Its business model has a legion of naysayers, but this week Pandora was named top online stock pick for 2014 by analysts at Needham & Company. Even through Pandora shares have risen about 215% in 2013, valuing the company at $5.6 billion, Needham believes there’s more room to grow.
The key driver for Pandora in 2014 will be mobile advertising, according to a Needham report released Monday. In its most recent quarter, Pandora got 60% of total revenue from mobile devices in its latest quarter. The ability to successfully navigate the desktop-to-mobile transition is vital for advertising-driven Internet companies like Facebook, Twitter and Pandora. Desktop revenues per impression have always exceeded their comparable mobile numbers, but this year mobile advertising took a big step forward. Expect more improvement in 2014, says Needham. The analysts believe “mobile monetization will be the most important revenue driver in 2014” for online content companies they follow.
So why does Needham like Pandora more than, say, Facebook or Twitter? There are main two reasons. First, Needham believes Pandora can unlock a lot of value if its ability to solve the “mobile monetization puzzle” extends to other countries. Second, the bigger share of mobile revenue Pandora grabs, the lower the chance a competitor will threaten its position in the marketplace.
Critics see a different outlook. One frequent criticism against Pandora is its unprofitability. In the three quarters ended October 31st, Pandora had a net loss of $38.1 million on revenue of $463.2 million. The loss is growing, too. A year earlier, the company had a lower loss, $23.6 million, on far lower revenue of $302 million. Pandora’s royalties are another source of criticism. The company pays fixed, per-stream royalties that rise linearly as listening increases. Those royalties have typically consumed over half of revenue — 54.4% of revenues in the nine months ended October 31st, to be exact. Pandora also faces some uncertainty with its royalties, as exemplified by its current legal battle with BMI.
Another source of risk for Pandora has traditionally been competition. Not actual competition, but the constant threat of new competition that may impede Pandora’s growth and market share. One thing about that competition, however: it hasn’t put a dent in Pandora’s growth.
Most recently, Apple’s iTunes Radio launched in the U.S. in September and will soon — in early 2014, according to reports — expand to some European countries. Although iTunes Radio got off to a good start and peeled off some Pandora listeners, time spent listening to Pandora increased 9.6% from September to November. Some listeners left in October as Pandora active users dropped to 70.9 million from 72.7 million. Most of them returned the following month as active users rose to 72.4 million.
Onlookers may wonder why a company with continued losses, a high royalty burden and a long list of competitors is currently valued at $5.6 billion and could reach a high of $6.2 billion. Needham says Pandora’s enterprise value-to-expected earnings ratio “does not look expensive” and “is consistent” with other Internet companies that get more than 50% of their revenue from mobile advertising. (Enterprise value is a company’s market value plus debt and minus cash. Pandora is currently valued at 6.5-times its ratio of enterprise value to expected 2014 earnings, according to Needham.) Put another way, Pandora is being valued not just on its expected future earnings, but also on its relative advantage in turning mobile impressions into dollars.
Such frequent criticisms are valid and were mentioned by Needham. But these risk factors may be overshadowed by Pandora’s momentum and fundamentals. Needham sees upside in rising local ad rates, the potential in local advertising markets and Pandora’s ability to increase the number of advertisements its listeners see and hear. International expansion is a wild card. Needham believes international opportunities “are an undervalued option” for Pandora. But negotiating licensing deals in other markets — that don’t have the statutory license Pandora enjoys in the U.S. — is likely to be a slow, ongoing process that will not positively impact Pandora’s financials in the next year.
Ultimately, one’s belief in Pandora comes down to a belief in mobile advertising. If Pandora can grasp the potential that exists in mobile advertising, and if its ability to monetize mobile usage is exported to other markets, its shares can command a premium over other mobile-focused Internet companies. Most equity analysts believe Pandora has upside. Of the 26 price targets currently assigned by analysts, 18 are greater than the current share price of $28.77. The median price target is $32, well above the current price, and just four analysts have a “sell” or equivalent rating.
But there are notable dissenters. Of the eight price targets below the current price, two — from BTIG’s Rich Greenfield and MKM Partners’ Rob Sanderson — are just $10. Richard Fetkyo of ABR Investment has a price target of $14. Rich Tullo of Alfred Fried, whose price target is $23, has sounded an alarm that Pandora could face strong pressure to pay higher royalties. Unless Pandora finds a way to improve its payouts, Tullo wrote in an investor note, “the industry and the artists will make the push back on the IRFA act in 2012 look like an honest dispute among close friends.”
There’s a standard disclaimer in the stock market: past performance is not an indicator of future results. Needham would argue otherwise. Given its momentum and fundamentals, Pandora will undoubtedly have a strong 2014 and continue to return value to record labels and artists. But will Pandora’s share price outperform its Internet peers? Let’s revisit in a year.
