MKM Partners’ Rob Sanderson, Managing Director, weighs in on Pandora Media Inc (NYSE:P), upgrading the stock to a Neutral rating.

Pandora

We are upgrading shares of Pandora Media Inc (NYSE:P) to Neutral and presenting a significantly more bullish outlook than our previous view. The company has a very large opportunity in local/ mobile advertising, a unique position with dominant share/scale in Internet radio and has proven to be more sticky than we believed 9-mos ago.

Our longer-term concerns on cost structure/music licensing rates, size of monetization opportunity, competitive environment and ultimately earnings power are unknowable. Meanwhile the bull story is compelling and attracting more interest among investors. We are tabling our long-term concerns, which may or may not play out, and embracing the Bull case:

Our scenario analysis suggests $3.00 in earnings power in 2017 and $6.00 in 2020. Assuming a 20x forward P/E and discounting 25% per year, this implies a fair value estimate of $38-$39 per share, which is where the stock is trading now.

The current price implies 15% compounded return to our 2017 scenario and 20% to our 2020 scenario. For risky, high-growth, long duration stocks, we think investors should expect more.

Our earnings power scenario now assumes the following:

Listener hours expand at 18% CAGR through 2017 then 15% CAGR through 2020. Pandora Media Inc (NYSE:P)’s share of industry listening grows from 8% in 2013 to 15% by 2017 and 23% in 2020.

Total RPM expands from $38 last year to $85 by 2017 and $115 by 2020. This drives a $2.8Bn and $5.7Bn top line in the respective periods. This is over 1/3 the current size of the radio advertising market by 2020.

Music licensing costs only increase 4% per year after 2015 renewal (8% annual step-ups currently).

Other expenses fall from 53% of revenue last year to 36% by 2017 and 33% by 2020. This is materially better than the company’s target model (where other costs are 40%).

Conclusion

Putting longer-term secular concerns aside and presenting a very bullish earnings power framework, we still struggle to justify a Buy-rating at current levels. We do think that investors are not factoring potential for unfavorable music licensing rates on renewal, but the outcome will not become known until late-2015. Until then, the RPM ramp matters more. We need to see $96 by 2017 and $129 by 2020 to recommend the stock at current levels, all else equal. A working model of our EPS power framework is available.

We would be more enthusiastic if the stock were to pull back to the $32 range, so long as the Bull case remains intact and the market continues to discount several years in valuation of mobile, social and local comps. Plateauing audience growth, a stall in RPM ramp or content cost escalators would make us more negative.