It seems there is a considerable amount of confusion out there surrounding the Internet Radio Fairness Act which gets presented before Congress on Wednesday, November 28th. This is especially so when it comes to discussions surrounding royalty rates paid by the likes of Pandora (NYSE:P) and Sirius XM (NASDAQ:SIRI). The implications of this act encompass many companies and not just Pandora or Sirius XM. Investors in any company that is subject to music royalty payments such as Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Spotify, MOG, etc. will do well to pay attention to this proposed legislation. It's interesting hearing the different opinions on the subject, and quite often one's own long or short stock position or opinion of the underlying service serves to contribute to that individuals position on the proposed act.
At its core, the act which I will refer to as IRFA from here on, seeks to standardize royalty payments for the use of musician's music. The pioneer of the act is Pandora, and you can listen to the message from Tim Westergren, the founder of Pandora, here.
Simply listening to this plea, paints a picture that Pandora is being unfairly treated. Consider Tim's statement:
"To give you an idea of how extreme this discrimination is, last year Pandora paid 50% of our revenue to record labels and artists. That's over six times the rate paid by Sirius XM."
Sirius XM pays 8% of total revenue for 2012 in royalties as outlined:
(A) In general. The monthly royalty fee to be paid by a Licensee for the public performance of sound recordings pursuant to 17 U.S.C. 114(d)(2) and the making of any number of ephemeral phonorecords to facilitate such performances pursuant to 17 U.S.C. 112(e) shall be the percentage of monthly Gross Revenues resulting from Residential services in the United States as follows: for 2007 and 2008, 6.0%; for 2009, 6.5%; for 2010, 7.0%; for 2011, 7.5%; and for 2012, 8.0%
Rates are expected to move to 13% of total revenue in 2013, a 62.5% increase over 2012 rates.
Pandora pays a special reduced rate of $0.0011 per performance (played song), set to increase per year by one one hundreth of a percent. For 2013 the rate is $.0012 per performance.
For the record, Sirius XM pays, in IP streamed content (for instance, through the smartphone application), the same rate as Pandora.
So what's the problem with how this is being presented by Tim? It's simply apples to oranges. When you discuss payments in terms of percentage of revenue, your argument is fatally flawed. The issue? Pandora doesn't make enough money.
Consider that in order to get how much a company pays as a percentage of revenue, one must divide how much that company pays by the revenue that company receives. To figure Pandora's rate as a percentage of revenue is a simple task. Take the amount Pandora pays in royalties, and divide by revenue, and you arrive at the rate. How do you decrease this rate? Increase revenue, decrease delivery of songs, or negotiate a lower per song rate. Pandora is attempting the latter, first. But consider that because all IP delivered radio is subject to a 25% minimum rate, Pandora could achieve this rate by increasing advertising. It would not take much, either. Increased advertising has the dual effect of adding revenue as well as decreasing songs played per hour.
- If Pandora increased advertising, the percentage of revenue paid in royalties would decrease, down to a minimum of 25% of revenue.
- If Pandora charged a subscription to all users, the percentage of revenue paid in royalties would decrease, down to a minimum of 25% of revenue.
Why does Pandora pay upwards of 50% of revenue in royalties? It does not deliver enough advertising, or it does not charge enough (read : $0) for subscriptions.
So why the discrepancy between the minimum 25% rate set for IP delivery of radio and what will be a 13% rate set for satellite delivery of radio?
There are several factors which come into play here.
First, there is a huge difference between broadcasting a song over satellite, to the potential of the entire subscription base, and personally delivering one play of one song to one user. In the former, it's not particularly trackable how many users are listening to that performance at any given time. At 8 a.m. when most drivers are on their commute and tuned in to Sirius XM? The number of listeners is likely high. At 3 a.m.? The number of listeners is likely very low. Estimations must be made, and a per performance fee the same as IP delivery of radio, or $0.0011 per song, would be abysmally low. Thus, for Sirius XM, the decision was made that it would pay a percentage of total revenue.
Why is it that the 13% 2013 rate is not as high as the 25% rate of IP delivered radio? One must consider that satellite radio provides more than "just music" as a part of its subscription fee. Satellite radio also offers talk, sports, comedy, and specialty programming like the Howard Stern Show. Each of these channels or options costs Sirius XM a percentage of income as well, and each of these options make up the complete package of value that Sirius XM offers. Were Sirius XM a "music only" service, it is likely and reasonable to assume that it would be subject to a higher rate nearing 25% similar to IP delivered radio.
The core of the issue here is business models.
Sirius XM charges a subscription fee to each and every user, and thus each and every user pays for the content they are provided. This works for artists, who get paid a royalty, this works for Sirius XM which makes a profit from delivery, and this works for users who pay for content.
Pandora provides music for free to users, and primarily receives income from advertising. Artists receive their agreed upon royalty, but Pandora struggles with profitability because it is unable or unwilling to deliver enough advertising. Users pay nothing except brief moments of their time subject to advertising. Pandora's advertising is exceptionally light when compared to terrestrial radio.
I understand the confusion here, and what I feel is misconception by many. Using the percentage of revenue comparison may be a good way to drum up support from those who take this at face value, but when this is presented to Congress (and likewise picked apart by artists, publishers, rights holders, their lawyers, etc.) the smoke and mirrors of the numbers game should be easy to expose.
Besides, how often are these rates going to be argued by Tim Westergren?
Consider when the rates were agreed upon in 2009, the following quotes by Tim:
"This is what we've been waiting for," Tim Westergren, founder of Oakland, California-based Pandora, said in an interview. "It's going to allow us to survive for a long time.
"The big anvil all this time has been the per-song minimum," Westergren said. "It's been reduced enough that we'll be able to make it."
Why has Pandora been unable to "make it"? It's hard to "make it" when you buy something, in this case a song, and then give it away for free.
Consider the table at this link here.
Now take the data for active users of 54.9 million and divide it into hours listened of 1.12 billion. Average hours listened per active user? 20.4. Assuming 12 songs per hour with commercials, cost to Pandora per user is $0.27 or $3.24 per year. If one considers 15 songs per hour with no advertising (subscription required) then the cost per user is $4.04 per year.
How much does Pandora need to charge per subscriber in an ad-free environment in order to pay the 25% minimum rate? $1.35 per month or $17 per year. How much does Pandora need to secure in advertising per user in order to pay the 25% minimum rate? $1.08 per user per month, or $12.92 per year.
At current rates by securing just 5 cents per day per user, Pandora would become extremely profitable. That's very important to consider. Why can't Pandora get individuals to pay 5 cents per day? Sirius XM is able to acquire revenue of nearly 40 cents per day from its users with a current ARPU of $12.14.
By looking at the per user cost to Pandora, and considering a majority are "free" users and not subscribers, we can compare (roughly) what Pandora pays per user vs. what Sirius XM pays per user in royalties. Pandora, as calculated above, pays roughly $0.27 per month, per user. Sirius XM pays varied amounts depending on the subscriber with ARPU at $12.14 per month. Sirius XM pays $0.97 per month per user and is set to pay $1.58 per month per user in royalties in 2013, or 584% MORE than what Pandora pays per user.
Funny how numbers can look so different when presented in different ways. When looked at in this light it begs the question, why doesn't Pandora simply charge all users $12.95 per year?
Perhaps that's the plan? Get government to fix the rates to artists, and then increase advertising and/or fees and rake in the cash.
I expect that SoundExchange, artists, and rights holders will prevail here. It's not about my long position in Sirius XM and it's not about the fact that I enjoy Pandora as a service but dislike Pandora as a business and investment. The fact of the matter is that the artists have a right to charge as they see fit for their creations, and that includes the right to charge more or less depending on the method of delivery and the composition of "total package" content provided by the companies that distribute their work.
Supporters of IRFA are on thin ice here and Internet radio providers such as Pandora had better be careful what they wish for. If the playing field is leveled as a per user royalty rate, and matched with what SIRI pays, Internet radio will absolutely cease to exist without charging a subscription. Invest accordingly.
Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.