Pandora, Apple Music and a Music Streaming Market in Flux

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Pandora's share price plummeted when Apple Music helped change investors' outlook... this is what happens when the market absorbs information.

The last three business days say a lot about the music streaming market. Internet radio giant Pandora announced its third-quarter earnings this past Thursday (Oct. 22), after which its stock fell precipitously Friday. Monday brought with it a modest rebound. This says a lot about the state of the music streaming market: things are in flux, and people are trying to figure out how much the winners will win and how badly the losers will lose.

Information in that earnings release changed a lot of minds. Competitive pressures and a weaker-than-expected forecast for fourth-quarter revenue -- traditionally a strong quarter for Pandora -- led to a 35 percent collapse in the share price, wiping out about $1.4 billion of market capitalization. The market was effectively saying, "We expected too much from this company." 

Many analysts adjusted down their outlooks accordingly. SunTrust's Robert Peck kept his "buy" rating, but slashed his price target to $15 from $25. FBR & Co. analyst Barton Crockett lowered his price target to $10 from $11. Analysts from Oppenheimer, Pacific Crest, RBC Capital Markets and Piper Jaffray also lowered their ratings on Pandora.

But some other analysts believe the sell-off went too far. Macquarie analyst Amy Young was a dissenting voice, upgrading Pandora on the belief that competitive pressures will subside and improved monetization can offset a slowdown in listener and listening hours growth. Goldman Sachs' Heath Terry dropped his price target to $24 from $25, but believes the values of Pandora's reach and scale are not reflected in the stock price.

Last week's fall in share price shouldn't be viewed as a final determination about Pandora's business model or its ability to pay royalties to rights holders and creators. Assessments are constantly in flux, because they depend on whatever information is available at the time. Analysts' opinions can change when additional information becomes available, and can change markedly when this information differs from previously held information or expectations.

Perhaps sensing a buying opportunity after Friday's $12.39 closing price on Friday, investors Monday pushed Pandora as high as $13.84, before pulling back slightly to around $13.04 at the end of trading. It's as if the market was saying, "Things might be bad, but they're not as bad as we thought a few days ago."

To price a stock, equity analysts build financial models that incorporate a variety of assumptions and expectations. A model values equity based on earnings per share or future cash flows. Tweaking a variable will change the model's outputs and, as a result, the estimate of the value of the shares issued by the company.

Two items from Pandora's earnings call last week changed many analysts' and investors' expectations. First, Pandora provided guidance on fourth-quarter revenue below many expectations. This information likely changed some assumptions about Pandora's ability to grow revenue and may have cast some doubt on the effectiveness of its sales team. A lower growth rate would result in lower earnings per share by changing a model's forecast for Pandora's future earnings. 

The second item was the slowing of growth in listeners and listener hours. Active listeners -- the average number of people that streamed a song in a month during the quarter -- grew 2.1 percent and listener hours grew 3 percent. A year earlier those annual increases were 5.2 percent for active listeners and 25 percent for listening hours. By consensus the culprit was Apple Music, whose June 30th launch, three-month free trial and marketing push seemed to have affected Pandora's quarter. Pandora executives said the impact was expected and downplayed the chance of a negative impact over the long-term. Nevertheless, the market seemed to believe competition is capturing the vast majority of the gains in music streaming activity.

Despite that assessment, competitors have been co-existing up to this point. Triton Digital numbers for Pandora and Spotify show the services' footprints have been roughly equal relative to one another this year. In January, the ratio of Pandora session starts to Spotify session starts was 2.03. The ratio dropped to 1.84 in May, and rose to 2.24 in August. (Triton defines a session start as the number of different stream requests with a duration over one minute. It has found approximately 20 percent of sessions lasted less than one minute.) In other words, Pandora's size relative to Spotify hasn't really changed this year.

The coming years could be different. Apple could upset the apple cart, so to speak. So too could Amazon's Prime Music, a service whose current size and potential have received little scrutiny. Tim Cook's mention on October 20th that Apple Music has 6.5 million subscribers (an unknown number of them in Pandora's main market, the United States) was a signal the U.S. streaming market is ripe for disruption. But the market waited until Pandora's earnings release three days later to absorb sturdier information. Even better information will be available in about three months when Pandora announces fourth-quarter earnings.


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