Don't bet against Pandora

Despite a tough week, the streaming-radio company's recent string of quarterly growth has turned it into a short seller's nightmare.

By StreetAuthority May 6, 2014 8:28AM
Caption: A music lover uses the Pandora app to listen to internet radio
Credit: © Richard Levine/AlamyBy David Sterman

When it comes to picking winners and losers, it's unwise to back the little guy when the big guy is so much more powerful.

That was a key concern I had about Pandora Media (P), in its attempts to steal the music spotlight from Apple (AAPL) and its iTunes juggernaut.

That analysis proved to be very wrong. Pandora went on to deliver a pair of solid quarters, highlighted by robust growth, and this surging stock became a short seller's nightmare.

Yet in just the past week, this stock has plunged sharply, all the way down to $23.

The formerly bearish view, in hindsight, would seemingly be justified. But I'm not betting against this stock twice.

Pandora's recent string of quarterly growth metrics are a harbinger of even better days to come. The share price may say this company is now in trouble.

Yet media industry trends paint a very different picture. And I'm pivoting away from the bearish camp and joining the bulls.

Rapid growth
At first glance, Pandora's first-quarter results provided no hint of the share price carnage to come. GAAP revenue surged 69 percent from a year ago to $194 million. Three-fourths of that sales base is tied to mobile devices, a ratio which many other media companies would love to attain.

Another impressive metric: Roughly 9 percent of all Americans now use Pandora for their radio-listening needs. That figure rises to 70 percent when only online music services are considered. Business trends are sufficiently robust to enable management to boost 2014 revenue guidance by around $10 million to the $890 million to $900 million range. That's up from $275 million in fiscal 2012.

Pandora delivered a quarterly loss in line with forecasts, despite a seasonal headwind. The first quarter is "the most difficult quarter for Pandora to improve gross profit as annual content cost increases take effect. SoundExchange pricing on content went up 8 percent this year, yet despite this Pandora managed to improve gross margins by 20 percent year over year as monetization improved faster than content pricing," note analysts at Merrill Lynch.

Specifically, Pandora earned $33.40 for every 1,000 hours of music streamed in the first quarter. That's up from $25 a year ago.

Advertisers understand that in many markets, Pandora is now more widely listened to than that market's leading traditional radio station. Still, Pandora's quarterly results raised legitimate concerns.

The number of active users fell by roughly 1 million from the fourth quarter to around 75 million. And management announced plans to heavily invest in the sales force and marketing, which explains why margins on earnings before interest, taxes, depreciation, and amortization (EBITDA) will remain under pressure this year.

Pandora CFO Michael Herring told Bloomberg that "We have said we invest aggressively in the front half as we are building sales teams," adding that "our investment curve is higher than the Street expected."

Yet it's crucial to understand that Pandora still faces a very large total addressable market. Automakers, for example, are increasingly looking to replace traditional car radios with app-based streaming services. Pandora is increasingly the streaming service of choice both as original equipment in the vehicle and through the smartphone-based plug-in streaming services. In that context, a decision to boost spending on sales and marketing now makes ample sense.

Analysts at Goldman Sachs "believe there is considerable upside to growth expectations as local advertisers move online and Pandora leverages investments in sales, technology, targeting, and ad buying platform integration, against its existing cost base."

A clear disconnect has emerged regarding Pandora. Investors have taken the quarterly report as a sign that Pandora's path to eventual profits has been dinged by that slight sequential drop in active users and the higher-than-expected overhead expenses now in place.

Yet Wall Street analysts greeted the quarter with much more enthusiasm. Goldman Sachs, and Merrill Lynch, for example, have $35 and $39 price targets, respectively. Merrill Lynch's Mat Schindler, for example, believes "Pandora's Internet-based radio service will continue to rapidly take share from traditional radio as users gravitate toward the greater flexibility and personalization of Pandora's Internet offering and advertisers are attracted to the better targeting."

Simply put, it's myopic to view Pandora's quarterly snapshot as a sign that this business model has already peaked.

Risks to consider:
Pandora has built a dedicated customer base, but firms such as Apple and Google (GOOG) are keen to be big players in this market, and price wars aimed at building market share may ensue.

Action to take:
Companies often get penalized for boosting spending on sales and marketing. To take a bearish view, such actions can be a sign that turf needs to be defended against a rising competitive threat. To take a more bullish view, such spending is crucial for any company that has built a solid lead in the early innings of a growing category. Pandora has a real shot at becoming the de facto car radio for millions of listeners, and the recent share price pullback provides a fresh chance to latch on to this high-growth business model.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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