Pandora Faces Significant Profit Headwinds With Proposed Royalty Hike And Department Of Justice Review

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For a long time now, there has been significant uncertainty around Pandora Media‘s (NYSE:P) long term sustainability. The company is among the largest Internet radio providers in the U.S. and it relies on advertisements for a bulk of its revenues. Although Pandora provides its customers with an option to remove ads with a $4.99 per month subscription, only 5% of the listeners choose to switch to ad free subscription. Others don’t mind ads as long as the music is free.

While Pandora’s listeners enjoy free music, the company spends a huge amount to buy the rights for these songs from artists, labels and songwriters. In fact, it spends more than half of its revenues on content acquisition and yet, the music industry believes that it is not being paid fairly by free music providers such as Pandora. Although Spotify claims that it pays close to 70% of its revenues back to the music industry, the problem is that such services aren’t making enough money through advertisements to satisfy songwriters and artists, while maintaining a steady bottomline growth. Moreover, several music labels have pointed out the fact that availability of free music deters the sales of their songs and albums through other more lucrative channels. For instance, Taylor Swift, recently pulled back her songs from Spotify, in an effort to drive the sales of her newly launched album, 1989.

Free music providers such as Pandora pay a royalty fees to songwriters and labels on per performance basis. It is interesting to note that at current royalty rates,  with which the music industry isn’t satisfied, Pandora is not profitable. The company reported net loss of $16.7 million in 2012, $38.1 million in 2013 and $42 million for the first nine months of 2014. While Pandora is already struggling to generate profits, a proposed rise in royalty rates and the ongoing Department of Justice review can cause further damage. The outcome of both can potentially increase Pandora’s content acquisition cost in the future.

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Our current price estimate for Pandora stands at $24, implying a premium of close to 40% to the current market price.

See our complete analysis for Pandora Media

Royalty Rates can Trouble Pandora

Copyright Royalty Board has set the royalty rates for Pandora Media on per performance basis. The Internet radio provider has stated in the past that royalties it pays have increased by 53% in the last five years and will go up by another 9% in 2015. During the last quarterly earnings call, the company’s CFO stated that Pandora has already paid more than $1 billion in royalties, which is highest among all the radio forms. While the Internet radio provider already pays a significant amount in royalties, it might have to pay even more in the coming years, thanks to SoundExchange’s latest proposal. Pandora paid just 0.00093 cents per performance in 2010 and it increased by only 10% every year, amounting to 0.0013 cents in 2013. For the next two years, the rates were set at 0.0014 cents and 0.0015 cents, respectively.

Although the increase in royalty rates has been moderate so far, SoundExchange has proposed a significant increase going forward. According to the proposal, SoundExchange wants to set royalty rates for Pandora at 0.0025 cents for 2016, with a 0.0001 cent increase every year through to 2020. [1] Given that royalties account for almost 40% of Pandora’s expenses, an increase in rates could greatly impact the company’s bottomline growth, which is already struggling. This is the reason why Pandora is soliciting legal help to bring down the proposed rates slightly. [2]

Department of Justice Review also Poses a Threat

The music industry has been repeatedly complaining about the outdated federal laws that governed royalties paid to songwriters and artists. In response to this, the Department of Justice decided to review the regulatory agreements for Ascap and BMI, two prominent licensing clearinghouses, earlier this year. [3] If the Department of Justice rules in the favor of the publishers, Pandora would no longer be able to buy the rights for the songs at rates set by the court. Instead, it would have to enter different agreements with content owners, that would give them the right to negotiate prices with Pandora. [4] This would most likely result in the Internet radio provider paying a significantly higher amount than it is paying right now, which is not a good news for its profits. The decision on the matter is expected shortly.

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Notes:
  1. Webcasting rate proposals for 2016-2020 now public, Broadcast law blog, Oct 19 2014 []
  2. Pandora’s Q3 2014 earnings transcript, Oct 24 2014 []
  3. Justice Department Plans to Begin a Review of Music Licensing Rules, The New York Times, Jun 4 2014 []
  4. Will Pandora Survive 2015, Ouartz, Nov 19 2014 []