Pandora (NYSE:P) is the leader in Internet radio offering personalized radio services to its listeners. In the broader radio market, it competes with radio service providers such as Clear Channel Radio, CBS Radio (NYSE:CBS), Sirius XM (NASDAQ:SIRI) along with on-demand music services such as Spotify. The company primarily makes money from advertising and has not generated positive cash flows yet, which is one of the primary concerns for the investors presently.
Can it do so in the future? What are the risks that exist and what can Pandora do about it? Here we look at some risks associated with its business model.
The Business Model
Pandora’s service is Internet-based and, therefore, the company specifically needs to secure the rights to stream music over the Internet. For this, it obtains relevant licenses from copyright owners of sound recordings and music compositions and pays royalty fee to them. The majority of the expenses arises from royalties paid to copyright owners of sound recordings.
Given that these royalty rates are established and intermediated by an independent body SoundExchange, Pandora cannot leverage a higher base to negotiate favorable rates directly with copyright owners. This implies that the costs are going to increase in direct proportion to listener hours and the company may not become profitable unless it finds a way to offset these costs.
Increasing Royalty Rates & Risk
Previously, Pandora had to pay according to the royalty rates established by Copyright Royalty Board (CRB). However, due to the lobbying efforts by webcasters, the U.S. government passed a law that allowed them to negotiate rates directly with SoundExchange. This helped bring down the costs for Pandora as well, but that may not be enough.
As visible in the chart below, the content acquisition costs dropped from 82% in 2008 to about 50% in 2010 supported by the new law. However, the problem is that the royalty rates are set to increase each year until 2015, after which a new schedule will be negotiated.
There are two risks.
First, Pandora may not be able to increase its monetization rate (either via ad or subscription) to offset rising royalties.
Second, the re-negotiation of contracts may lead to substantially higher royalties as SoundExchange has been trying to push the same for the satellite radio services.
What Can Pandora Do?
Pandora can try to do a few things:
- Push for direct negotiation with copyright owners.
- Increase the ad rates or frequency of ads for its free users
- Increase the subscription fee and push subscription-based service by effective marketing and enhancing features
- Offset royalty costs by reducing other expenses (as % of revenues) such as sales and marketing, general and administrative and product development costs.
Our current price estimate for Pandora stands at $9.89, implying a discount of little under 15% to the market price. We have priced Pandora assuming that a decline in other costs and improved monetization will help it mitigate content-related costs and make it profitable in the future. If that doesn’t happen, the stock may see a drop.