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Pandora paying hefty sums for music royalties

By Vignesh Ramachandran | 5 Mar 2012

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Tomorrow’s fiscal fourth quarter and year-end earnings report will likely shed light on whether Pandora Media, Inc. (NYSE: P), the internet radio company, will be able to offset growing costs with revenue growth.

While its listener base is consistently growing, analysts say that, at least in the short term, a crescendo of costs continues to threaten the company’s bottom line due to expensive music royalties and a heavy dependence on advertising revenues.

Longer term, most analysts are bullish, however. Earlier today, Pandora saw its stock shoot up almost 6 percent after Jordan Rohan at Stifel Nicolaus raised his rating to “buy” from “hold,” citing the company’s ability to leverage its platform to take advantage of growth in mobile and tablets.

In its fiscal Q3 earnings results announced last November, the company reported total listener hours of 2.1 billion for the quarter, a key metric for the music streaming service.  That represented a 104 percent growth year-over-year.

But with this growth, the company is racking up more content acquisition and royalty costs. Content acquisition costs for the third quarter stacked up to $37.6 million, accounting for almost 51 percent of the company’s total costs and expenses. This is up from $18.1 million in the same quarter of 2010. The ratio between content acquisition costs and total costs and expenses remained about the same, at almost two-to-one.

Pandora analyst Rich Tullo, of Albert Fried & Co., said content acquisition costs will move up or down correspondingly with revenues. He expects fiscal Q4 total revenues to be $78.6 million, and content acquisition costs to correspond at around $35 million. However, today, Rohan said he expects the company to report revenues of $86.5 million, or one cent per share. He also set a stock price target of $18. Pandora began trading on the New York Stock Exchange in June 2011 at $16 a share. After-hours, Pandora shares were trading at $14.98.

Pandora is considered a general broadcaster, and like all terrestrial radio broadcasters, it can play any content that is made publicly available. By contrast, digital music services, like Spotify or Apple’s iTunes, play by different rules and forge different sorts of agreements with musicians, because they are not broadcasters.

As a broadcaster, Pandora is not prohibited from playing new music for 30 days and hasn’t traditionally had to woo bands with lucrative deals. For example, Adele’s chart-topping album, “21,” is still not available for streaming on Spotify, after disagreements over the terms of streaming access. Coldplay’s latest album, “Mylo Xyloto,”  only became available a few weeks ago on Spotify, months after its October 2011 release.

After launching in 2005, Oakland, Calif.-based Pandora in 2009 adopted a “freemium” model: offering a free, ad-supported base service and a premium, ad-free “Pandora One” subscription for $36 per year. But the numbers show that subscription dollars are dwarfed by the almost 88 percent of fiscal Q3 revenues that came from advertising.

What’s more, each time one of the tracks in Pandora’s library of more than 900,000 songs is played, the company must pay full royalties—even if the song only plays for a few seconds. This is why the service limits free users to the number of times that songs can be skipped on stations. “The daily skip limit helps us prevent having to pay royalties on songs that are not being heard,” the company states in its online help section.

Pandora pays royalties in two parts: First, the company pays the composer and songwriter 5 percent of revenues through the big three performance rights organizations: The American Society of Composers, Authors and Publishers (ASCAP), Broadcast Music, Inc. (BMI) and SESAC. Then on a per track basis, the company also pays the performer and the record label $0.0011 through SoundExchange, a non-profit organization that operates as an independent middleman collector.

On Feb. 14 at the Goldman Sachs Technology and Internet Conference in San Francisco, Pandora Chief Financial Officer Steve Cakebread said payments to music royalty collectors all translate into artist funding.

“That’s a big part of our experience as well is that we help artists get discovered, through your discoveries. We also make sure that the artists get paid,” Cakebread said.

Pandora analyst James Goss, at Barrington Research Associates, said the metrics to focus on are not royalty costs, but rather the company’s numbers of active users and the listener hours. “That’s what’s going to generate the potential for ad revenues for the most part,” Goss said.

As of last October, Pandora had 40 million active users of its 100 million registered users. Listener hours have doubled year over year, to the 2.1 billion hours reported for Q3.

The company is trying to localize Pandora and has initiated advertising offices in some of the country’s largest radio ad markets, according to Tullo. He said the strategy is about tapping into local markets by transitioning local advertisers from buying spots on traditional radio to Pandora.

Those audio advertising slots are the most important assets that will drive the value of Pandora, Tullo believes.

“Right now, that minute an hour is being sold at digital pennies, and it really should be selling at media dollars,” Tullo said.

Pandora declined comment. But in its third fiscal quarter earnings report said:  “…Our ability to achieve operating leverage depends on our ability to increase our revenue per hour of streaming through increased advertising sales.”

Compounding matters, more than 70 percent  of Pandora users listen on their mobile devices, often in vehicles. Since effective mobile advertising has not reached maturity, monetizing this growth in mobile use continues to be a challenge some analysts say.

In its Q3 earnings report, the company acknowledged, “The mobile advertising market is nascent and faces technical challenges due to fragmented platforms and lack of standard audience measurement protocols.”

However, Rohan today pointed to Pandora’s capability of becoming a mobile advertising platform, noting “increased downloads from new connected devices (phones and tablets).”

Because so much radio listening occurs in the car, Pandora is actively teaming up with car manufacturers—most recently, Acura and Kia Motors America, Inc.—to incorporate the service in its new vehicles. This positions Pandora as a growing competitor to Sirius XM Radio, the sole satellite radio provider that has been an option in most vehicles for many years.

Pandora reported a modest net income of $638,000 in Q3, a decline from the same quarter in 2010 when the company recorded profits of $1,044,000.

“I think they feel they can generate incremental ad dollars, particularly in the mobile platform, that will help improve the rate of profitability over time, or create profitability and then improve it,” Goss said.

Dr. Gigi Johnson is the Los Angeles-based executive director of the Maremel Institute, which studies digital change issues in the media business. She said in companies like Pandora a “real tension” exists between having enough advertising or too much advertising.

Johnson, who also lectures at UCLA about digital media and disruptive technologies, explained that the history and discussion surrounding music royalties is complex. While Pandora’s content acquisition costs appear large at initial glance, with context as Johnson suggests, the numbers may actually make sense.

“It’s other people’s music that they’re providing,” Johnson said. “It’s valid that they should be paying out a decent chunk of change.”

The company’s fiscal Q4 and year-end earnings are scheduled to be released at 5 p.m. Eastern Standard Time March 6.

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