The way music royalties are paid to artists and record labels work very differently for Sirius XM (NASDAQ:SIRI) and Pandora (NYSE:P), respectively. Yet both the companies are engaged in a similar battle to gain greater control over the royalty rates in a bid to stem rising content costs. These costs constitute a very large portion of their overall expenses and have been the primary determinants of their profitability. Pandora is still running as its current level of ad monetization is insufficient and its content acquisition costs stands at more than 55% of its revenues. Since Pandora is an Internet radio service provider, it can accurately measure how many times a specific song was played during a specific period. Therefore, the company has to pay royalties to artists and record labels on per song basis. As a satellite radio service provider, Sirius XM pays royalties as a proportion of its gross revenues.
Recently, SoundExchange sued Sirius XM demanding somewhere between $50-$100 million in royalty payments for certain songs that the radio company played between 2007 and 2012.  This case sheds light on what has been an ongoing battle between radio companies, intermediary bodies and music owners. The repercussions can be significant for both Pandora and Sirius XM if royalty rates were to jump. A lot of these artists have spoken out against extremely low compensation levels they receive from these radio companies. Let’s take a look at what this means for Sirius XM and Pandora.
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Sirius XM’s Intentions Of Direct Negoatiations
Last year, Sirius XM filed a complaint against SoundExchange Inc. and the American Association of Independent Music with the intention of cutting out the mediating organizations in order to secure audio licenses directly from the labels and artists. This will give the company greater flexibility, a price advantage and faster processing. Sirius XM argues that SoundExchange currently deducts its administrative fee from the royalties that the companies pay. Sirius XM can eliminate this thus benefiting the artists. Furthermore, it may also be looking at personalizing its radio service as direct access to record labels could help it personalize and improve its service better.
On the other hand, SoundExchange believes that it is protecting the artists and copyright owners who might not get favorable terms if Sirius XM is allowed to directly negotiate with them. The organization believes that current royalty rates are below the market standards and plans to raise them for Sirius XM. SoundExchange was looking to raise the royalty rate from 7.5% of the gross revenue in 2011 to 13% of the gross revenue in 2013. According to royalty rates set by Copyright Royalty Board, Sirius XM has to pay 9% of gross revenues as royalty payment in 2013, but argues that the market rate is around 5% to 7% of the defined revenue.
The relevant cost driver in our model that gets affected as a result of this legal battle is Sirius XM’s revenue share and royalty cost. Given the subscription and advertising revenues of close to $3.05 billion in 2012 and 8% royalty rate, we estimate that Sirius XM paid close to $245 million in royalty fee while total royalty & revenue share cost stood at $551 million. If the royalty rate rises to 13%, Sirius XM will be paying close to $450 million in royalty fee alone which can result in a downside of about 10-15% to our current price estimate.
Pandora’s Battle To Lower The Royalty Rates
Given that the Internet radio royalty rates are established and intermediated by the independent body SoundExchange, Pandora does not have the same leverage to negotiate favorable rates directly with the copyright owners. This implies that the costs will increase proportionally with listener hours, and the company may not become profitable unless it substantially improves its monetization.
Previously, Pandora had to pay according to the royalty rates set by the 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. However the company is also urging its users to support a bill called the “Internet Radio Fairness Act,” which was introduced last year and is aimed at bringing Internet radio business under the same roof as terrestrial and satellite radio. This could improve its cost structure further.
For 2012, Pandora’s content acquisition costs stood at just over 60% of its total revenues. In comparison, Sirius XM’s revenue sharing and royalty costs stood at around 18.6% of its subscription revenues for the same year. However, this is not a true comparison. Sirius XM spends additional money on acquiring and producing content, the costs of which do not come under the revenue sharing model. Keeping this in mind, the overall content related costs for Sirius XM stood at close to 30% of its subscription revenues in 2012. This still puts Pandora’s content spending (as percentage of revenues) at a much higher level compared to Sirius XM. If this spending was to come down to a level similar to that of Sirius XM, there could be close to 90% upside to our current price estimate of $14.50. On the other hand, there could be a downside of close to 50% if the spending was to remain at around current levels. There is a lot of incentive for the company to push for the bill, and there’s a lot of uncertainty around its future cost structure.
Our price estimate for Sirius XM stands $3.20, implying a discount of about 15% to the market price.Notes: