Traders have gone bananas for Pandora (P), bidding the stock of the awesome Internet radio service up to a ~$4 billion valuation.So is the stock now absurdly overvalued, as the market parrots are smugly and uniformly asserting?
Not necessarily. (But probably.)
On the bull side, think about it this way: Pandora should be a major beneficiary of the future of global music radio. Unlike terrestrial radio stations, Pandora has no distance or frequency constraints. It can create a unique station for everyone in the world. And that means it could eventually be more valuable than most of today’s music radio stations put together. (Which it pretty much is.)
Pandora should also be able to target ads very precisely, locally, nationally, and globally, and it will quickly become immensely important to the music labels–so much so that the idea that they’ll eventually put it out of business by demanding usurious royalties is preposterous.
(By 2015, when the next big label renegotiation comes around, Pandora will likely be many times the size it is today. And, like a huge cable company negotiating with content producers that can’t collude unless they actually collude–which is illegal–the company will have enormous leverage. The same phenomenon is working in Netflix’s favour. Movie and TV studios can boast all they want about how they’re going to stiff Netflix, but with ~25 million subscribers, Netflix is in a position to write humongous checks, and at the end of the day, the studios and networks are going to take them.)
Of course, that doesn’t make Pandora “worth” $4 billion today. There are dozens of things that could go wrong over the next several years. And, even if everything goes right, eventually, when the company’s growth slows, its valuation multiple will likely compress.Right now, Pandora’s losing money, so you can’t evaluate it on a cash-flow or profit basis.
(Importantly, this doesn’t mean that the company is worthless, as many armchair pundits are proclaiming. Many companies lose money when they’re in land-grab investment mode. Amazon lost money all through the 1990s, during which time many smart analysts predicted that it would “never make money.” Now Amazon makes boatloads of money, and it’s worth $85 billion.)
What you can do is evaluate Pandora on a revenue basis. Specifically, you can look at the company’s value relative to its revenue–and then, importantly, estimate what this “revenue multiple” might look like when the company has settled into a more stable growth rate.
At $23 a share, or $4 billion, Pandora is trading at about 16X this year’s revenue estimate of $250 million. The estimates for next year’s revenue range between $350 million and $500 million, and the lower end of that range seems way too low. (The company is more than doubling revenue every year, and anyone who has listened to Pandora knows they can squeeze a lot more ads into their streams than they currently do.)
So let’s say Pandora will generate $250 million of revenue this year and $500 million next year and $1 billion the following year.
These are optimistic estimates, but when you’re trying to evaluate the value of a company like this, it’s as easy to be too conservative as it is too aggressive.
How much profit could Pandora earn on $1 billion of revenue? (Ultimately, the revenue multiple has to correspond with the underlying earnings power of the company. Specifically, the appropriateness of the revenue multiple depends on the company’s eventual profit margin: How much it will earn per dollar of revenue. Some companies, with high profit margins, can trade at 10X revenue. Other companies, with low profit margins, trade at 1X-2X revenue–or lower.)
Pandora’s biggest expense right now is content royalties. Analysts like BTIG’s Rich Greenfield think that content costs will remain very high and that, as a result, Pandora will eventually have a gross margin of only 35% and an operating profit margin of only 6%.
If Pandora’s future margin is really that low, the company’s revenue multiple will eventually compress to about 2X-3X (from 16X today). This could happen either through revenue growth or a price collapse–or a combination of both.
But it seems possible that Greenfield is being too conservative on his profit margin estimate and that Pandora might eventually have a 10%-15% operating margin. (As Pandora gains scale, its per-unit royalties will likely shrink, and it will likely ad a lot more advertising per hour).
If Pandora eventually has a 10%-15% operating margin and is growing at a reasonable rate (20%+ per year), it will probably trade at a revenue multiple of 3X-5X.
So, the three key questions for investors evaluating the company’s value today are:
- How fast can Pandora grow? (100% a year for several years?)
- What will the company’s operating profit margin eventually be? (10%-15%?)
- What annual rate of return on the stock will you need to be compensated for the risk that your estimates are too optimistic? (25%?)
Answer those questions, and you’ll have a more thoughtful take on Pandora’s current valuation than the sheep and parrots who are smugly dismissing its valuation as ridiculous because its “losing money.”
(For what it’s worth, our own conclusion is that, at this level, the stock isn’t worth the risk. We’d happily pay 4X revenue for Pandora. But it will likely take at least a couple of years for the company’s revenue to hit $1 billion, thus justifying the current price. And there’s just too much potential downside if something goes wrong.)
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