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PANDORA MEDIA, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our Transition Report on Form 10-K for the eleven months ended December 31, 2013 filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act"). We changed our fiscal year to the calendar twelve months ending December 31, effective beginning with the year ended December 31, 2013. As a result of this change, our prior fiscal year was an 11-month transition period ended on December 31, 2013. All references herein to a fiscal year refer to the twelve months ended December 31 of such year, and references to the first, second, third and fourth fiscal quarters refer to the three months ended March 31, June 30, September 30 and December 31, respectively. Prior year results have been recast on a calendar quarter basis. Refer to our Transition Report on Form 10-K for the eleven months ended December 31, 2013 for additional information regarding our fiscal year change. This Quarterly Report on Form 10-Q contains "forward-looking statements" that involve substantial risks and uncertainties. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Exchange Act, including, but not limited to, statements regarding our expectations, beliefs, intentions, strategies, future operations, future financial position, future revenue, projected expenses, plans and objectives of management and economic, competitive and technological trends. In some cases, you can identify forward-looking statements by terms such as "anticipate," "believe," "estimate," "expect," "intend," "may," "might," "plan," "project," "will," "would," "should," "could," "can," "predict," "potential," "continue," "objective," or the negative of these terms, and similar expressions intended to identify forward-looking statements. However, not all forward-looking statements contain these identifying words. These forward-looking statements reflect our current views about future events and involve known risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievement to be materially different from those expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included in this Quarterly Report on Form 10-Q and our Transition Report on Form 10-K for the eleven months ended December 31, 2013. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. We qualify all of our forward-looking statements by these cautionary statements. These and other factors could cause our results to differ materially from those expressed in this Quarterly Report on Form 10-Q. Some of the industry and market data contained in this Quarterly Report on Form 10-Q are based on independent industry publications, including those generated by Triton Digital Media ("Triton") or other publicly available information. This information involves a number of assumptions and limitations. Although we believe that each source is reliable as of its respective date, we have not independently verified the accuracy or completeness of this information. As used herein, "Pandora," the "Company," "we," "our," and similar terms refer to Pandora Media, Inc., unless the context indicates otherwise. "Pandora" and other trademarks of ours appearing in this report are our property. This report may contain additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. Overview Pandora is the leader in internet radio in the United States, offering a personalized experience for each of our listeners wherever and whenever they want to listen to radio on a wide range of smartphones, tablets, traditional computers and car 18-------------------------------------------------------------------------------- Table of Contents audio systems, as well as a range of other internet-connected devices. The majority of our listener hours occur on mobile devices, with the majority of our revenue generated from advertising on these devices. We have pioneered a new form of radio-one that uses intrinsic qualities of music to initially create stations and then adapts playlists in real-time based on the individual feedback of each listener. We offer local and national advertisers an opportunity to deliver targeted messages to our listeners using a combination of audio, display and video advertisements. As of September 30, 2014, we had more than 250 million registered users, and more than 200 million registered users had accessed Pandora through smartphones and tablets. For the three months ended September 30, 2014, we streamed 4.99 billion hours of radio, and as of September 30, 2014, we had 76.5 million active users during the prior 30 day period. According to an August 2014 report by Triton, we have more than a 70% share of internet radio among the top 20 stations and networks in the United States. Since we launched our free, advertising-supported radio service in 2005 our listeners have created over 7 billion stations. At the core of our service is our set of proprietary personalization technologies, including the Music Genome Project and our playlist generating algorithms. The Music Genome Project is a database of over 1,000,000 uniquely analyzed songs from over 125,000 artists, spanning over 600 genres and sub-genres, which we develop one song at a time by evaluating and cataloging each song's particular attributes. When a listener enters a single song, artist or genre to start a station, the Pandora service instantly generates a station that plays music we think that listener will enjoy. Based on listener reactions to the songs we stream, we further tailor the station to match the listener's preferences in real time. We currently provide the Pandora service through two models: • Free Service. Our free service is advertising-based and allows listeners access to our music and comedy catalogs and personalized playlist generating system for free across all of our delivery platforms. • Pandora One. Pandora One is provided to paying subscribers without any external advertising. Pandora One enables listeners to create more stations, have more daily skips and enjoy higher quality audio on supported devices. A key element of our strategy is to make the Pandora service available everywhere that there is internet connectivity. To this end, we make the Pandora service available through a variety of distribution channels. In addition to streaming our service to traditional computers, we have developed Pandora mobile device applications or "apps" for smartphones such as iPhone, Android and the Windows Phone and for tablets including the iPad and Android tablets. We distribute those mobile apps free to listeners via app stores. In addition, Pandora is now integrated with more than 1,000 connected devices, including automobiles, automotive aftermarket devices and consumer electronic devices. Recent Events In August 2014, we announced an agreement to partner with Music and Entertainment Rights Licensing Independent Network ("Merlin"), the global rights agency for the independent label sector, whose membership includes over 20,000 independent record labels and distributors worldwide. This partnership was designed to help independent labels and artists increase the audiences they reach. Participating labels, and the artists they represent, can also take advantage of the marketing capabilities of our connected platform, including providing direct access to our metadata to help participating labels make data-driven business decisions. We do not expect this partnership to have a material effect on our financial condition or operating results. In July 2014, we signed a multi-year agreement with BMG Rights Management US LLC ("BMG") for a U.S. license for BMG's complete Broadcast Music, Inc. ("BMI") and the American Society of Composers, Authors and Publishers ("ASCAP") catalog of musical works. We do not expect this agreement to have a material effect on our consolidated financial condition or operating results. Effective in March 2014, we implemented a change in the pricing structure for Pandora One under which the $36 annual subscription option was eliminated. In addition, effective in May 2014, the monthly pricing option for Pandora One was increased to $4.99 per-month for new subscribers. Existing monthly subscribers who did not lapse maintained the $3.99 per-month pricing structure, and existing annual subscribers who did not lapse were migrated to the $3.99 per-month monthly pricing structure. An important element of our strategy to achieve greater penetration of the local radio advertising market is to have Pandora's audience data presented in a manner consistent with similar data on terrestrial radio stations so that advertisers and 19-------------------------------------------------------------------------------- Table of Contents advertising agencies can better evaluate the relative value proposition of advertising on Pandora. In February 2014, Triton received Media Rating Council ("MRC") accreditation for its Webcast Metrics Local ("WCML") product, which allows agencies and advertisers to evaluate Pandora's relative audience scale using broadcast metrics in specific advertising markets. Also in February 2014, we completed the WCML publisher audit of our user-declared geographic and demographic listener data. We believe this accreditation validates that our local audience metrics are reliable and effective. In June 2013, we entered into a local marketing agreement to program KXMZ-FM, a Rapid City, South Dakota-area terrestrial radio station. In addition, we entered into an agreement to purchase the assets of KXMZ-FM for a total purchase price of approximately $0.6 million in cash, subject to certain closing conditions. These agreements were made in part to allow us to qualify for certain settlement agreements concerning royalties for the public performance of musical works between the Radio Music Licensing Committee ("RMLC") and ASCAP and BMI. We believe that we qualify for the RMLC royalty rates, which provide us with savings of less than 1% of revenue in cost of revenue - content acquisition costs, compared with the latest contractual rates. As of September 30, 2014, we have paid $0.4 million of the purchase price, which is included in the other long-term assets line item of our balance sheets. Completion of the KXMZ-FM acquisition is subject to various closing conditions. These include, but are not limited to, regulatory approval by the Federal Communications Commission. Upon completion of these conditions, we expect to account for this transaction as a business combination. Factors Affecting our Business Model As our mobile listenership increases, we face new challenges in optimizing our advertising products for delivery on mobile and other connected device platforms and monetizing inventory generated by listeners using these platforms. The mobile digital advertising market is at an early stage of development, with lower overall spending levels than traditional online advertising markets, and faces technical challenges due to fragmented platforms and a lack of standard audience measurement protocols. As a greater share of our listenership is consumed on mobile devices, our ability to monetize increased mobile streaming may not keep up with our past monetization of streaming to desktop computers and laptops. In addition, our monetization strategy includes increasing the number of ad campaigns for traditional computer, mobile and other connected device platforms sold to local advertisers, placing us in more direct competition with broadcast radio for advertiser spending, especially for audio advertisements. By contrast, historically our display advertisers have been predominantly national brands. To successfully monetize our growing listener hours, a key strategy is to convince a substantial base of local advertisers of the benefits of advertising on the Pandora service including demonstrating the effectiveness and relevance of our advertising products, and in particular, audio advertising products, across the range of our delivery platforms. Growth in our active users and distribution platforms has fueled a corresponding growth in listener hours. Our total number of listener hours is a key driver for both revenue generation opportunities and content acquisition costs, which are the largest component of our expenses. • Revenue. Listener hours define the number of opportunities we have to sell advertisements, which we refer to as inventory. Our ability to attract advertisers depends in large part on our ability to offer sufficient inventory within desired demographics. In turn, our ability to generate revenue depends on the extent to which we are able to sell the inventory we have. • Cost of Revenue-Content Acquisition Costs. The number of sound recordings we transmit to users of the Pandora service, as generally reflected by listener hours, drives substantially all of our content acquisition costs, although certain of our licensing agreements require us to pay fees for public performances of musical works based on a percentage of revenue. We pay royalties to the copyright owners, or their agents, of each sound recording that we stream and to the copyright owners, or their agents, of the musical work embodied in that sound recording, subject to certain exclusions. Royalties for sound recordings are negotiated with and paid to record labels, rights organizations or to SoundExchange. Royalties for musical works are most often negotiated with and paid to PROs such as ASCAP, BMI and SESAC or directly to publishing companies. Royalties are calculated based on the number of sound recordings streamed, revenue earned or other usage measures. We stream spoken word comedy content pursuant to a federal statutory license, for which the underlying literary works are not currently entitled to eligibility for licensing by any PRO for the United States. Rather, pursuant to industry-wide custom and practice, this content is performed absent a specific license from any such PRO or the copyright owner of such content. However, we pay royalties to SoundExchange at rates negotiated between representatives of online music services and SoundExchange for the right to stream this spoken word comedy content. 20-------------------------------------------------------------------------------- Table of Contents Given the current royalty structures in effect through 2015 with respect to the public performance of sound recordings in the United States, our content acquisition costs increase with each additional listener hour, regardless of whether we are able to generate more revenue. As such, our ability to achieve and sustain profitability and operating leverage depends on our ability to increase our revenue per hour of streaming through increased advertising revenue across all of our delivery platforms. In addition, we expect to invest heavily in our operations to support anticipated future growth. One of our key objectives is furthering our market leadership in internet radio, which we believe will strengthen our brand and help us to convince advertisers to allocate spending towards our ad products. As such, a central focus is adding, retaining and engaging listeners to build market share and grow our listener hours. As our business matures, we expect that our revenue growth will exceed the growth in our listener hours. However, we expect to incur annual net losses on a U.S. GAAP basis in the near term because our current strategy is to leverage any improvements in gross profit by investing in broadening distribution channels, developing innovative and scalable advertising products, increasing utilization of advertising inventory and building our sales force. These investments are intended to drive further growth in our business through both increased listener hours and monetization of those hours, and as a result we are targeting gradual improvements in gross profit over time. Our planned reinvestment of any resulting incremental gross profit will continue to depress any growth of bottom line profitability. Key Metrics Listener Hours We track listener hours because it is a key indicator of the growth of our business. We calculate listener hours based on the total bytes served for each track that is requested and served from our servers, as measured by our internal analytics systems, whether or not a listener listens to the entire track. To the extent that third-party measurements of listener hours are not calculated using a similar server-based approach, the third-party measurements may differ from our measurements. The table below sets forth our total listener hours for the three and nine months ended September 30, 2013 and 2014. Three months ended Nine months ended September 30, September 30, 2013 2014 2013 2014 (in billions) (in billions) Listener hours 3.99 4.99 12.16 14.83 Active Users We track the number of active users as an additional indicator of the breadth of audience we are reaching at a given time. Active users are defined as the number of distinct registered users, including subscribers, that have requested audio from our servers within the trailing 30 days to the end of the final calendar month of the period. The number of active users may overstate the number of unique individuals who actively use our service within a month as one individual may register for, and use, multiple accounts. The table below sets forth our total active users as of September 30, 2013 and 2014. As of September 30, 2013 2014 (in millions) Active users 72.7 76.5 Revenue per Thousand Listener Hours ("RPMs") 21-------------------------------------------------------------------------------- Table of Contents We track total RPMs for our service, which includes ad and subscription RPMs, because it is a key indicator of our ability to monetize our listener hours. We focus on total RPMs across all of our delivery platforms. Total RPMs compare advertising and subscription and other revenue in a given period to total listener hours in the period. We calculate total RPMs by dividing the total revenue by the number of thousands of listener hours using the inputs below. The table below sets forth our users on an advertising and subscription basis as of September 30, 2013 and 2014. As of September 30, 2013 2014 User type Users (in millions) Ad-based active users 70.1 73.5 Subscribers* 3.1 3.5 Total 73.2 77.0 * Includes subscribers that have not used our service within the trailing 30 days to the end of the final calendar month of the period. The table below sets forth our listener hours on an advertising and subscription basis for the three and nine months ended September 30, 2013 and 2014. Three months ended September 30, Nine months ended September 30, 2013 2014 2013 2014 User type Listener hours (in billions) Listener hours (in billions) Ad-based active users 3.41 4.38 10.66 13.01 Subscribers 0.58 0.61 1.50 1.82 Total 3.99 4.99 12.16 14.83 Advertising-based active users ("ad-based active users") are defined as the number of users, excluding subscribers, that have requested audio from our servers within the trailing 30 days to the end of the final calendar month of the period. Subscribers are defined as the number of distinct users at the end of the period that have subscribed to our service. Inactive subscribers are included as they contribute towards revenue per thousand listener hours ("RPMs"), which are described in further detail below. Advertising Revenue per Thousand Listener Hours ("ad RPMs") We track ad RPMs for our free, advertising-supported service because it is a key indicator of our ability to monetize advertising inventory created by our listener hours. We focus on ad RPMs across all of our delivery platforms. We believe ad RPMs to be the central top-line indicator for evaluating the results of our monetization efforts. Ad RPMs are calculated by dividing advertising revenue by the number of thousands of listener hours of our advertising-based service. Subscription and Other Revenue per Thousand Listener Hours ("subscription RPMs") We track subscription RPMs because it is a key indicator of the performance of our subscription service. We focus on subscription RPMs across all of our delivery platforms. Subscription RPMs are calculated by dividing subscription and other revenue by the number of thousands of listener hours of our subscription service. Total Revenue per Thousand Listener Hours ("total RPMs") We track total RPMs for our service, which includes ad and subscription RPMs, because it is a key indicator of our ability to monetize our listener hours. Total RPMs compare advertising and subscription and other revenue in a given period to total listener hours in the period. We calculate total RPMs by dividing the total revenue by the number of thousands of listener hours. 22-------------------------------------------------------------------------------- Table of Contents Licensing Costs per Thousand Listener Hours ("LPMs") We track LPMs and analyze them in combination with our analysis of RPMs as they provide a key indicator of our profitability. LPMs are relatively fixed licensing costs with scheduled annual rate increases that drive period-over-period changes in LPMs. As such, the margin on our business varies principally with variances in ad RPMs and subscription RPMs. Estimated RPMs and LPMs by Platform We also provide estimates of disaggregated ad RPMs, subscription RPMs, total RPMs and related LPMs for our traditional computer platform as well as our mobile and other connected devices platforms, which we calculate by dividing the estimated revenue and costs generated through the respective platforms by the number of thousands of listener hours of our services delivered through such platforms. While we believe that such disaggregated data provides directional insight for evaluating our efforts to monetize our service, we do not validate such disaggregated data to the level of financial statement reporting. Such data should be seen as indicative only and as management's best estimate. We continue to refine our systems and methodologies used to categorize RPMs and LPMs. Period-to-period results should not be regarded as precise nor can they be relied upon as indicative of results for future periods. In addition, as our business matures and in response to technological evolutions, we anticipate that the relevant indicators we monitor for evaluating our business may change. The table below sets forth our RPMs and LPMs, including total, traditional computer and mobile and other connected devices, on an advertising ("ad"), subscription and total basis for the three months ended September 30, 2013 and 2014. Three months ended September 30, 2013 2014 RPM LPM* RPM LPM* Advertising: Traditional computer $ 58.44 $ 19.08 $ 64.13 $ 20.59 Mobile and other connected devices 35.31 18.85 40.82 20.33 Total advertising $ 39.68 $ 18.89 $ 44.35 $ 20.37 Subscription: Traditional computer $ 53.52 $ 31.91 $ 61.56 $ 33.53 Mobile and other connected devices 60.85 33.49 78.11 36.94 Total subscription $ 58.93 $ 33.08 $ 74.14 $ 36.12 Total: Total traditional computer $ 57.50 $ 21.54 $ 63.67 $ 22.94 Total mobile and other connected devices 38.75 20.82 44.96 22.18 Total $ 42.49 $ 20.97 $ 48.00 $ 22.30 * Under the Pureplay Settlement agreement, we pay per-performance rates for the streaming of sound recordings for our Pandora One subscription service that are higher than the per-performance rates for our free, advertising-supported service. The table below sets forth our RPMs and LPMs, including total, traditional computer and mobile and other connected devices, on an ad and subscription basis for the nine months ended September 30, 2013 and 2014. 23-------------------------------------------------------------------------------- Table of Contents Nine months ended September 30, 2013 2014 RPM LPM* RPM LPM* Advertising: Traditional computer $ 53.67 $ 18.91 $ 59.64 $ 20.76 Mobile and other connected devices 28.96 18.55 35.55 20.38 Total advertising $ 33.70 $ 18.62 $ 39.37 $ 20.44 Subscription: Traditional computer $ 49.95 $ 31.86 $ 60.09 $ 33.54 Mobile and other connected devices 52.97 34.51 84.39 36.59 Total subscription $ 52.08 $ 33.73 $ 77.32 $ 35.82 Total: Total traditional computer $ 53.01 $ 21.21 $ 59.59 $ 23.09 Total mobile and other connected devices 31.59 20.30 40.82 22.16 Total $ 35.97 $ 20.49 $ 44.02 $ 22.32 * Under the Pureplay Settlement agreement, we pay per-performance rates for the streaming of sound recordings for our Pandora One subscription service that are higher than the per-performance rates for our free, advertising-supported service. Total ad RPMs For the three and nine months ended September 30, 2014 compared to 2013, total ad RPMs increased primarily due to an increase in ad RPMs on the mobile and other connected devices platform. Ad RPMs on the mobile and other connected devices platform increased as advertising revenue growth outpaced the growth in advertising listener hours as a result of an increase in the average price per ad sold on that platform, due in part to our shift to local ad sales. Total subscription RPMs For the three months ended September 30, 2014 compared to 2013, total subscription RPMs increased as the growth in subscription and other revenue outpaced the growth in subscription listener hours on both the traditional computer and the mobile and other connected devices platforms, primarily due to an increase in the average price per subscriber as a result of the increase in the Pandora One pricing structure. For the nine months ended September 30, 2014 compared to 2013, total subscription RPMs increased as the growth in subscription and other revenue outpaced the growth in subscription listener hours on both the traditional computer and the mobile and other connected devices platforms, primarily due to an increase in the average price per subscriber as a result of the increase in the Pandora One pricing structure. In addition, the changes in subscription RPMs for the nine months ended September 30, 2014 reflect a $14.2 million increase in subscription revenue in connection with the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions. Refer to "Deferred Revenue" below for further details regarding these in-app subscriptions. Total ad LPMs Total ad LPMs in the three and nine months ended September 30, 2014 increased compared to the respective prior year periods primarily due to scheduled rate increases for sound recording royalties paid to SoundExchange. Total subscription LPMs 24-------------------------------------------------------------------------------- Table of Contents Total subscription LPMs in the three and nine months ended September 30, 2014 increased compared to the respective prior year periods primarily due to scheduled rate increases for sound recording royalties paid to SoundExchange. 25 -------------------------------------------------------------------------------- Table of Contents Basis of Presentation and Results of Operations The following table presents our results of operations for the periods indicated as a percentage of total revenue. The period-to-period comparisons of results are not necessarily indicative of results for future periods. Three months ended Nine months ended September 30, September 30, 2013 2014 2013 2014 Revenue: Advertising 80 % 81 % 82 % 78 % Subscription and other 20 19 18 22 Total revenue 100 100 100 100 Cost of revenue: Cost of revenue - Content acquisition costs 49 46 57 51 Cost of revenue - Other(1) 7 6 7 7 Total cost of revenue 57 53 64 58 Gross profit 43 47 36 42 Operating expenses: Product development(1) 5 6 5 6 Sales and marketing(1) 28 30 30 31 General and administrative(1) 13 12 12 12 Total operating expenses 46 48 47 49 Loss from operations (2 ) (1 ) (11 ) (7 ) Other income (expense), net - - - - Loss before provision for income taxes (2 ) (1 ) (11 ) (7 ) Provision for income taxes - - - - Net Loss (2 )% (1 )% (11 )% (7 )% (1) Includes stock-based compensation as follows: Cost of revenue - Other 0.3 % 0.4 % 0.3 % 0.5 % Product development 1.5 1.8 1.5 1.9 Sales and marketing 3.4 4.4 3.5 4.4 General and administrative 1.9 2.6 1.3 2.5 Note: Amounts may not recalculate due to rounding Revenue Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Advertising $ 134,963 $ 194,293 $ 59,330 $ 359,232 $ 512,251 $ 153,019 Subscription and other 34,340 45,300 10,960 78,299 140,551 62,252 Total revenue $ 169,303 $ 239,593 $ 70,290 $ 437,531 $ 652,802 $ 215,271 Advertising revenue 26-------------------------------------------------------------------------------- Table of Contents We generate advertising revenue primarily from audio, display and video advertising, which is typically sold on a cost-per-thousand impressions, or CPM, basis. Advertising campaigns typically range from one to twelve months, and advertisers generally pay us based on the number of delivered impressions or the satisfaction of other criteria, such as click-throughs. We also have arrangements with advertising agencies under which these agencies sell advertising inventory on our service directly to advertisers. We report revenue under these arrangements net of amounts due to agencies. For the three months ended September 30, 2013 and 2014 and the nine months ended September 30, 2013 and 2014, advertising revenue accounted for 80%, 81%, 82% and 78%, of our total revenue, respectively. We expect that advertising will comprise a substantial majority of revenue for the foreseeable future. For the three months ended September 30, 2014 compared to 2013, advertising revenue increased $59.3 million or 44%, primarily due to an approximate 20% increase in the average price per ad sold, due in part to our shift to local ad sales and our focus on monetizing mobile inventory, and an approximate 20% increase in the number of ads sold, primarily due to an increase in advertising listener hours. For the nine months ended September 30, 2014 compared to 2013, advertising revenue increased $153.0 million or 43%, primarily due to an approximate 30% increase in the average price per ad sold, due in part to our shift to local ad sales and our focus on monetizing mobile inventory, and an approximate 10% increase in the number of ads sold, primarily due to an increase in advertising listener hours. Subscription and other revenue Subscription and other revenue is generated primarily through the sale of Pandora One, a premium version of the Pandora service, which currently includes advertisement-free access and higher audio quality on the devices that support it. Subscription revenue is recognized on a straight-line basis over the duration of the subscription period. For the three months ended September 30, 2013 and 2014 and the nine months ended September 30, 2013 and 2014, subscription and other revenue accounted for 20%, 19%, 18% and 22% of our total revenue, respectively. Effective in March 2014, we implemented a change in the pricing structure for Pandora One under which the $36 annual subscription option was eliminated. In addition, effective in May 2014, the monthly pricing option for Pandora One was increased to $4.99 per-month for new subscribers. Existing monthly subscribers who did not lapse maintained the $3.99 per-month pricing structure, and existing annual subscribers who did not lapse were migrated to the $3.99 per-month monthly pricing structure. For the three months ended September 30, 2014 compared to 2013, subscription revenue increased $11.0 million or 32%, primarily due to an approximate 15% increase in the average price per subscription as a result of the change in the Pandora One pricing structure and due to an approximate 10% increase in the number of subscribers. For the nine months ended September 30, 2014 compared to 2013, subscription revenue increased $62.3 million or 80%, primarily due to an approximate 30% increase in the average price per subscription as a result of the change in the Pandora One pricing structure and due to an approximate 10% increase in the number of subscribers. The increase in subscription revenue for the nine months ended September 30, 2014 was also due to a $14.2 million increase in subscription revenue in connection with the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions. Refer to "Deferred Revenue" below for further details regarding these in-app subscriptions. Deferred revenue Our deferred revenue consists principally of both prepaid but unrecognized subscription revenue and advertising fees received or billed in advance of the delivery or completion of the delivery of services. Deferred revenue is recognized as revenue when the services are provided and all other revenue recognition criteria have been met. In addition, subscription revenue derived from sales through certain mobile devices may be subject to refund or cancellation terms which may affect the timing or amount of the subscription revenue recognition. When refund rights exist, we recognize revenue when services have been provided and the rights lapse or when we have developed sufficient transaction history to estimate a return reserve. We were required to defer revenue for certain in-app mobile subscriptions that contained refund rights until the refund rights lapsed or until we developed sufficient operating history to estimate a return reserve. As of December 31, 2013, we had deferred all revenue related to these in-app mobile subscriptions subject to refund rights totaling approximately $14.2 million, as we did not have sufficient transaction history to estimate a return reserve. Beginning in January 2014, we had sufficient 27-------------------------------------------------------------------------------- Table of Contents transaction history that enabled us to estimate future returns. Accordingly, in January 2014, we began recording revenue related to these in-app mobile subscriptions net of estimated returns. This resulted in a one-time increase in subscription revenue in the three months ended March 31, 2014 of approximately $14.2 million, as the previously deferred revenue was recognized. As of September 30, 2014, the deferred revenue related to the return reserve was not significant. Deferred revenue in our condensed consolidated balance sheet as of September 30, 2014 decreased as compared to December 31, 2013 in connection with the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions in the three months ended March 31, 2014. In addition, deferred revenue also decreased due to the elimination of the annual pricing option, as we collected less cash upfront under the one-month subscription period as opposed to the twelve-month subscription period under the annual subscription option. Costs and Expenses Cost of revenue consists of cost of revenue - content acquisition costs and cost of revenue - other. Our operating expenses consist of product development, sales and marketing and general and administrative costs. Cost of revenue - content acquisition costs are the most significant component of our costs and expenses, followed by employee-related costs, which include stock-based compensation expenses. We expect to continue to hire additional employees in order to support our anticipated growth and our product development initiatives. In any particular period, the timing of additional hires could materially affect our cost of revenue and operating expenses, both in absolute dollars and as a percentage of revenue. We anticipate that our costs and expenses will increase in the future. Cost of revenue - content acquisition costs Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Cost of revenue - content acquisition costs $ 83,535 $ 111,315 $ 27,780 $ 249,186 $ 331,051 $ 81,865 Content acquisition costs as a percentage of advertising revenue by platform Three months ended Nine months ended September 30, September 30, 2013 2014 2013 2014 Traditional computer 34 % 33 % 36 % 35 % Mobile and other connected devices 53 % 50 % 64 % 56 % Cost of revenue-content acquisition costs principally consist of royalties paid for streaming music or other content to our listeners. Royalties are currently calculated using negotiated rates documented in agreements. The majority of our royalties are payable based on a fee per public performance of a sound recording, while in other cases our royalties are payable based on a percentage of our revenue or a formula that involves a combination of per performance and revenue metrics. For royalty arrangements under negotiation, we accrue for estimated royalties based on the available facts and circumstances and adjust these estimates as more information becomes available. The results of any finalized negotiation may be materially different from our estimates. We estimate our advertising-based content acquisition costs attributable to specific platforms by allocating costs from royalties payable based on a fee per track to the platform for which the track is served and by allocating costs from royalties based on a percentage of our revenue in accordance with the overall percentage of our revenue estimated to be attributable to such platforms. While we believe that comparing disaggregated content acquisition costs and revenues across our delivery platforms may provide directional insight for evaluating our efforts to monetize the rapid adoption of our service on mobile and other connected devices, we do not validate such disaggregated metrics to the level of financial statement reporting. We continue to refine our systems and methodologies used to categorize such metrics across our delivery platforms and the period-to-period comparisons of results are not necessarily indicative of results for future periods. For the three months ended September 30, 2014 compared to 2013, content acquisition costs increased $27.8 million or 33%, primarily due to an approximate 25% increase in listener hours and scheduled royalty rate increases of 8%. Content 28-------------------------------------------------------------------------------- Table of Contents acquisition costs as a percentage of total revenue decreased from 49% to 46%, primarily due to an increase in advertising revenue. Estimated content acquisition costs as a percentage of the advertising revenue attributable to our traditional computer platform decreased from 34% to 33%, primarily due to an increase in advertising revenue on the traditional computer platform as a result of an increase in the average price per ad sold, offset by scheduled rate increases. Estimated content acquisition costs as a percentage of the advertising revenue attributable to our mobile and other connected devices platform decreased from 53% to 50%, primarily due an increase in advertising revenue on the mobile and other connected devices platform as a result of an increase in the average price per ad sold and an increase in the number of ads sold, offset by scheduled rate increases. For the nine months ended September 30, 2014 compared to 2013, content acquisition costs increased $81.9 million or 33%, primarily due to an approximate 20% increase in listener hours and scheduled royalty rate increases of 8%. Content acquisition costs as a percentage of total revenue decreased from 57% to 51%, primarily due to an increase in advertising revenue and a $14.2 million increase in subscription revenue in connection with the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions. Refer to "Deferred Revenue" above for further details regarding these in-app subscriptions. Estimated content acquisition costs as a percentage of the advertising revenue attributable to our traditional computer platform decreased from 36% to 35%, primarily due to an increase in advertising revenue on the traditional computer platform as a result of an increase in the average price per ad sold, offset by scheduled rate increases. Estimated content acquisition costs as a percentage of the advertising revenue attributable to our mobile and other connected devices platform decreased from 64% to 56%, primarily due to an increase in advertising revenue on the mobile and other connected devices platform as a result of an increase in the average price per ad sold and an increase in the number of ads sold. The decrease in estimated content acquisition costs as a percentage of the advertising revenue attributable to our mobile and other connected devices platform was also due to the effect of measures we have adopted to manage the growth of mobile content acquisition costs while minimizing adverse effects on the listener experience, such as adjusting the number of times users can skip songs during a given listening session, as well as optimizing time-based thresholds whereby music will stop playing after a certain length of user inactivity with the service, partially offset by scheduled rate increases. Cost of revenue-other Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Cost of revenue - other $ 12,126 $ 15,453 $ 3,327 $ 32,749 $ 44,421 $ 11,672 Cost of revenue-other consists primarily of hosting and infrastructure costs and other costs of ad sales. Hosting and infrastructure costs consist of content streaming, maintaining our internet radio service, creating and serving advertisements through third-party ad servers and the employee-related costs associated with supporting those functions. Other costs of ad sales include support costs related to music events that are sold as part of advertising arrangements. We make payments to third-party ad servers for the period the advertising impressions or click-through actions are delivered or occur, and accordingly, we record this as a cost of revenue in the related period. For the three months ended September 30, 2014 compared to 2013, cost of revenue increased $3.3 million or 27%, primarily due to a $1.6 million increase in hosting and infrastructure costs driven by an increase in listener hours and a $1.5 million increase in employee-related costs driven by an approximate 40% increase in headcount. For the nine months ended September 30, 2014 compared to 2013, cost of revenue increased $11.7 million or 36%, primarily due to a $4.3 million increase in employee-related costs and a $1.6 million increase in facilities and equipment expenses, both of which were driven by an approximate 40% increase in headcount, a $3.7 million increase in hosting and infrastructure costs driven by an increase in listener hours and a $2.1 million increase in other costs of ad sales related to events sold as part of advertising arrangements. Gross profit 29-------------------------------------------------------------------------------- Table of Contents Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Total revenue $ 169,303 $ 239,593 $ 70,290 $ 437,531 $ 652,802 $ 215,271 Total cost of revenue 95,661 126,768 31,107 281,935 375,472 93,537 Gross profit $ 73,642 $ 112,825 $ 39,183 $ 155,596 $ 277,330 $ 121,734 Gross margin 43 % 47 % 36 % 42 % For the three months ended September 30, 2014 compared to 2013, gross profit increased by $39.2 million or 53%, primarily due to an increase in advertising revenue as a result of an increase in the average price per ad sold and an increase in the number of ads sold. Gross margin increased from 43% to 47% as the growth in revenue outpaced the growth in content acquisition costs primarily due to an increase in advertising revenue and the effect of measures we have adopted to manage the growth of mobile content acquisition costs while minimizing adverse effects on the listener experience, such as adjusting the number of times users can skip songs during a given listening session, as well as optimizing time-based thresholds whereby music will stop playing after a certain length of user inactivity with the service. For the nine months ended September 30, 2014 compared to 2013, gross profit increased by $121.7 million or 78%, primarily due to an increase in advertising revenue as a result of an increase in the average price per ad sold and an increase in the number of ads sold. Gross margin increased from 36% to 42% as the growth in revenue outpaced the growth in content acquisition costs primarily due to an increase in advertising revenue and the effect of measures we have adopted to manage the growth of mobile content acquisition costs while minimizing adverse effects on the listener experience, such as adjusting the number of times users can skip songs during a given listening session, as well as optimizing time-based thresholds whereby music will stop playing after a certain length of user inactivity with the service. The increase in gross margin was also due to an increase in subscription and other revenue driven by a $14.2 million increase in connection with the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions. Refer to "Deferred Revenue" above for further details regarding these in-app subscriptions. Product development Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Product development $ 9,099 $ 13,381 $ 4,282 $ 23,661 $ 38,288 $ 14,627 Product development consists primarily of employee-related costs, including salaries and benefits related to employees in software engineering, music analysis and product management departments, facilities-related expenses, information technology and costs associated with supporting consumer connected-device manufacturers in implementing our service in their products. We incur product development expenses primarily for improvements to our website and the Pandora app, development of new advertising products and development and enhancement of our personalized station generating system. We have generally expensed product development as incurred. Certain website development and internal use software development costs are capitalized when specific criteria are met. In such cases, the capitalized amounts are amortized over the useful life of the related application once the application is placed in service. We intend to continue making significant investments in developing new products and enhancing the functionality of our existing products. For the three months ended September 30, 2014 compared to 2013, product development expenses increased $4.3 million or 47%, primarily due to a $4.0 million increase in employee-related costs driven by an approximate 40% increase in headcount. For the nine months ended September 30, 2014 compared to 2013, product development expenses increased $14.6 million or 62%, primarily due to a $13.4 million increase in employee-related costs and a $1.1 million increase in facilities and equipment expenses, both of which were driven by an approximate 40% increase in headcount. Sales and marketing 30-------------------------------------------------------------------------------- Table of Contents Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) Sales and marketing $ 47,049 $ 72,320 $ 25,271 $ 129,465 $ 200,416 $ 70,951 Sales and marketing consists primarily of employee-related costs, including salaries, commissions and benefits related to employees in sales, sales support and marketing departments. In addition, sales and marketing expenses include transaction processing commissions on subscription purchases on mobile platforms, external sales and marketing expenses such as third-party marketing, branding, advertising and public relations expenses, facilities-related expenses, infrastructure costs and credit card fees. We expect sales and marketing expenses to increase as we hire additional personnel to build out our sales and sales support teams, particularly as we continue to build out our local market sales team. For the three months ended September 30, 2014 compared to 2013, sales and marketing expenses increased $25.3 million or 54%, primarily due to a $16.9 million increase in employee-related costs driven by an approximate 30% increase in headcount, a $4.2 million increase in marketing expenses, a $1.9 million increase in transaction processing commissions on subscription purchases on mobile platforms and a $1.0 million increase in music events. For the nine months ended September 30, 2014 compared to 2013, sales and marketing expenses increased $71.0 million or 55%, primarily due to a $49.0 million increase in employee-related costs and a $3.5 million increase in facilities and equipment expenses, both of which were driven by an approximate 30% increase in headcount, a $8.1 million increase in transaction processing commissions on subscription purchases on mobile platforms, a $7.1 million increase in marketing expenses and a $1.9 million increase in music events. General and administrative Three months ended Nine months ended September 30, September 30, 2013 2014 $ Change 2013 2014 $ Change (in thousands) (in thousands) General and administrative $ 21,397 $ 29,143 $ 7,746 $ 51,683 $ 81,369 $ 29,686 General and administrative consists primarily of employee-related costs, including salaries and benefits for finance, accounting, legal, internal information technology and other administrative personnel. In addition, general and administrative expenses include professional services costs for outside legal and accounting services, facilities-related expenses and infrastructure costs. We expect general and administrative expenses to increase in future periods as we continue to invest in corporate infrastructure, including adding personnel and systems to our administrative functions. For the three months ended September 30, 2014 compared to 2013, general and administrative expenses increased $7.7 million or 36%, primarily due to a $6.0 million increase in employee-related costs driven by an approximate 40% increase in headcount. For the nine months ended September 30, 2014 compared to 2013 general and administrative expenses increased $29.7 million or 57%, primarily due to a $19.0 million increase in employee-related costs and a $2.8 million increase in facilities and equipment expenses, both of which were driven by an approximate 40% increase in headcount, and a $5.4 million increase in professional services costs primarily due to royalty-related legal matters. Income tax benefit (expense) We have historically been subject to income taxes only in the United States. As we expand our operations outside the United States, we become subject to taxation based on the foreign statutory rates and our effective tax rate could fluctuate accordingly. Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted statutory income tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. 31-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements Our liquidity is not dependent on the use of off-balance sheet financing arrangements and as of September 30, 2014 we had no such arrangements. There has been no material change in our contractual obligations other than in the ordinary course of business since the eleven months ended December 31, 2013. Quarterly Trends Our operating results fluctuate from quarter to quarter as a result of a variety of factors. We expect our operating results to continue to fluctuate in future quarters. Our results reflect the effects of seasonal trends in listener behavior. During the last three months of each calendar year, we experience higher advertising revenue as a result of greater advertiser demand during the holiday season. We also experience lower advertising revenue in the first three months of the calendar year due to reduced advertiser demand. In addition, we expect to experience increased usage during the last three months of each calendar year during the holiday season, and in the first three months of each calendar year due to increased use of media-streaming devices received as gifts during the holiday season. We believe these seasonal trends have affected, and will continue to affect our operating results, particularly as increases in content acquisition costs from increased usage are not offset by increases in advertising revenue in the first calendar quarter. We believe that our business may become more seasonal in the future and that such seasonal variations in listener behavior may result in fluctuations in our financial results. In addition, expenditures by advertisers tend to be cyclical and discretionary in nature, reflecting overall economic conditions, the economic prospects of specific advertisers or industries, budgeting constraints and buying patterns and a variety of other factors, many of which are outside our control. As a result of these and other factors, the results of any prior quarterly or annual periods should not be relied upon as indications of our future operating performance. Liquidity and Capital Resources As of September 30, 2014, we had cash, cash equivalents and investments totaling $437.3 million, which consisted of cash and money market funds held at major financial institutions, commercial paper and investment-grade corporate debt securities. Our principal uses of cash during the nine months ended September 30, 2014 were funding our operations, as described below, and capital expenditures. Sources of Funds We believe, based on our current operating plan, that our existing cash and cash equivalents and available borrowings under our credit facility will be sufficient to meet our anticipated cash needs for at least the next twelve months. From time to time, we may explore additional financing sources and means to lower our cost of capital, which could include equity, equity-linked and debt financing. In addition, in connection with any future acquisitions, we may require additional funding which may be provided in the form of additional debt, equity or equity-linked financing or a combination thereof. There can be no assurance that any additional financing will be available to us on acceptable terms. Our Indebtedness We are party to a $60.0 million credit facility with a syndicate of financial institutions, which expires on September 12, 2018. Refer to Note 8 "Debt Instruments" in the Notes to Condensed Consolidated Financial Statements for further details regarding our credit facility. Capital Expenditures Consistent with previous periods, future capital expenditures will primarily focus on acquiring additional hosting and general corporate infrastructure. Our access to capital is adequate to meet our anticipated capital expenditures for our current plans. Historical Trends 32-------------------------------------------------------------------------------- Table of Contents The following table summarizes our cash flow data for the nine months ended September 30, 2013 and 2014. Nine months ended September 30, 2013 2014 (in thousands) (unaudited)Net cash used in operating activities $ (11,713 ) $ (4,315 ) Net cash used in investing activities (4,135 ) (109,954 ) Net cash provided by financing activities 393,019 17,570 Operating activities In the nine months ended September 30, 2014, net cash used in operating activities was $4.3 million and primarily consisted of our net loss of $42.7 million, which was more than offset by non-cash charges of $73.6 million, primarily related to $60.1 million in stock-based compensation charges. Net cash used in operating activities also included a $24.4 million decrease in deferred revenue from December 31, 2013, primarily due to the one-time recognition of the accumulation of deferred revenue related to in-app subscriptions of $14.2 million and due to a decrease in deferred revenue as a result of the elimination of the annual subscription option, as we collected less cash upfront under the one-month subscription period as opposed to the twelve-month subscription period under the annual subscription option. Cash used in operating activities decreased $7.4 million from the nine months ended September 30, 2013 primarily due to a $7.0 million decrease in our net loss. Investing activities In the nine months ended September 30, 2014, net cash used in investing activities was $110.0 million, primarily due to $273.4 million of purchases of investments and $23.2 million of capital expenditures for leasehold improvements and server equipment, partially offset by $186.7 million in maturities of investments. Financing activities In the nine months ended September 30, 2014, net cash provided by financing activities was $17.6 million, primarily consisting of $15.2 million in proceeds from the exercise of stock options. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Our estimates form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimate that are reasonably likely to occur, could materially impact the condensed consolidated financial statements. We believe that our critical accounting policies reflect the more significant estimates and assumptions used in the preparation of the condensed consolidated financial statements. Other than those discussed below, there have been no material changes to our critical accounting policies and estimates as compared to those described in our Transition Report on Form 10-K for the eleven months ended December 31, 2013 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates." Deferred Revenue 33-------------------------------------------------------------------------------- Table of Contents We were required to defer revenue for certain in-app mobile subscriptions that contained refund rights until the refund rights lapsed or until we developed sufficient operating history to estimate a return reserve. As of December 31, 2013, we had deferred all revenue related to these in-app mobile subscriptions subject to refund rights totaling approximately $14.2 million, as we did not have sufficient history to estimate a return reserve. Beginning in January 2014, we had sufficient historic transactional information which enabled us to estimate future returns. Accordingly, in January 2014, we began recording revenue related to these in-app mobile subscriptions net of estimated returns. This change resulted in a one-time increase in subscription revenue in the three months ended March 31, 2014 of approximately $14.2 million, as the previously deferred revenue was recognized. As of September 30, 2014, the deferred revenue related to the return reserve was not significant. Stock-Based Compensation Stock-based compensation expenses are classified in the statement of operations based on the department to which the related employee reports. Our stock-based awards are comprised principally of restricted stock units ("RSUs") and stock options. We measure stock-based compensation expense for employees at the grant date fair value of the award, and recognize expense on a straight-line basis over the requisite service period, which is generally the vesting period, net of estimated forfeitures. We estimate the grant date fair value of RSUs at our stock price. We generally estimate the grant date fair value of stock options using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model is affected by our stock price on the date of grant, the expected stock price volatility over the expected term of the award, which is based on projected employee stock option exercise behaviors, the risk-free interest rate for the expected term of the award and expected dividends. Stock-based compensation expense is recorded net of estimated forfeitures in the statement of operations for only those stock-based awards that we expect to vest. We estimate the forfeiture rate based on historical forfeitures of equity awards and adjust the rate to reflect changes in facts and circumstances, if any. We will revise our estimated forfeiture rate if actual forfeitures differ from our initial estimates. 34-------------------------------------------------------------------------------- Table of Contents |