Short logic

Pandora’s IPO yesterday peaked at $26/share, giving them a brief valuation of $4 billion. The stock quickly deflated to a closing price of $17.50, moving that valuation to $2.8 billion. Even that is a fantastical and bubblicious number that will not stand up to scrutiny. Here is a back-of-the-envelope analysis based on the S-1 that investors should have made before throwing their money in the box:

Best possible case of active users growth

• 80M users have tried Pandora
• 30M users converted to active users (listen at least 1x per week)
• That gives us a 37.5% conversion rate (30M/80M)
• Pandora is currently only available in the US (and expanding to foreign markets is very hard)
• The US has 240M people online (310M people * 77% internet penetration)
• Facebook is one of the most popular services in the US
• 146M users have tried Facebook in the US (who knows how many are active)
• If Pandora could become as popular as Facebook, they’ll reach another 66M users (146M - 80M)
• That will give them another 25M active users (66M * 37.5%)
• So the likely maximum Pandora’s userbase can grow in the US is 85%, or 55M active users

Revenue extrapolation for 2010
Pandora has reported $77.8M in advertising revenue for the first 9 months of 2010. For the sake of analyzing per customer numbers on a yearly basis, let’s assume no additional growth for the last 3 months (although they most certainly will grow). So that’s $104M in advertising revenue for 2010 (($77.8M / 9 months) * 12 months).

Best case scenario for net advertising profits

• Pandora made $3.46/user from advertising in 2010 ($104M revs / 30M active users)
• It paid $1.56/user in music royalties for 2010 ($45M / 30M active users)
• Thus, gross profit from advertising (before other costs like servers, bandwidth, staff, and marketing) was $2/user ($3.46 - $1.56)
• Music royalty cost may go down a little with additional scale, but that’s not a given (they paid 45% of revenues in royalties in ‘07, 81% in ‘08, 60% in ‘09, and now 50% in ‘10 — it was very high in ‘08/09 before the Copyright Royalty Board adjusted rates until 2015)
• But let’s be kind and assume reduced royalty costs of 40%, so the number drops to $1.24/user, which would increase gross profit per user to $2.21 ($3.46 - $1.24)
• So the most Pandora can make from advertising in gross advertising profits is $122M (55M active users * $2.21)
• Let’s say they reach fantastic economies of scale and their remaining costs only go up 50% even as their user base soars 85%. That means other costs will total 66M (44M * 1.5)
• So the best case scenario for advertising profits (assuming Facebook-like popularity) would be a net $56M ($122M gross profit - $66M costs)

Best case scenario for net subscription profits

• Using the same assumption for 2010 as above, Pandora made $16M from subscriptions
• A subscription costs $36/yr, so that means they have 444K paying subscribers ($16M / $36)
• So their free-to-paid conversion rate is 1.5% (444K paying users / 30M active users)
• If they can keep up that conversion rate as they grow to Facebook popularity (highly unlikely), they’ll get a total of 821K paying subscribers
• That would net a total of $30M from subscriptions (we’ve already included costs of content and operation in the advertising analysis above, so let’s just assume it’s all profit)

Adjusting the best case scenario for total profits
Based on the quick analysis above, the best case scenario for growth in the US gives Pandora the potential for $86M/year in profits ($56M from advertising and $30M in subscriptions). Given that they’d have to become as popular as Facebook to get there, that’s beyond optimistic. So let’s just say if they become 2/3s as popular, they’d make $56M/yr. Still highly optimistic, but not as far removed from reality.

But what if they go international?
They could, but it would be incredibly tough and expensive. Not only would they face daunting competitors in Europe like Spotify, they’d also have to deal with a labyrinth of licensing issues. Add in the increased cost of marketing, overseas offices, and the hardship of international advertising sales (you don’t think it’s as profitable to sell ads in Portugal as it is in the US, do you?) and you’re left with an international expansion that is unlikely to materially increase Pandora’s worth as a business.

So where does that leave the valuation?

• The best case scenario is to become a $56M/yr-in-profits business
• Let’s say they’ll be worth 12x P/E at that point (a generous number given that Apple is trading at a forward 12x P/E and have tremendous growth upside)
• That means Pandora’s market cap — by the time they hit all their best case scenario marks! — would be $672M ($56M * 12)
• Given the current number of outstanding shares, that means the price per share should be $4 ($672M market cap / 160M outstanding shares)

That means $4/share is where the price should land after an awesome 85% growth in active users AND a decade of losses transformed into a delicious $56M/yr in profits. Now factor in that this best case scenario has big risks: they don’t become as popular, royalty costs go up, they get more competition, the users switch to mobile instead of computer with less profitable ads, and on and on. What exactly do you think is the fair price for the stock today? 

Let me continue my generous streak and say that Pandora might be a reasonable gamble at $2/share, tops. That would still value a company that’s never seen a dollar of profit in its decade-long history at almost $320M (~160M outstanding shares at the moment). An astonishing, princely sum for a promise-of-a-perhaps profitable business in the future.