Pandora’s Price Estimate Revised To $20.22 On Expected Rise In Content Acquisition Costs

Pandora Media‘s (NYSE:P) stock has gone down by more than 60% over the last 12 months, with the biggest fall coming recently after its Q4 earnings. The most significant concern surrounding the company has been the long term sustainability of its business model, which relies on advertisements for almost all the revenues. The overall budget a particular company allocates for advertising cannot increase beyond a certain point.  Hence, Pandora’s target market is constrained and will most likely cease to grow in the coming years. However, competition within this market is increasing rapidly with a number of free music streaming apps trying to entice advertisers. While this puts Pandora’s topline growth in question, the bigger problem is its highly sensitive bottomline.

Pandora is not profitable with the royalty rates it pays currently, which the music industry feels are too low. To make this worse, SoundExchange has proposed a significant increase in royalty rates from 2016 on-wards, that will likely increase Pandora’s content acquisition costs, making it more difficult for the Internet radio company to generate profits. Even in the best case scenario, Pandora might be able to negotiate only a marginal revision in the proposed rates. Keeping this in mind, we have revised our price estimate for Pandora from $24.16 to $20.22, by adjusting its “content acquisition costs as % of revenues”. There is a growing belief in the music industry that free music providers are not paying song writers and labels fairly. Hence, a rise in royalty rates is increasingly inevitable.

See our complete analysis for Pandora Media

While Pandora was able to bring down its “content acquisition costs as % of revenues” in the fourth quarter slightly, potential rise in royalty rates still threatens its bottomline. The company said that it is well positioned for 2015 in terms of managing content acquisition costs, but it may well lose this control in 2016. Pandora’s “content acquisition costs as % of revenues” declined from 54% in 2013 to 48% in 2014, even though its per performance royalty rate increased from $0.0013 to $0.0014. For 2015, the rate is set to increase by just $0.0001 and hence, we have retained our forecast of three percentage points decline in Pandora’s “content acquisition costs as % of revenues”.

However, we have revised our forecast for 2016 from three percentage points decline to three percentage points increase, keeping SoundExchange’s proposal in mind. For 2016, Pandora’s royalty rates are not yet set, and SoundExchange has proposed the rates at $0.0025 per performance, drastically above what Pandora will pay in 2015. ^[1] Even after negotiations, we believe that the Copyright Royalty Board will set rates closer to SoundExchange’s proposal, keeping song writers’ and artists’ interest in mind. Royalty rates will most likely increase at $0.0001 per year after 2016, similar to how they have increased in the past. We believe that Pandora will have a tough time in managing its content acquisition costs in 2017 as well, since it could well be paying close to $0.0026 per performance, as per the proposal. Hence, we have forecast an increase of three percentage points (previous forecast was three percentage points decline) points in 2017 as well.

After 2017, we expect that Pandora will be able to decrease its “content acquisition costs as % of revenues” with better cost optimization, though overall content acquisition costs are likely to be significantly higher. As per our new forecast, “content acquisition costs as % of revenues” will fall to 46% in 2015, increase to 49% in 2016 and 52% in 2017. Thereafter, we expect the figure to decline gradually and reach 44% over the next four-five years. Our earlier forecast suggested that the figure would decline steadily and reach 36% over the course of next six-seven years. These changes have resulted in more than 15% decline in our price estimate.

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1. Webcasting rate proposals for 2016-2020 now public, Broadcast law blog, Oct 19 2014 [↩]