Pandora’s Cost Structure Brings Big Downside Risks

The internet radio giant Pandora Media (NYSE:P) recently reported its Q1 fiscal 2013 earnings. The crux of the results that was while the growth of revenues, subscribers and listener hours continue to be high, the costs are rising faster even more quickly than revenues and so 2012 may be another year with negative free cash flows for the company.

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We expect content acquisition costs (as % of revenues) to amount to close to 57% in 2012 compared to 54% in 2011 based on current quarterly results. However, subsequently we expect this ratio of costs to revenues to lower in the coming years.

This is based on our assumption that given that current monetization levels on mobile media are unsustainable for Pandora, the company will inevitably need to improve them significantly by better targeting ads and benefiting from general shift of advertising to mobile. A scenario where these costs don’t come down would imply a fundamental price estimate of $5.20.

Although Pandora will look to gain share of the radio advertising dominated by names such as CBS (NYSE:CBS), Clear Channel etc., the high cost structure is clearly a significant risk for its investors.

We are in the process of lowering our price estimate for Pandora to $7.90 given the significant increase in content acquisition as well as sales and marketing costs in Q1 fiscal 2013. It must be noted that our current price estimate is hinged on our expectation that in future, Pandora will improve monetization and content and other costs will come down leveraging a higher subscriber base. If this does not happen, there could be further downside to our price estimate which is already at a significant discount of close to 25% to the market price.

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