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3 Reasons to Buy Pandora Today

By David Meier - Dec 7, 2013 at 9:00AM

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Pandora's stock has been climbing in 2013, but it's not done yet.

Pandora (P) has been on quite a run, even in the face of incessant chatter from the bears. They make a good case. The company isn't making a profit. Apple (AAPL 0.56%) has considerably more resources to devote to iTunes Radio. And other competitors like Spotify and Rdio offer differentiated music services that could hurt Pandora over time.

But they're missing something by not looking deeper into what Pandora really is and what the company really does. I'm going to give three reasons why Pandora is going to be a huge success as it continues to disrupt terrestrial radio, which will push its stock price even higher over the next 10 years.

Follow the ears
The rule of thumb is that online advertisers follow the eyeballs. In Pandora's case, they follow they ears. And Pandora continues to broadcast some great numbers that advertisers just can't ignore. Active Pandora listeners increased 20% to 70.9 million in the third quarter . October's monthly users were down 2.6% from September, when Apple launched iTunes radio  . But the trend has already reversed. Pandora finished November with 72.4 million users, up from 70.9 million in October .

Looking at user data, iTunes Radio doesn't look like the Pandora killer many thought it would be. That notion becomes even stronger when we look at listener hours, which increased 17% to 4.18 billion during the quarter . Listener hours actually increased 8% from September to October and rose slightly again in November, giving Pandora 8.44% of total radio listening, up from 7.17% a year ago .

As I said above, advertisers clearly see the growth and have responded in kind, especially on mobile devices. Mobile ads sales eclipsed the $100 million market for the first time last quarter, growing 58% to $104.9 million. And Mobile Ad RPMs (revenue per 1,000 hours of ad-supported listening), the price Pandora charges for mobile ads, increased 41% to $36 . The combination of more volume at higher prices bodes very well for Pandora.

The wind is clearly at Pandora's back, too. Facebook COO Sheryl Sandberg recently said, "Today mobile represents 12% of consumer media time but it's still only 3% of ad budget." As the gap continues to close and more advertisers send more of their budgets to mobile devices where the people are consuming content, Pandora is going to benefit far more than traditional radio players.

Build it and they will come
The reason Pandora is going to pull advertising dollars away from terrestrial radio is that Pandora has significantly better data. Pandora knows more about its listeners, more about their listening habits, and, most important, just how many people are actually listening. With advertisers, as with most things in business, it's all about return on investment: Higher returns attract the most investment dollars. Armed with great data, Pandora's sales force continues to make compelling arguments for advertisers to invest with the online radio leader.

The digital format not only provides better data for advertisers, it also gives Pandora the data the company needs to experiment with different advertising strategies: audio formats, audio versus video, shorter versus longer ads, and the frequency of ad placements. Unlike traditional radio, Pandora can experiment with all sorts of combinations in order to find the optimal balance of a great listener experience and the highest return on investment for its customers. That's a great position to be in going forward, as more and more people will continue to move to streaming radio over time.

Here is the prize Pandora is going after. Terrestrial radio advertising is a $15 billion industry and ripe for disruption, especially now that Pandora has the infrastructure in place to bring its data to local advertisers. The proliferation of mobile computing is making Pandora nearly ubiquitous. Right now, Pandora is the third largest mobile ad player by revenue, only behind Google and Facebook . And that market is expected to growth from about $17 billion today to nearly $62 billion in 2017 .

When we compare those numbers to the $588 million of revenue over the past 12 months, Pandora has a huge opportunity ahead of it, which should help its infrastructure investments pay off handsomely. Here's how.

It's all about scale
As I said earlier, the vocal bears rightly say that Pandora has not been profitable. Today, they're right. Just simply look at Pandora's bottom line. However, Fools like us always try to put numbers into context, not just take them at face value. And Pandora's third-quarter results reveal some very useful information for long-term investors who take the time to dig a little deeper into the numbers to see what's really happening.

1. Content costs scaled, pushing its gross margin higher
2. Marketing and selling spending growth outpaced revenue growth. If Pandora was not spending aggressively to build out the final piece of their advertising sales team, the company would have been very profitable.

Here's what that means going forward. As more listeners log more listening hours on Pandora, its share of the radio market will continue to grow. The increase in those two metrics will attract more advertisers to the platform. With the sales teams and data analytics in place, Pandora will pull more advertising dollars away from terrestrial radio, especially on its mobile platform. Given the scale it's now achieving, margins will start to expand, leading to growing profits and cash flow over time.

The Foolish bottom line
It's difficult to break free from the short-term thinking that drives the markets today. That's why I encourage you to remember the following quote from Wayne Gretzky. When asked about the secret to his success, he responded by saying, "I skate to where the puck is going to be, not to where it has been." The same is true for investing in innovative companies like Pandora. Early on in their lives, they can look like such poor investment ideas. Yes, Pandora doesn't turn a profit today. But there's a reason. And that reason is Pandora has been investing in growth in order to forgo a little profit today in order to make considerably more profit in the future. The market continues to slowly recognize the momentum Pandora has in its business. And even though the stock price has risen nicely over the past year, the best is still to come, making Pandora an attractive opportunity today.

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