How to Fix a Broken Business Model
Halina is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Pandora Media (NYSE: P) has not been having an easy time on the markets since its IPO in June of 2011. The stock tumbled to under $8 a share at one point, way down from its starting price of $16. Currently, the online radio company trades at $10 a share, but experts estimate that its price will head into single digit territory in the coming months. This is in spite of Pandora clearing over $80 million in revenues for the most recent quarter and predicting about $100 million for the upcoming one. Why the investor doldrums?
You Can't Beat Free Radio, Right?
As an idea, Pandora makes good on the promise to bring free streaming radio to its users which, according to the company's first quarter results, numbered almost 52 million and streamed nearly 3.1 billion hours of content. Pandora Radio streams across numerous platforms too, including computers, autos (e.g., Toyota Camry), mobile devices and consumer electronics (e.g., Roku). Pandora's free radio version features ads; its ad-free version, known as Pandora One, is available with a $36/year subscription. The lion's share of Pandora's revenue (87%) comes from sponsor advertising, with the remainder being subscriber fees.
Unfortunately, Pandora also has to "pay the piper" every time a song is accessed by a subscriber, whether paid or free. Those royalty fees currently amount to almost 50% of the company's generated revenue. At one time, they were as high as 80%! Most of the fees are paid to SoundExchange, a non-profit government organization that redistributes the monies to song artists and sound recording copyright owners. Smaller royalty payments are also made by Pandora to BMI (Broadcast Music, Inc.), ASCAP (The American Society of Composers, Authors and Publishers) and SESAC (Society of European Stage Authors & Composers).
Because Pandora's business model has been touted as a provider of "free Internet radio" since its founding in 2000, the company derives most of its revenues from online and mobile advertising. Subscriber generated earnings constitute a much smaller portion of Pandora's pay, with many users only knowing that Pandora means "free radio." However, with any for-profit business (including terrestrial radio), nothing is really "free"- the costs are merely hidden in the intrusive ads that radio listeners have always hated and the biggest reason why they switched to Internet radio in the first place. As Pandora seeks to become profitable, it will probably resort to more advertising, thereby increasing the risk of alienating its listeners.
More Sirius About Money?
By comparison, Sirius XM Radio (NASDAQ: SIRI), which provides Internet radio but specializes mostly in satellite radio, reported earnings of $805 million and a net income of $108 million for the most recent fiscal quarter, giving it a profit margin of 13.4%. What made Sirius so much more profitable than Pandora? Lower royalty payments, for starters. Compared with Pandora, Sirius paid out $225 million in royalties on its 2011 revenues of over $3 billion. On its projected 2012 revenues of $3.3 billion, Sirius is supposed to pay $264 million in royalties. Pandora, on the other hand, was shelling out nearly $56 million in royalty fees on this quarter's revenues of roughly $81 million. That's almost 70%! With other costs included, the company ended up being in the hole by $20 million. On Pandora's 2011 revenues of $274 million, content acquisition costs were nearly $149 million, leading to an income loss of almost $11 million.
Part of the reason for this payment difference is because satellite radio is charged a much lower song royalty rate compared to Internet radio (although that may change in the future). However, Sirius does not just play endless songs on all of its stations. Only 71 stations on Sirius XM actually play commercial-free music; the rest are dedicated to news programs, political commentary, sports, etc. The amount of actual music content that Sirius streams is thus far less than Pandora, making its business model more sustainable.
Furthermore, subscribers to Sirius have always understood it to be a paid radio service. Sirius subscriptions provide 75% or so of the company's revenue, with 70% of that derived from subscribers that have satellite radio installed in their vehicles. Advertising makes up not even 10% of Sirius' overall revenue stream, allowing the company to provide top quality and nearly ad-free service to its subscribers. Aside from the enormous selection of radio stations, having commercial-free radio stations is one of the biggest perks of non-terrestrial radio.
So, What's a Pandora to Do?
The name Pandora drives from the Greek word Pan, meaning all, and Dora, meaning gifted or giving. Pandora Media has, perhaps unfortunately, lived up to its namesake by giving away too much for too little. Indeed, back in 2008 Pandora announced that it would probably cease operations because royalty fees were eating up too much of its revenues. This ominous announcement came on the ruling of a federal panel that song royalty fees be doubled for Web radio providers. Pandora, which at the time was already paying out 70% of its revenues to artists and record companies, noted that the increased fees would put it out of business. Fortunately, by July of 2009 an agreement was reached by Pandora and SoundExchange and the proposed royalty fees lowered to a more realistic sum.
Nevertheless, Pandora still struggles to achieve profitability. Because the company must pay the majority of its royalties through a third party intermediary, it cannot directly negotiate rates with copyright owners. Also, the current pay schedule set by SoundExchange is set to increase each year until 2015. So, what can the "all-giving" company do? Here are my recommendations:
1. Start pushing paid subscriptions. Pandora can offer trial subscriptions to its ad-free Pandora One premium service. Once users have customized their music subscriptions via the company's Music Genome Project and become used to Pandora's large selection of songs, they'll be reluctant to return to the ad-infested free service.
2. Raise the subscription price. Currently, Pandora One costs only $36/year. That's an incredible bargain compared with Sirius XM's $29.99/month subscription plan. Pandora could probably charge $36/month for its premium subscription and still win new subscribers.
3. Fight for direct negotiation with copyright owners. Recently, Sirius XM sued SoundExchange for federal antitrust activities relating to "an industrywide conspiracy” preventing Sirius from directly dealing with labels. In essence, Sirius claimed that SoundExchange put pressure on labels to not sign the deals that Sirius had sent to them. These deals paid less to the labels than SoundExchange. While Pandora need not sue any entity just yet, it should push for direct negotiation rights with artists and studios. Otherwise, its business model might not be sustainable.
4. No more ads please! The last thing that Pandora should do is push for more advertising, a maneuver that has been suggested by many a company analyst to increase company revenues. Ads will only push subscribers away, since that is what they already endure - and hate- with terrestrial radio.
halina23 owns shares of Sirius XM Radio. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.