Pandora Media, Inc. (P) – Faraz Farzam, CFA
We have been accumulating shares of Pandora over the course of the last year which has been rather tumultuous for the popular streaming music app. We believe it is one of the most strategic internet assets trading now at rock-bottom prices. According to comScore, Pandora boasts nearly 90 million active users representing five billion listener hours. This level of usage, 22 hours per user per month, rivals both Facebook and YouTube. This compares to Spotify at 100 million (of which only 30 million are paying subscribers) and 15 million for Apple Music. It is important to note that Pandora’s core service is free; supported by advertising revenue. Spotify and Apple Music require a monthly subscription for an on-demand service. Furthermore, the active user metrics for Pandora’s competition are global while Pandora’s is almost exclusively domestic.
The key point of differentiation between Pandora and other services is that, not only is it a free advertising supported service akin to terrestrial radio, it serves as a unique discovery engine for new music for its listeners. The company has developed algorithms that use intrinsic qualities of music to initially create stations that then adapt playlists in real-time based on the individual feedback of each listener. Its streaming service is available through various distribution channels and it has developed applications for smart phones, tablets, smart televisions, gaming consoles, and home streaming devices. Furthermore, Pandora is currently integrated into the automotive infotainment systems of 190 car models. Management expects this integration to be expanded to 50% of all cars sold in the U.S. in 2016.
Utilizing an advertising based model, Pandora aims to capture a share of the massive $23 billion digital advertising market and the $17 billion radio advertising market. We believe Pandora will eventually close the gap between its leading share of US radio listening hours (estimated at 10%) and its advertising share, estimated at approximately 4%. This implies that, if pricing is held constant, the company has the opportunity to double its revenue as it closes that gap. However, the company also has an opportunity on the pricing front. Today their ad rates are far lower that the rates charged by terrestrial radio, even though Pandora has been steadily raising rates. Over the course of the last 3 years, Pandora has expended considerable effort building out a sizable sales force, nearly 160 strong “feet-on-the-street” in 39 markets, to attack the local radio advertising market. This is an asset that neither Spotify nor Apple possess.
In our opinion, neither Apple Inc. (AAPL) nor Spotify are truly direct competitors. This is a point of confusion amongst investors that caused a lot of volatility in the stock over the course of the last year. As we mentioned earlier, Pandora’s service is free to listeners who are willing to listen to a few ads per hour. However, Spotify and Apple Music offer a paid service that amounts to $120 per year. This requires the building of playlists and is often referred to in industry parlance as a “lean in” model vs Pandora’s “lean back” model. A few months ago, Apple quietly shuttered its iRadio business, the service that directly competes with Pandora, to focus on Apple Music, the Spotify-like service. Although Spotify offers a radio service, in our opinion, it lacks a meaningful recommendation engine. Spotify also does not possess the local sales force required to compete for local ad dollars.
2014 was a watershed year for Pandora. The company hit $1 billion in revenue and generated nearly $60 million in earnings before interest, taxes and amortization (“EBITDA”), a measure of cash flow. By the fourth quarter, it hit a run-rate EBITDA of $175 million, demonstrating the economic power of the business model. 2014 was also the peak year for the stock price, topping $40 per share. However, over the course of the following year and a half, the stock came under considerable pressure for several reasons.
First, investors began to “climb a wall of worry.” The Copyright Royalty Board (“CRB”), a three judge panel that sets royalty rates for the industry, began deliberations on what rates Pandora and other providers would have to pay artists and record labels over the next five years. Investors feared a dramatic increase in rates that would permanently impair the economic model. The royalty rates were eventually set and, although modestly higher, they were nowhere near the dramatic increase bearish investors predicted.
Second, the company acquired Ticketfly, an online music venue ticketing app similar to Ticketmaster. Pandora aims to marry the vast storehouse of information on its users, their likes, their stations, and music preferences with performing artists’ touring schedules. In the age of digital music, 80% of an artist’s income is generated through touring. According to Pandora, 50% of tickets go unsold prior to the event. Pandora sits in the unique position to help artists connect with their fans, providing a unique service that no one else can deliver.
Third, Pandora acquired the technology assets of Rdio, Inc. out of bankruptcy to deliver a Spotify-like on-demand platform in 2017. According to Pandora, the company will break even on the acquisition if they convert a mere 2% of their already vast user base to a paid on-demand service. Although bearish investors point to a company that struggles to make money, we believe that the core ad-supported radio business is generating EBITDA. In our opinion, this is currently masked by the investments in the two new platforms.
Pandora’s goals are ambitious. They aim to be the dominant music platform for consumers; spanning radio, on demand, and concerts ticketing. We believe that, if Pandora can achieve these goals, the value of the company will be dramatically higher than today's price. However, should they fail, the core radio asset with its 90 million user base and 160 strong domestic sales force will surely be a sought after asset for other internet platforms such as Spotify or Facebook.