Pandora Media (NYSE:P) has been urging its users to support a bill called the “Internet Radio Fairness Act,” which was introduced recently and is under the consideration of the U.S. Congress.  This bill is aimed at bringing Internet radio business under the same roof as terrestrial and satellite radio. The basic issue is that Pandora pays much higher royalties (as a % of revenues) for music compared to traditional radio companies such as Sirius XM (NASDAQ:SIRI). Part of this has to do with higher rates and partly with the fact that Pandora is an under-monetized service due to its almost sole dependence on advertising revenues. It appears that, in the near term, Pandora will continue to suffer losses unless it can improve its mobile monetization significantly or lower its royalty rates. The Internet Radio Fairness Act aims to address the latter. If the bill is passed, it could add significant upside to Pandora’s stock.
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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 for which it pays a royalty fee. The majority of the expenses arise from royalties paid to copyright owners of sound recordings.
Given that these royalty rates are established and intermediated by the independent body SoundExchange, Pandora cannot leverage a higher base to negotiate favorable rates directly with the copyright owners. This implies that the costs will 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 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, but that may not be enough.
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.
100% Potential Jump In Stock If The Bill Is Passed
For 2011, Pandora’s content acquisition costs stood at close to 54% of its total revenues. In comparison, Sirius XM’s revenue sharing and royalty costs stood at around 18% of its subscription revenues for the same year. However, this is not a true comparison. Sirius XM spends additional money on acquiring and producing the 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 29% of its subscription revenues in 2011. This still puts Pandora’s content spending (as % of revenues) at a much higher level compared to Sirius XM.
If, as a result of the bill, Pandora’s content spending was to come down to a level similar to that of Sirius XM, there could be more than 100% upside to our current price estimate of $9.85. Our current price estimate is in line with the current market price. You can modify our forecast above to see how a change in content acquisition costs (as % of revenues) can impact Pandora’s price estimate.Notes: