora's biggest competitor, but that was before the juggernaut Apple entered the market. According to Venture Beat, Apple hired former Cumulus Media exec, Michael Pallad, to run advertising sales for this new business. Apple is currently offering a free service with advertising, as well as an ad-free/paid service at a cheaper rate than Pandora ($25 per year vs $36 per year), but the real differentiation is in the ability to leverage prior iTunes downloads and purchases to create radio stations. Pandora uses its Music Genome Project to manually create links between similar pieces of music, which amounts to 13 years of experience. If Apple can create a similar experience, users probably won't mind. Reviews rate the service behind Pandora, but good for a first attempt.

Ad pricing is holding up
Pandora's meat and potatoes is still its web application. Even though mobile is growing faster, the pricing to advertise on the company's web portal is 70% greater than it is on mobile. A look at Pandora's earnings call transcript shows, "Advertising RPMs also reached record highs for the fourth quarter on both traditional desktop and mobile at $61.92 and $36.20 respectively."

Pricing for each of these services is at an all-time high, which shows that advertising clients are still willing to accept pricing increases, at least in the seasonally strong period.

Costs are going to play a bigger role
Going forward, though, the investment thesis isn't just about growth in subscribers or revenue. Unlike Facebook or Twitter, Pandora has a high cost of content, which the company has to fight to control. In 2014, new royalty rates go into effect where the CRB rate increases from $0.0021 to $0.0023 per song. This may not seem like much, but it represents a 10% increase in costs. Looking slightly farther out, in 2015, new royalty rates will be negotiated, which could raise the cost of content even further in 2016 and beyond.

Pandora is taking steps to differentiate itself from competitors such as Apple and Spotify by offering a venue for new performers to get exposure. A new site provides local artists a venue from which to submit their material. In time, if this builds a significant amount of high-quality content, this could be a way for the company to reduce its costs while developing deeper ties with younger audiences. Pandora is also sponsoring local concerts with brand name performers. The company is also sponsoring "Pandora Presents," a custom concert series with top-billing artists. However, both of these new initiatives cost money and this need for differentiation may keep Pandora in the red.

Show me the money
Pandora was one of the best-performing stocks of 2013, logging a 164% gain as both pricing on advertising and the number of active listeners increased. On the recent earnings call, Pandora's CEO said, "our bias continues to be revenue and market share growth over profitability," which translates into losses when growth slows. Since there is no earnings support today, the decline could be much deeper and faster than with other companies.

Eventually, shares of Pandora will trade on a multiple of earnings the way every other stock eventually does. The question is will the management team generate a stream of sustainable earnings before that day approaches. Until Pandora's management can generate sustainable profits, you should probably refrain from purchases.

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