This is a summary of the salient points behind our thesis. As usual, we will be publishing follow-up notes with incremental analysis, and hosting a call to run through the detail. In the interim, let us know if you have any questions or would like to discuss in more detail.
- USERS TO DECLINE IN 2015: P has serious retention issues, churning through more accounts than it has retained since 1Q11. Our survey work suggests that P has already exhausted much of its TAM, so new user growth moving forward will not be able to offset attrition for much longer.
- ARPU CAN’T FILL THE VOID: Outside of listener hours, advertising revenue per user (ARPU) is driven by increasing ad load and ad rates. Any future increases in ad load will likely exacerbate its retention issues, which we belief was the case in both 2013 and 2014. P’s push into local advertising is a considerable tailwind for ad rates, but unless that can drive accelerating growth (vs. 2014), 2015 estimates are unattainable.
- VALUATION? YOU TELL US: How much do you pay for a company that starts losing users before it generates positive FCF? What happens to the stock the first time P prints declining users? We're not exactly sure, but we believe the stock could easily trade in the $13-$16 range based on 0.5x-1.0x turns of P/S multiple compression on our 2015 estimate of $1.1B (13%-30% downside). Note that it closed at $16.90 last Tuesday.
USERS TO DECLINE IN 2015
We have previously identified that P has historical retention issues, which we detail in the chart below. Since 1Q11, P has added more than 160M registered accounts, yet only grew active users by 45M, suggesting total churn of at least 115M accounts, or 72% of its gross account gains during this period. The bigger issue is that P has already exhausted much of its TAM, particularly the low-hanging fruit.
Back in August, we ran a survey of 20K US internet users to determine P's actual penetration levels. Our survey results suggested that P has penetrated roughly 55% of US adult internet users. That may sound like a ton of runway, but we estimate that roughly 2/3 of P’s remaining adult TAM is over the age of 45, roughly half is over age 55. Further, we also estimate that P has likely penetrated over 70% of the teenage population. In short, new user growth will prove more challenging from here.
We estimate that P needs to sustain a run-rate of gross new quarterly account adds of 11M-13M to maintain its active user base given our estimate of mid to high-teens quarterly churn rate. Even If that run-rate was possible over the long-run, and P could penetrate every internet user in the US, we estimate that P would exhaust its unpenetrated TAM within 7-10 quarters
In a more likely scenario, we expect gross new account adds to slow given the high concentration of older users within P's unpenetrated TAM, which should lead to y/y declines in user and/or listener hour growth sometime in 2015. See the link below supporting detail and charts on our survey results & TAM analysis.
P: User Penetration Survey (N=20,000)
08/28/14 04:12 PM EDT
APRU CAN’T FILL THE VOID
Outside of listener hours, advertising revenue per user (ARPU) is driven by increasing ad load and ad rates; we're most concerned about the former. P’s ad load has steadily risen throughout its history. However, we suspect that it’s these increases in ad load that are exacerbating its retention issues, particularly its most recent one in late 2013.
Back in August 2013, P increased its max ad load per listener hour from 4 to 6, but the bigger issue was that P altered its ad feed from 1 every 15 minutes to 2 every 20. Collectively that translates to as much as a 33%-100% increase in ad load depending on how long the user’s session lasts. Further, the altered ad feed conditioned the user to expect back-to-back ads, which we suspect may cause some users to end their session prematurely upon hearing the first ad.
That said, it shouldn’t be a surprise that in 4Q13, P saw its sharpest deceleration in net user growth in its reported history (from 25% to 14% y/y growth). We suspect that surge in ad load in 8/13 led to accelerated churn in the following quarter. Moving forward, we have no reason to expect anything different when/if P increases ad load again: rising ad load will push the user away, especially with a growing wave of options for streaming music online.
The one big positive for P is ad rates, specifically its push into the local advertising market, which the company suggests carries rates as high as 2.5x the national average. However, we do not believe P has the geo-targeting ability to command rates that high (P’s geo-targeting based on the zipcode provided by the user during the registration process). Regardless, consensus estimates already imply a sharp acceleration in ad pricing; even if the sell-side doesn’t realize it (we’re likely alone in our declining user view).
In the table below, we’re running a scenario analysis on 2015 revenues; flexing ad-supported listener hours against Ad RPMs (proxy for ARPU). We have included P’s 2014 YTD performance on both fronts for perspective. We caution not to read too much into its YTD listener hour growth since that is inflated by the removal of P's mobile listening cap from 2013 (see chart below). In 2015, we don't believe listener hour growth will exceed double-digits.
That means that consensus estimates for 2015 are unattainable outside of a considerable acceleration in ARPU. As mentioned above, increasing ad load will come at the expense of listener hours and/or user retention. So the question is whether its local ad push can produce accelerating pricing growth vs. 2014, and if so, by how much…all things considered, we suspect it won’t be enough.
VALUATION? YOU TELL US
We believe the stock could easily trade in the $13-$16 range (~15%-30% downside) based on 0.5x-1.0x turns of P/S multiple compression on our 2015 estimate of $1.1B. Note that P recently closed at $16.90 last Tuesday
But the better question is how much do you pay for a company that starts losing users before it generates positive FCF? Or what happens to the stock the first time P prints declining users? Our price target range may be too optimistic.
Let us know if you have any questions, or would like to discuss in more detail.
Hesham Shaaban, CFA