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]