What If Pandora’s Royalty Rates Don’t Rise Much In 2016 And Beyond?

The Copyright Royalty Board (CRB) set Pandora Media‘s (NYSE:P) royalty rates for years until 2015, when SoundExchange, an independent body representing the music industry, proposed a 66% increase in the company’s per performance royalty rates for 2016. Both the parties have submitted their arguments with the Copyright office and the final verdict on the ‘Webcasting IV’ proceedings will be out by December 16th. Pandora is not profitable with the rates it currently pays to artists and song writers, which they feel are too low. And a substantial increase in royalty rates would raise several questions around the company’s long term sustainability.

Currently, content acquisition costs (which include advertisement and subscription based royalty payments) are at about 46% of Pandora’s revenues. If the CRB accepts SoundExchange’s proposal for advertisement royalty rates and even increases the company’s subscription royalty rates at a faster than historic pace, this figure could jump to 68% next year, which could result in a significant downside in our price estimate for Pandora. However, if the company is able to bend the verdict its way with only a moderate increase in royalty rates, the figure would increase to only around 52% in 2016 and decline slowly after a few years with operating leverage gain. At this point, it entirely depends on the rate of increase in Pandora’s per performance royalty rates and how rapidly it can grow its revenues.

To help our readers assess the impact, we have created a mini interactive model where they can modify Pandora’s Advertisement and subscription-based revenues, royalty rates, listener hours and per-performance duration to see the change in content acquisition costs as percentage of revenues. (select grid view on top right corner for concise view of all drivers and output).

Our current price estimate for Pandora stands at $19, implying a significant premium to the current market price.

See our complete analysis for Pandora Media

What Could Happen With Moderate Royalty Rate And Rapid Revenue Growth?

According to SoundExchange’s proposal, Pandora’s royalty rates should be revised up by two-thirds from $0.0015 in 2015 to $0.0025 in 2016. Pandora understandably is opposed to the increase. In our base case scenario, we have assumed that the CRB could set the increase in the royalty rates half way between the proposals, which means that Pandora could end up paying advertisement royalty rates at $0.0020 in 2016 with $0.0001 increase every year thereafter. Since much information is not available around subscription royalty rates proposal, we believe that the increase in the metric, which was at $0.0025 in 2014, should remain at its historic levels. With these predictions, content acquisition costs as a percentage of revenues comes out to be 57% in 2016, with a gradual decline following a few years of marginal increase.

1.) However, given that Pandora’s business sustainability is directly impacted by this decision, it will do its best to keep the rise in royalty rates near the historic levels. If advertisement and subscription royalty rates increase by just $0.0003 and $0.0002, respectively, in 2016 and rise by $0.0001 annually thereafter, content acquisition cost as percentage of revenues will come down to 52% in 2016 and 50% by 2022, as depicted in the image below. (The forecast is based on the assumption that advertisement and subscription revenues will grow at a CAGR of 16% and 14% respectively between 2014 and 2022)

2.) Additionally, Pandora can reduce the figure further by increasing its subscription and advertisement revenues at a faster-than-expected pace. In our base case, we project advertisement revenues to grow at a CAGR of 16% and subscription revenues to increase at a CAGR of 14%, between 2014-2022. A two percentage point increase in the figures would bring content acquisition cost as percentage of revenues down to 50% in 2016 and 44% over the next six years.

What Could Trigger The Fall In The Figure

A couple of months back, Pandora stated that the Copyright office has agreed to consider its deal with Merlin, a global rights agency, as a valid benchmark for royalties in the case. This was an important development for company on the rate setting front as it is comfortable with how it pays royalties through Merlin, an agency representing 20,000 independent music labels and distributors. There is cause for hope, accordingly, that the CRB’s verdict can go Pandora’s way. In another development, Pandora announced that it has signed a direct multi-year agreement with Sony/ATV, in order to provide “better” rates to artists and songwriters represented by the music publisher. The terms of the deal haven’t been disclosed yet, but it is apparent that Pandora is looking to shield itself against the future rise in royalty rates. In fact, the company stipulated that it would benefit from greater rate certainty, and the deal would allow more flexibility in its product offerings. Pandora is even reaching out to other music publishers, in an effort to extend the rate benefits across the board. The cumulative effect of the aforementioned factors may lead to a weaker-than-expected rise in royalty rates.

To grow revenues at a fast pace, Pandora is ramping up its sales & marketing teams to propel local advertising revenues. Terrestrial radio services currently dominate the local ad industry, earning close to $14 billion in revenues from local ads, which is over 80% of their overall ad revenues. Pandora on the other hand earns just over $200 million from local advertisement, which clearly indicates a huge scope for improvement. Effective monetization on this front can help the company improve its overall revenues at a faster pace and offset the impact of rising content costs.

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