Pandora Media (NYSE:P) has been repeatedly challenged over its royalty fee agreements by organizations such as Ascap and BMI that represent songwriters in the U.S. The U.S. Justice Department will review these agreements and the outcome could notably impact Pandora’s business. The key risk includes the possibility of an increase in royalty rates which could prompt Pandora to rethink its business model and focus more on promoting a subscription-based service. Such promotion could include incentives that deter the usage of an ad-supported free service. This, in turn, will impact its user base growth. The situation underscores the ongoing battle of artists, songwriters and label companies against Pandora. Pandora has struggled to become profitable even with current royalty rates, and any increase would further dent its ability to churn profits.
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. The company has mostly given up its legislation efforts and has been seeking other resolutions for reducing royalty rates. The company’s management had stated last year that it expects to lower its content acquisition costs (as % of revenues) to 40% over the next few years. It may not be an easy task considering consistent attempts from music community to increase royalty rates. But the company has come a long way in terms of improving its monetization.
Our price estimate for Pandora stands at $24, roughly in line with the market price.
Pandora’s Monetization Has been Improving
Compared to $44.63 in the first quarter of 2013, Pandora’s desktop ad RPM (revenue per 1000 listener hours) rose to $52.75 in Q1 2014. Similarly, the figure for mobile platform went up from $20.43 to $29.46, registering a year-over-year growth of 44%. Total RPM, which includes both free ad-supported service and subscription model, maintained a similar growth trajectory. While the majority of the growth in its RPM can be attributed to sale of more mobile ad inventory, higher ad pricing has also played a notable role. As Pandora can precisely measure the usage metrics for every user, it can help advertisers in targeting right customers. This is how social networking giant Facebook (NASDAQ:FB) has built its fortune over the last few years.
20% Downside If Monetization Improvement Proves Insufficient
We currently forecast Pandora’s content costs as percentage of revenues to decline from 53.8% in 2013 to around 37% by the end of our forecast period. This will be primarily driven by an improvement in monetization and is based on the assumption that royalty rates will only see a gradual increase as they have in the past. However, if lobbying and litigation efforts from songwriters, artists and record labels result in a dramatic shift in the content cost structure and Pandora pays a much higher royalty rate, its content costs (as % of revenue) may not decline as much as we anticipate. If the figure falls to only 45% by 2020, there can be more than 20% downside to our current price estimate.
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