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P | Fixing the Story

Takeaway: P could be a massive long under the right strategy, but remains on our bench until mgmt shifts its priorities (chart series at end of note).

KEY POINTS

  1. AD-SUPPORTED MODEL = FIZZLING OUT: We only need to look so far as P’s 4Q15 declining users, and worse, Local Ad Revenue growth that lagged the rate that it onboarded local reps in 2015 to realize that P shouldn’t continue prioritizing the ad-supported model that has already shown us its limitations.  We’re not suggesting that P sunset that model, but it would be better served as funnel to an expanded subscription offering that it could create overnight (see point 3).
  2. DIVERSIFICATION ISN’T ENOUGH: Ticketfly could have some promise, but for now it’s an unprofitable business growing at a slower rate than its core (at least before organic 4Q15 results).  P’s efforts to expand into the interactive market is definitely a promising opportunity, but the longer the negotiations go on, the greater the opportunity cost since it just allows more time for the competition to poach P’s prospective users.  Also remember that any negotiated terms will ultimately serve as precedent to Web V, which will slow down negotiations.  That said, there’s no guarantee that P will be able to offer an interactive product by 1Q17.
  3. CREATING A NEW MARKET: The only two streaming music products that P is currently offering is the ad-supported product and a $5/month all-you-can-eat non-interactive subscription, with nothing in between.  If P wants to own this space, and more importantly defend its turf, it needs to start offering something in the middle before somebody else does (i.e. tiered non-interactive subscription plans).  Don’t assume that market wouldn’t exist; P’s history with its listener caps and our survey results suggest otherwise; and that opportunity would be considerable.  But more importantly, this would be a strategic defensive move (retention) that could actually help drive conversion for P’s pending interactive product (up-sell).   
  4. BUT ON THE BENCH: As a reminder, we're out of the short, and we’re almost tempted to go long now that sentiment has all but troughed following the CEO departure.  But the longer mgmt waits to shift its priorities, the worse P’s prospects will become.  Outside of the potential churn and opportunity cost mentioned above, P is heavily levered to a cyclical Advertising industry, including Radio Advertising, which has been in secular decline.  Our Macro team suggests we could be moving into a recession this year.  If that’s the case, P is the last place we want to be.  But if P branches out into low-cost subscription model (today), it could be one of the only accelerating revenue growth stories on the street.  

 

AD-SUPPORTED MODEL = FIZZLING OUT

The problem with the ad-supported model is that its growth drivers are effectively double-edged swords.  Simply put, there are two drivers to the model: ad-load (aka sell-through) and expanding into Local Radio (price).

 

The problem with increasing ad load is that has been pushing P’s users away, which there is no denying anymore after down y/y users in 4Q15.  We estimate that P has churned through nearly 70% of its accounts since 2011, which can’t be explained away by duplicate accounts (see notes below).

 

P’s Local Radio expansion allows P to sell higher priced units, but that requires heavily investing in local reps.  Note that P’s Sales & Marketing expenses have consistently grown as a percentage of revenue since at least 2011.  The problem with the Local Radio push is that its sales reps' benefit wanes after the initial year or two after migrating ad load into the higher-priced local ad unit; in turn, becoming more dependent on ad load to drive growth. 

 

For context, P’s 4Q15 Local Ad Revenue growth of 34% was lower than the rate that it onboarded local reps at any point in the last 5 quarters, which is as far back as we can calculate y/y local sales rep growth.  There couldn’t be a scarier omen for the long-term viability of the Local Radio push, regardless of whatever explanation mgmt offers to justify it.

 

In short, P has already shown us the longer-term limitations of the ad-supported model.  We’re not suggesting that P sunset that model, but it would be better served as funnel to an expanded subscription offering that it could create overnight (point 3).

 

DIVERSIFICATION ISN’T ENOUGH

Ticketfly could have some promise, but for now it’s an unprofitable business growing at a slower rate than its core (at least before organic 4Q15 results).  By P’s own admission, the long-term opportunity of the business is fairly limited (5-Yr target of $300M); it’s almost not worth paying attention to.

 

P’s plan to expand into the interactive market (e.g. Spotify) is definitely a promising opportunity.  But the longer the negotiations go on, the greater the opportunity cost since it just allows for time for P’s interactive competition to poach those prospective users.

 

Also remember that any negotiated terms will ultimately serve as precedent to Web V since the interactive agreements have always been used as benchmarks.  In short, we suspect the labels are proceeding with caution in striking any deals, and P needs to strike deals with all three to offer an interactive product.  That said, there’s no guarantee that P will be able to offer an interactive product by 1Q17. 

 

CREATING A NEW MARKET

The only two streaming music products that P is offering today is the ad-supported product and a $5/month all-you-can eat non-interactive subscription, with nothing in between.  If P wants to own this space, and more importantly defend its turf, it needs to start offering something in the middle before somebody else does (i.e. tiered non-interactive subscription plans).  The reduced Web IV subscription royalty rate and clarity around annual rate increases gives P a lot of options to offer a tiered product that it can throttle by usage.   

 

The big question is demand since we’ve all been conditioned to believe that the user will never pay for music.  If we go back to the last time P implemented a listener cap, we can see a clear surge in demand for the subscription product, so we need to consider that availability of the free option is in some part facilitating that dynamic.

 

We also ran a small survey (n=1000) asking an open-ended question to gauge if there is a market for a tiered non-interactive subscription service.  Currently, only 35% would be willing to pay more $1/month to listen to Pandora ad-free, but given the APRU differential b/w those rates and P’s monthly Ad-Supported ARPU, the opportunity would be considerable (see table & scenario analysis below).  But even at a $1, there could be an opportunity to introduce an ad-lite product, especially in regions where sell-through (aka ad load) is tougher to achieve.  

 

The other potential obstacle is the 30% “Apple Tax”, but all P really needs to do bypass that tax is to incentive potential subs to register for the service outside of the app (e.g. a discount on its website).  For context, P’s subscription commission payments as a % of Subscription revenue averaged only 19% in 2015, so P has been able to work around that tax.  As an aside, S&M expense as a % of Ad Revenue (net commissions, direct marketing expenses, & SBE) averaged 26% in 2015. 

 

The other potential risk is cannibalizing existing Pandora One plans via downgrades into lower-tiered plans.  Naturally that is a risk, but it wouldn’t take much conversion of P’s Ad-Supported users into a lower-tiered subscription product to offset that risk given the considerable ARPU differential.  In the scenario analysis below, we detail the incremental upside to P’s NTM revenues assuming various levels of conversion into a tiered non-interactive subscription product.  We’re using very restrictive assumptions, including full cannibalization of its Pandora One user base into a lower tier.  We’re also bounding the upper range of conversion based on what Spotify has disclosed for conversion rates into its interactive product.  In short, we believe the opportunity is well worth the risk. 

 

But most importantly, offering tiered non-interactive subscription plans would be a defensive strategic move with potential upside.  Locking a user into an annual subscription inherently limits attrition, particularly of those would-be interactive subs into a competitor’s current product.  And whenever it is that P can actually offer the interactive product, the up-sell becomes that much easier for those users P has conditioned to pay for music through a cheaper subscription plan.

 

BUT ON THE BENCH

As a reminder, we’re out of the short.  We're almost tempted to go long now that sentiment has all but troughed following the CEO departure.  But the longer mgmt waits to shift its priorities, the worse P’s prospects will become.  Outside of the potential churn and opportunity cost mentioned above, P is heavily levered to a cyclical Advertising industry, including Radio Advertising, which has been in secular decline.  Our Macro team suggests we could be moving into a recession this year.  If that’s the case, P is the last place we want to be.  But if P branches out into low-cost subscription model (today), it could be one of the only accelerating revenue growth stories on the street.  

 

 

Please see chart series and selected notes below for supporting detail/analysis.  Let us know if you have any questions, or would like to discuss further.

 

Hesham Shaaban, CFA


@HedgeyeInternet 

 

P | Fixing the Story - P   Long Bench 1

P | Fixing the Story - P   Long Bench 2

P | Fixing the Story - P   Long Bench 3

P | Fixing the Story - P   Long Bench 4

P | Fixing the Story - P   Long Bench 5

P | Fixing the Story - P   Long Bench 8

P | Fixing the Story - P   Long Bench 6

P | Fixing the Story - P   Long Bench 9

 

 

P: New Best Idea (Short)
12/22/14 03:56 PM EST
[click here]

 

P: User Penetration Survey (N=20,000)

08/28/14 04:12 PM EDT

[click here]  


#LOWERHIGHS, #EARNINGS and EUROPE

Client Talking Points

#LOWERHIGHS

While industrial activity has stabilized against 13 months of negative comps, domestic service sector activity continues to slow off its mid-2015 highs. Headline ISM Services along with the Employment and New Orders components improved sequentially in March but the 9-month trend remains one of lower highs and lower lows.  On the Labor Front, the trend has been similar as yesterday’s JOLTS data for February showed Job Openings decline by -159K, continuing the 8-month retreat off the mid-2015 peak.  

#EARNINGS

Q1 earnings season kicks-off next week with the bulge bracket banks leading the way (JPM next Wednesday). If you think we’ll follow-up an awful Q4 2015 reporting season (S&P revs -4.0% Earnings -6.9%) with a rebound, think again. We won’t be lapping bad comps until at least Q3 of this year (reported in Q4). In Q1 of 2015, 8/10 sectors saw Y/Y earnings growth, and the one sector with awful earnings was energy, where WTI averaged $48.57 vs. $33.63 in Q1 0f this year. Don’t get excited about Q1 earnings season. It will be more of the same. #thecycle.  

EUROPE

Eurozone conflicted?  If the Brexit debate wasn’t enough, German Finance Minister Wolfgang Schaeuble is out saying  “It's a problem of our common currency union that we have ... an independent central bank, which conducts unified monetary policy for 19 member states that is less favorable for Germany than for other countries.”  While we’ve identified the ECB’s conflicted policy framework for years, it underlines just how quickly risk can form across Eurozone assets.  For the EUR/USD cross we continue to suggest trading the immediate term range, $1.11-$1.14.

Asset Allocation

CASH 67% US EQUITIES 0%
INTL EQUITIES 0% COMMODITIES 6%
FIXED INCOME 23% INTL CURRENCIES 4%

Top Long Ideas

Company Ticker Sector Duration
MCD

McDonald's (MCD) hit an all-time highs last week. "They can't chase Energy Charts today, so they're just dog-piling into our long calls on GIS and MCD," wrote Hedgeye CEO Keith McCullough on Friday.

 

We've said it before, McDonald's has all the style factors that we like during these turbulent macro market times; high market cap, low beta and liquidity. The stock is up 7.5% this year beating the S&P 500 by more than 600 bps. In August 2015, Restaurants analyst Howard Penney wrote that "2015 will be the last time this stock is below $100."

CME

CME Group (CME) stock is among the small cohort of financial companies that benefit from volatile markets. With the exchange's open interest continuing to expand, which will drag trading volume higher, CME Group is one of the few lower beta longs that will hold up relatively better in the current environment.

 

The exchange guided to just a +1% operating expense increase for 2016, guided to slightly lower annual taxes for '16 (with more activity coming from abroad), and again announced that open interest was setting a new record, at over 111 million contracts. Even assuming some mean reversion to just over 16.5 million contracts (depending on product group), 1Q is running at ~$1.20 per share in earnings, which means the Street will need to perk up its current $1.06 estimate. Simply put, this is one of the few growth stories in the current macro environment within Financials.

TLT

Non-Farm payroll additions came in over +200 again (+215K to be exact) and private sector wage growth was also “good,” increasing +4.2% year-over-year on Friday. We’re most concerned with "better" or "worse" from a rate of change perspective. The non-farm payroll number is "less good" (i.e. "worse") from a year-over-year rate-of-change perspective. Growth in non-farm payrolls peaked in February 2015 at +2.3% year-over-year and the trend since then has been one of decline (+2.0% Y/Y for March 2016). And private sector salary and wage growth peaked on a year-over-year percent change basis in December of 2014.

 

We remain bullish on Long Bonds (TLT and ZROZ), Utilities (XLU) and short Junk Bonds (JNK). We expect more alpha after what was a great Q1, as the back-end of the Treasury curve continues to get flatter regardless of Fed rate hikes. We were alone in that camp, in December, when we first told you that a rate hike was in fact good for long-duration Treasury bonds. Stick with what's worked.

 

Here's the Q1 2016 Scorecard (data through 3/31):

  • TLT +8.3%
  • XLU +14.7%
  • JNK +1.0%
  • versus S&P 500 +0.7%

Three for the Road

TWEET OF THE DAY

**New Video | Game Over. Central Bankers Can’t Do Anymore  https://app.hedgeye.com/insights/50122-game-over-central-bankers-can-t-do-anymore?type=video… cc @KeithMcCullough

@Hedgeye

QUOTE OF THE DAY

I'm not saying I'm gonna change the world, but I guarantee that I will spark the brain that will change the world.

Tupac Shakur

STAT OF THE DAY

Alaska Airlines will acquire Virgin America for $2.6 billion after a short bidding war with JetBlue.


[UNLOCKED] Keith's Daily Trading Ranges

We've made some new enhancements to Daily Trading Ranges - our proprietary buy and sell levels on major markets, commodities and currencies sent to subscribers weekday mornings by CEO Keith McCullough. Click here to view a brief video of McCullough explaining how to use it most effectively.

 

Subscribers now receive risk ranges for 20 tickers each day -  the last five of which are determined by what's flashing on Keith's screen and by what names subscribers are asking about. Click here to subscribe.

 

  • Bullish Trend
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  • Neutral

INDEX BUY TRADE SELL TRADE PREV. CLOSE
UST10Y
10-Year U.S. Treasury Yield
1.83 1.70 1.73
SPX
S&P 500
2,020 2,077 2,045
RUT
Russell 2000
1,066 1,130 1,095
COMPQ
NASDAQ Composite
4,737 4,933 4,843
NIKK
Nikkei 225 Index
15,590 16,640 15,723
DAX
German DAX Composite
9,508 9,798 9,563
VIX
Volatility Index
13.01 19.38 15.42
USD
U.S. Dollar Index
94.01 95.99 94.64
EURUSD
Euro
1.11 1.14 1.14
USDJPY
Japanese Yen
110.19 112.95 110.29
WTIC
Light Crude Oil Spot Price
35.09 38.12 36.56
NATGAS
Natural Gas Spot Price
1.84 2.05 1.94
GOLD
Gold Spot Price
1,206 1,245 1,232
COPPER
Copper Spot Price
2.10 2.23 2.14
AAPL
Apple Inc.
104 112 109
AMZN
Amazon.com Inc.
560 609 586
MCD
McDonald's Inc.
122 128 127
XLU
Utilities Select Sector SPDR
48.06 50.13 48.67
TSLA
Tesla Motors Inc.
219 257 255
GM
General Motors Co.
29.15 30.99 29.60


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Key Call-Outs (GDX, NEM, GG, ABX)

The extreme bearish to bullish reversal in sentiment YTD in gold happened quickly (Jan.-Feb.). The pace of relative bullishness has decelerated, but the market remains notably long of gold:

  • Gold is a chart with a story, and investors have repeatedly chased price on a lag. Gold has been a newsy item for the last month, AFTER the bullish move, and has since gone down on a 1-mth window (-3.6%) despite a 1) dovish pivot from the fed on growth and inflation; And, 2) a flatter curve and a weaker USD. Coincidentally historical USD/Gold correlations have broken down on that same window
  • Net Futures and Options Positioning is +2.3x/+2.3x Long on a 1Yr and 3Yr Z-Score Basis
  • After reaching the highest level of open interest since 2011 in March, the pace of open interest increases in all active futures months has slowed considerably, and is now flattening out. When put against the CFTC positioning, we know which way the outstanding OI is leaning
  • Option skew (prices investors are willing to pay for calls vs. puts in volatility terms) shows bullish sentiment, which like the CFTC positioning, is a classic indicator that chases price. Currently the surface is shaped exactly how it was in mid-October (upside calls more expensive than downside puts in volatility terms). The opposite shape was priced-in moving into 2016. Putting this chart next to the CFTC positioning chart shows the intermediate-term price risk to stretched positioning.   

Click HERE  for a link to our February note adding NEM to our best ideas short list. For the corresponding model and blackbook, feel free to ping us back directly.

 

Key Call-Outs (GDX, NEM, GG, ABX) - Gold Price vs. CFTC Net Positioning

Key Call-Outs (GDX, NEM, GG, ABX) - COMEX OI Build

Key Call-Outs (GDX, NEM, GG, ABX) - Vol Skew

 

 



Cartoon of the Day: US Growth Stinks

Cartoon of the Day: US Growth Stinks - growth  cartoon 04.05.2016

 

"Unlike many strategists (who missed calling the cycle top in US Consumption, Employment, and Profits last year), we have stayed with The Cycle call we’ve had all along here in Q2," Hedgeye CEO Keith McCullough wrote today.


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.45%
  • SHORT SIGNALS 78.37%
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