Before we begin today’s regularly scheduled blog post, I would like to point out something important about the Pandora IPO situation that no one seems to have noticed: Except for costs associated with the process of going public, Pandora is profitable — and has been for the past year and a half!
According to the quarter-by-quarter level detail in their most-recent S-1 filing, Pandora was profitable on an operating basis (i.e., approx. EBITDA, and ignoring such issues as the repricing of warrants) in its fiscal Q4 2010 and again in Q2 2011 and Q3 2011. At that point, the company started ramping up its G&A expenses to prepare for its IPO.
Over the past 18 months, Pandora has lost $3 million on an operating basis…but that, I believe, includes about $8 million in costs associated with the IPO (e.g., preparing to be able to comply with Sarbanes–Oxley, etc.). On what I would personally consider a true operating basis, they’re now consistently profitable.
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As you know, Pandora is expected to debut on the NYSE this week at an offering price of $10 to $12 per share, which would put the company valuation at up to $2 billion. As discussed here in this space last week, that would make Pandora the fifth most-valuable radio company in America in terms of enterprise value (after Sirius XM, Clear Channel Radio, CBS Radio, and the upcoming Cumulus-Citadel combination).
Yesterday (6/13), some pessimists — primarily a couple of analysts from BTIG and Morningstar — were in the news, pointing out primarily that Pandora’s business model lacks the economies of scale, at least in terms of its music royalty licenses, that Internet investors like to see.
That’s true. It’s also true that Pandora’s sound recordings performance license rate is only set through 2015 and will need to be either renegotiated, readjucated, or relegislated for the 2016-2020 period, it’s true that broadcast radio is still a reasonably healthy business that isn’t going to roll over or disappear, and it’s true that other competitors also exist. So there’s an argument to be made that a $10-12 stock price today might be rich.
On the other hand, I believe there’s also a case that can be made that if Pandora can continue to grow its audience, while slowly increasing its advertising spot loads and CPMs and keeping its other costs in line, it could also reasonably be a $70 stock within the next few years.
Here’s how that could happen:
First, Pandora’s audience would have to continue to grow, although not necessarily at the 100% to 110% per year rates it’s seen the past two years. Let’s say its AQH grows 60% this year, then 50%, 35%, and 20% in subsequent years. That would give it a Mon-Sun 6a-12m AQH in 2014 of about 2 million listeners. Conceivable. (About the size of the Cumulus-Citadel AQH.)
Then, since Pandora is only running about four 20-second commercials per hour (compared to broadcast radio’s 10 to 14 minutes per hour), let’s assume it can get away with adding one unit per hour EACH YEAR, and that as its effectiveness as an ad medium gets proven, its CPMs can also be grown 5-8% per year.
Multiply those two factors together, assuming reasonable continued increases in subscription revenues, and you can foresee that Pandora’s 2014 revenues could be in the range of $1.3 billion. (That’s pretty far behind Sirius XM’s current revenues of almost $3 billion and Clear Channel’s $2.4 billion, and in the range of CBS Radio and Cumulus-Citadel.)
Now let’s get through the dicey part: If Pandora’s audience quadruples during the next four years, their royalty payments (because the rate goes up each year) are going to quintuple. However, that would only be about $360 million in 2014 — over a quarter of their revenues, yes, and inequitable compared to other forms of radio like satellite radio, but not a company-killer the way some analysts would have you believe.
Pandora’s marketing and sales expenses were 73% of revenues in roughly 2008, 35% in 2009, and 30% in 2010. Let’s assume that if their sales staff gets more efficient, that percentage could drop about a point a year to 25% of revenues by 2014.
And finally, let’s assume they might be able to keep a reasonable handle on their other expenses (cost of revenue, product development, and G&A) ($32 million last year) — perhaps with each category growing at no more than 10-20% per year.
Add it up, and that gives you total expenses for 2014 of about $750 million. That leaves a potential net profit from operations of $550 million. A company growing at that rate could be worth a 20x multiple, or $11 billion.
Divide that valuation by 160 million shares outstanding and you get a potential stock price of about $70.
I’m not saying that’s a sure bet. I’m not saying that Pandora might not pull a Friendster or a MySpace and find itself supplanted by a next-generation Internet radio property. I’m not saying I’d pay $70 for their stock this week.
But I do see consumers moving to Internet-delivered radio for their music radio listening needs, because it’s a technically-better transmission mechanism (just as FM was technically better for music than AM; FM had stereo and Internet has personalization). And Pandora clearly has a leading brand name in the space.
So I do see a path by which this valuation could, within the next few years, happen.
Here’s the above analysis in spreadsheet form: