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Just recently, Pandora Radio (P) reported impressive numbers for FY 2012, including:

  • 8.2 M listener hours, a 109% increase from 2011, and over 5% market share.
  • Mobile use accounted for 65% of total listener hours.
  • 62% YOY increase in active users, which grew to 47 M.

Revenue Growth:

In addition to growth in listener hours and total users, revenues also increased dramatically. The company experienced nearly 100% increase in revenue since last year, led by immense growth in mobile revenues. This critical segment which equaled 65% of total use, quadrupled revenues versus 2011, growing from $25M to $100M. As per the 10-K, revenue growth has been very healthy since 2010:

The portrait I have painted thus far seems beautiful, except for one problem, Pandora has yet to turn a profit, nor meaningfully grow earnings, and admits it may suffer losses at least through 2013. Why is this? The company states the issue clear as day on page 13 of the 10-k:

...as the number of listener hours increases, the royalties we pay for content acquisition also increases...

Content Acquisition Costs:

A quick look at the financial metrics indicate the growth in listener hours which led to the increase in revenues, also led to a huge increase in content acquisition costs: (click to enlarge)

As a percentage of total revenue, it seems content acquisition has stayed relatively steady at around 50%-60% of revenues over the past 3 years:

This means for every dollar of revenue the company generates, more than $0.50 gets eaten up by royalty payments. These royalties are like a ball and chain for Pandora, and are unique to its internet radio business. The company admits other radio business models, such as terrestrial radio, pay zero royalties for its use of sound recordings, while satellite radio providers, such as Sirius XM (SIRI), pays just 8% of total revenues for content. These much lower content costs give broadcast and satellite radio companies distinct cost advantages over Pandora. I suppose higher content costs is the price it pays for access to the fast growing market of internet radio. Why is Pandora paying so much for content?

Content Agreements:

Perhaps in response to the Napster bonanza at the turn of the century, the royalty rates established by the government for streaming music were so pricey, Pandora wouldn't exist today if they were still in effect. In response to lobbying efforts of internet companies including Pandora, Congress passed the Webcaster Settlement Acts, which resulted in the more favorable royalty rates currently in effect. These lower rates were implemented in 2009 by the CRB, and will exist under law until 2015. Therefore, Pandora can do little to reduce content costs until 2015, as the current statutes do not expire until this time. However, this opportunity to reduce content costs at expiration is a simultaneous threat, as a rate increase is just as possible. The company stated on page 20 of the 10-k:

The CRB, which still has rate-making authority over us upon expiration of our agreement with SoundExchange, has consistently established royalty rates that would, if paid by us, consume an unsustainable percentage of our revenue. If we are unable to reach a new agreement with SoundExchange for the period after 2015, our operating costs may significantly increase, which could harm our financial condition and inhibit the implementation of our business plan.

Summary:

Pandora may turn a small profit in 2014 if it continues to grow revenues as meaningfully as it has over the past 3 years. However, this growth is only a prelude to what could be the most important event in Pandora's history; the 2015 CRB rate renewal. Pandora is at the mercy of this government entity, as content acquisition costs account for over 50% of revenues at current royalty rates. If these rates are reduced, Pandora's margins will increase greatly and will prove to be a fantastic, game changing catalyst for investors.

Source: Pandora Radio: Stuck In The Mud Until 2015's Catalyst