Pandora Media Inc (NYSE:P) has had a volatile couple of months, but even though it has regained most of the ground lost since the beginning of July the internet radio company is still well off its YTD high of $39.43 from back in January (currently $27.32) and MKM Partners managing director Rob Sanderson thinks that’s because investors are too focused on monthly active users when they should be looking at the potential for RPM growth.

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“RPM is the key variable in earnings power and valuation analysis for the stock. Our longer-term earnings power scenario projects P achieving $125 RPM by 2020 (from $36 in 2013),” writes Sanderson, who rates Pandora Media Inc (NYSE:P) a Buy with a $35 price target. “This seems to be an aggressive assumption by many investors (and our previous view). As P is increasingly a radio replacement, there is more room on ad load than we thought before.”

Pandora competing with radio, not Facebook: MKM Partners

Sanderson argues that Pandora Media Inc (NYSE:P) isn’t competing for advertising dollars with Google Inc (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook Inc (NASDAQ:FB), but with the moribund radio industry that hasn’t innovated that much in years, and that RPM (revenue per mille or thousand hours) is the best metric to judge its future potential. It’s true that Pandora’s user base is growing more slowly, but with 76 million users already that’s about a third as large as the entire audience for traditional radio, which should be more than enough to sell ad time. The change has also come as a gradual change, not a sharp drop in growth, so Sanderson thinks the sudden reaction this July is an overreaction to predictable results.

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Getting RPM to $125

With that in mind, Sanderson thinks that Pandora Media Inc (NYSE:P)’s competitive edge is in hyper-local advertising, which commands a higher nominal CPM (cost per thousand impressions) but is actually more effective for many small businesses. For example, a small business with only one location in a large radio market would have to pay CPM rates for the entire city, even though they might only want to target neighborhoods within a few miles of the store. Paying even double the nominal CPM is more effective for many small businesses if the ads can be targeted down to the zip code level.

This argument isn’t purely speculative, spot local and hyper local advertising spending makes up more than half of the US radio spend because of the higher CPM rates.

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By increasing the mix of high-end, local ads and increasing the user base to 93 million by 2020, Sanderson thinks that it’s realistic to push the blended audio RPM to $94 and total RPM to $125.

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