SUMMARY: We're not fans of P's ad-supported model, but mgmt's recent/recurring comments around up-selling its users along the demand curve suggest P may see the ad model as more of a funnel rather than a longer-term opportunity, even though mgmt would never publicly admit to it. We're hoping P's interactive foray is part of a concerted push to prioritize the sub model, but the longer-term sub opportunity really depends on how aggressively P plans to pursue it. However, we're going long the initial-year ramp of its interactive/expanded subscription launch, with expected headlines around direct license agreements likely propelling the stock higher in the interim. But if P can't get its interactive deals in place in order to launch by 4Q16/1Q17, we expect increasing take-out pressure and/or speculation to buoy the stock, if not force P to entertain offers. We're adding P as a Best Idea Long with an expected holding period through 2017. We will be hosting a call Thursday, August 25th at 1pm EDT to run through our analysis in more detail.
- BIG OPPORTUNITY VS. WEAK CORE: The two themes here are ARPU and distribution costs; collectively where the ad-supported model struggles. Regarding ARPU, P plans to offer new sub products at varying price points; very little sub conversion at pretty much any price point will go a very long way vs. P’s paltry ad-supported ARPU (TTM average of $1.12/month), especially in the initial year(s) following its expanded launch. Regarding distribution costs, the sub commission rate (aka Apple Tax) tops out at 30%, but Apple just reduced the rate to 15% after the initial year. Further, the commission only applies to in-app purchases; P's effective commission rate over the LTM is ~20%, so P can work around the tax. P's ad-supported model on the other hand still hasn't achieved any leverage, and its 2Q results basically confirm that its revenue growth is tied to its salesforce growth (2nd note below). P also paid out ~27% of its Ad revenue in Sales & Marketing expense over the LTM (ex commissions, direct marketing, and SBC). In short, we're not buying the longer-term sub opportunity, but the initial-year upside of comping against the ad-supported model, which is so poorly monetized that very little sub conversion would really move the needle (1st note below).
- P = CALL OPTION: P reiterated its expected interactive launch date multiple times during its last call, suggesting that mgmt realizes it needs to go to market on schedule to appease the street; especially given growing pressure to sell the company amidst softening core fundamentals. If P hopes to go market by late 4Q16/1Q17, we suspect it needs to strike at least one deal with one of the three majors before 3Q results. Any deal announced with any of the major labels will likely drive the stock higher, especially since the street would likely assume that the rest will follow suit. But there is a risk that the stock sells off if mgmt can’t get any deals done by the 3Q release and/or it pushes out its expected interactive launch date when it reports. But if that happens, we expect certain activists to step up the pressure to sell the company, and any associated headlines should help put a floor into the stock. Further, mgmt doesn’t really have many tools to fight off an activist effort; there are no super-voting class B shares, and mgmt doesn’t own enough of the common stock to have any real say. So if the interactive opportunity doesn’t come to fruition as quickly as expected, we suspect the activist sell-camp may find growing support, and P may be forced to the table.
Let us know if you have any questions or would like to discuss in more detail.
Hesham Shaaban, CFA
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