Description

Pandora

Brief Overview/Intro

Pandora Media is a business most of us are probably familiar with, and many of us have used in the past (or use currently). The company provides internet radio and allows users to create personalized stations. The company has two models: a free ad-supported version as well as a subscription service which is ad-free but costs $3.99 a month. The company is currently the largest internet radio company in the world and is growing users and listening hours EXTREMLY fast. The company believes that its “Music Genome Project” combined with its millions of “thumbs up and thumbs down” ratings from viewers, allows them to create a personalized experience and high barrier to entry for someone to offer a competing compelling product.

Thesis

I am no short selling expert, and prefer to stick to the land of special sits equity and credit, but I think this is a strong short opportunity. I believe Pandora is not only ridiculously overvalued, but more importantly has a fundamentally flawed business model which will never allow the Company to reach the astronomically profitable levels that either terrestrial radio stations enjoy, or the extremely high growth rates for EBIT that are underwritten in the bullish sell side estimates. The goal in this write up is to explore the “bull case scenario” as written up by certain sell-side analysts with aggressive price targets and to analyze Revenues, Costs and Competition in order to show that the projections laid out by the street are unachievable. In order to “set the table” this analyst has a target about 30% higher than the current price and has done a fair job of laying out his assumptions. His price target is based on a DCF model going out approximately 10 years plus a terminal, where as a note, his final year has $350mm of Free cash flow vs. the current -$10mm.  As opposed to going out that far in the future, I think it is more beneficial to focus on numbers within the next few years, lets say fiscal year 2016, to prove the point. For a brief highlight, the analyst is assuming $1bb in revenue and EBIT of ~$100 mm.

Happy to take questions and discuss, particularly if you don’t agree with my thesis as that is often where the real value add of VIC comes into play.

Brief Historical I/S

Revenue

The company has been able to grow revenue at an astounding pace in the past years. In 2010, revenue was approximately $55mm, the company this year can realistically come in at levels north of $425mm, so revenues will be up almost 8x in 3 years! Holy cow! This revenue comes from two separate streams:

First is Subscription revenue. Users have the option of a pay version of Pandora which is fairly simple: users pay $3.99 a month and can listen to the company’s music ad-free whenever they want.  The company does not breakdown exactly what is subscription vs. ad supported, however Subscription is deemed to be a tiny part of the revenue stream, around 10%-11% of total revenue.

The larger part of the company’s revenue comes from the free but ad-supported content. Like a traditional radio company, you are listening to your music and then the occasional highly annoying interruption from someone pitching me to go to community college or rehab comes on (My music choices must paint a very different picture of me than my proud parents have always believed).

In terms of overall listening hours, the company believes that its users make up over 7% of total radio hours in the United States, and its market share is growing quickly. I do not argue with this point and think it is quite possibly accurate. I would argue in short order it is quite possible for Pandora to “control” a market share of north of 10% of listening hours.

According to the radio advertising bureau, total radio advertising in 2012 was approximately $16.5 billion dollars up approximately 1% over the previous year. So using the current ad expected revenue for this year of $375mm, the company has about 2.5% of the market in terms of advertising vs its current 7% “listening share”.

For arguments sake let assume that ad dollars that Pandora could target are $18 billion by FY 2016. That is using the 16.5 bb growing @ 3% (faster than the current market rate but factors in maybe some market share gains for internet radio vs other advertising forms as well). In order for the company to gain $1bb of top line revenue from ad supported dollars, the company would need to control about 5.5% of the overall market. While that is north of a double from current levels, you know what I think that’s “reasonable” as well. So in reality I don’t really disagree THAT much with the revenue side of this story (I could argue it further but will discuss that in the competition). The real problem with this story is the cost side.

Costs

The company has 2 major costs we can focus on: content costs and marketing/SG&A.

Lets first go through content:

Unlike traditional radio, the company has to pay artists to play its music. This process is set through arbitration by a government battle, and the CEO did a great job of discussing the process in a recent conference @ Needham so I would suggest you pull the transcript. The company pays an amount to a non-profit organization called SESAC based on hours listened in a graduated scale over time. Further there are two scales: one for non-subscription revenue (i.e. ad supported users) and one for subscription based users. The amount can be seen in the table below (these are PER MINUTE RATES):

As you can see these amounts grow over time, and that the costs for subscription based users are significantly higher for ad based users. This is where the story for Pandora starts to unravel.

A subscription user pays about $50 a year. Using 2016 costs, an hour of listening costs Pandora about 16 cents, so if the user listens to an hour a day on average Pandora loses money. In fact the general estimate is that subscription users listen to between 2 and 3 hours a day! Using 2 hours a day, the average listener who buys a subscription service would lead to a loss for Pandora of over $70 a year per user. UGH. The non-subscription side continues to ratchet up yearly as well, and forces the company to find more add dollars to offset its increasing spend – the company is a victim of its own success in order to grow into its valuation, the company will need to gain market share and more listening hours, the more listening hours the more they spend on content. So why offer this contract? The CEO is less focused on profitability and more at the moment on building up a user base and listeners.

So in order to make this work, basically the subscriber side won’t work, so the company will either have to take down content costs or boost advertising revenue. Let’s focus briefly on the content cost side.

The company is trying to aggressively lobby against the content fees saying they are unfair and they should be treated more like an XM/Sirius or internet radio. The internet radio fairness act in their words is “An important piece of legislation has been introduced in Congress to help end the long-standing discrimination against internet radio”. If capitalism doesn’t work in your favor than just lobby to change the rules I guess.

Bluntly the main case is as follows:

The issue is long-standing royalty rate discrimination against internet radio. As each new form of radio was invented (including cable and satellite radio), new legislation was passed but only addressed the new form. The result is dramatically different royalty rates: satellite pays about 7.5% of revenues and cable pays about 15%, while Pandora pays more than 50% of revenue in royalties. The inequity in how different digital radio formats are treated under the law when it comes to setting royalties is a clear case of legislation falling behind advances in technology. The current law penalizes new media and is astonishingly unfair to internet radio.

You can read more about it at the company’s website:

http://www.pandora.com/static/ads/irfa/irfa.html

There are plenty of news articles discussing the current situation, and I would suggest you read a multi-part series put together by the NYT on the subject as well as the following link: http://soundcheck.wnyc.org/blogs/soundcheck-blog/2012/nov/21/internet-radio-fairness-act-explained-sort/

If Pandora was able to get its content acquisition costs to drop it would be a game changer (while it would invite in more competition, frankly that is a day where the short would hurt more than a little).

However I believe it is unlikely: First, the current schedule already assumes that costs are rising into the future, for them to start dropping is unlikely as opposed to more of a plateau. Second, as can be seen below, more competition is entering the space, it is hard to argue that the rates are not “fair” when capital is flowing in to compete with Pandora. Third I think it is a solid question as to why this business needs to exist at all. As the old sale of CDs has moved to itunes and amazon, why SHOULD internet radio have the right to exist? Musicians already generally feel most radio stations have outlived their usefulness as a “free advertising for new music”, and feel they are now undercompensated due to the loss of their traditional cash flow stream (album sales). Record labels feel in general they have historically given up too much in the previous negotiations and between Radio, Satellite, Cable etc, there are plenty of alternative sources for “radio” and its time the listening public pays.

So assuming that Pandora isn’t able to convince some evil politician to sponsor their way to profit: the goal here is to focus on driving ad dollars. The problem is in order to grow ads, Pandora is having to spend a ton to build out its marketing/SG&A. By 2016, in order to hit sell side EBIT numbers the street has prepared, and assuming reasonable growth rates in total user listening hours, and following the schedule for content costs as listed above, the Sell side is modeling only about $275 mm in total costs for marketing and SG&A , vs the nearly $130mm today. First, the company is growing its marketing and SG&A spend rapidly, so that would call for a fairly steep decline in the growth rate almost immediately. Further let us  compare these numbers to Clear Channel’s radio division (CCME). CCME has $3bb of revenue, and about $1.9bb in SG&A and marketing costs for that specific division. Advertising is mostly a local market and I FIND IT INCREDULOUS to believe that Pandora can reach a third of the revenue of a large efficient player at less than 15% of the cost. You need feet on the ground and local offices to get that type of scale.

Finally the proof is also in the numbers: the company has grown revenue nearly 7x since 2010 (assuming they hit revenue numbers), however $ margins have not expanded at all. Any company that can increase revenue by seven fold and not increase profit (and in this case EBIT has become MORE negative), helps to show there is a fundamental flaw in the business. This fundamental flaw is clearly in the cost side.

Competition

Competition in the space is growing and becoming more creative. I will not go into an in-depth analysis of traditional radio or satellite radio or itunes and youtube as competition for your listening hours, but needless to say they exist and are all battling for either your wallets or advertisers money.

Spotify – Spotify is a solid competitor that is actually part owned by the music companies. The company offers a $10 a month product that has a radio like component, but more importantly allows you to choose songs to download and listen to offline or to listen to songs on demand as opposed to traditional radio (or Pandora), where you listen to what the “DJ” chooses. Pandora does not consider Spotify competiton as they believe names like Spotify occupy a different market as it is “on-demand” vs. true radio. We believe this is nonsense, listening hours are listening hours and if Spotify ever chooses to simply offer a $5 version with some ads but offline listening it will clearly take dollars from Pandora (Who wouldn’t want to listen to a song on demand with a radio feature on the side?).

Songza/Mog and other hybrids-  Songza and Mog actually already offer the opportunity for online/offline and radio listening some is premium with charge, and some are free and ad driven.

Apple – I would say this is a natural entrant to the market that has been rumored but yet to happen. This could be a nice tie-in to the current itunes store and draw people into the “apple eco system”. There are many stories out there discussing this:

http://www.bloomberg.com/news/2012-10-25/apple-s-online-radio-service-to-challenge-pandora-in-2013.html

This one is new and particularly interesting

http://www.macrumors.com/2013/02/05/hidden-buttons-in-ios-6-1-lend-weight-to-apple-radio-service-rumors/

If Apple were to enter this market it would be a tremendous increase in competition for Pandora and hamper its goals for long term user growth and revenue growth.

Amazon/Google:

I have little here of note, but it frankly just seems logical for both of these firms to eventually look to create/roll out their own versions of either on-demand or “radio” like services as further completion.

The bottom line is competition is heating up in the space, and if the ability to convert terrestrial ad dollars to internet dollars exist, Pandora will have little ability to raise pricing to offset content costs increase and will have a difficult time meeting street expectations.

Capitalization

The company has no debt, and it is generally cash flow neutral, however unlike many of its internet peers, the company does NOT have a large cash hoard, with only a little over $91 mm in cash and short term investments. I consider this a positive from the short perspective as there is large cash cushion in terms of valuation.

Risks

This is a crazy internet company. All I hear about from people right now is “multiples of revenue” and % of total U.S. listening hours. The company is basically net cash flow neutral so if people want to focus on “revenue multiples” in the short/medium run, the company can continue to trade at these prices or higher.

It is possible the company is acquired. I think it is unlikely, as there are competitors popping up daily, and the large strategic buyers as discussed above, seem to be more focused on creating their own platform as opposed to buying one.

It is possible that the company somehow finds a way to scale on the SG&A side significantly better than its radio peers allowing it to find local ad dollars without the costs.

The largest risk by far is if the company wins its battle and gets some version of the Internet Radio Fairness Act passed. The company’s cost structure will become far more profitable, however as discussed earlier I believe not only is that unlikely, but further it will simply attract even more competition which will make it less likely the company will be able to garner the ad dollars it needs.

GENERAL DISCLAIMER: MY FIRM HAS A POSITION IN THE ABOVE SECURITY, AND MAY CHANGE IT AT ANYTIME. FURTHER AS ALWAYS, DO YOUR OWN RESEARCH.

Catalyst