"Talking about music is like dancing about architecture."-Steve Martin
In exploring the future viability of these two types of radio (satellite & Internet) and gauging if they are worth investing in, one must first understand the cost of royalties for Sirius XM (NASDAQ:SIRI) and Pandora (NYSE:P). It is essential to assign a value to the integral component and true source of each business' growing popularity and this (of course) is the music. Although some of the creators of music share the benevolent nature of a Jonas Salk and think their music should be free, the fact remains that most artists wish to become famous, popular and ultimately...highly paid. The journey of a song from creation to exploitation is a varied and a convoluted tale, so it should best be described in broad generalities, to which I will seek to let brevity be my guide. I'll give it a shot.
"Do your job and demand your compensation, but in that order."-Carey Grant
An artist sits down with an idea, a pad, a pencil, a piano, guitar or possibly a hookah, and through the enviable alchemy of intangible inspiration or (more commonly) through the warmed-over hackery of mediocre mimicry, a song is created. This artist may be unaware that the song was automatically copyrighted the moment it was fixed in a "tangible" medium (i.e. song tablature, CD, tape, etc.) however a smart artist will also register the song with the U.S. Copyright office for verification purposes and protection against possible future infringement or plagiarism. The artist should then acquire representation either from a lawyer or publisher who then shops the song to the A&R department (Artists & Repertoire) of a record company or "label". As a rule, an unsolicited song submission is generally discarded or returned unopened and unexplored. Once a song is approved by a label, a recording contract will be negotiated (overwhelmingly in favor of the label) and signed. A substantial yet fully recoupable advance usually is all that is needed to distract an artist from the contractual inequities. Signing to a label affords the artist the benefits of a record company contract which mainly consists of access to their professional recording and production facilities as well as their promotion and distribution services. In order to drive sales to the song, getting the song played on radio remains the first best exposure for the buying public and today this means terrestrial, satellite and internet radio. So, how does the average artist earn money from their song? You might be surprised, but let us first face the startling facts.
"It is piracy, not overt online music stores, which is our main competitor."-Steve Jobs
Prior to 1999, piracy of music was seen as a minimal concern to artists and labels. This concern was assuaged by a tiny royalty attached to recording devices and recordable media, implemented to reimburse copyright owners from inveterate music thieves. 1999 signaled the beginning of a brave new world of "shame-free" theft, thanks to Napster and the other more nefarious music "sharing" websites. The following image from the RIAA (Recording Industry Association of America) tells the tale of declining CD sales in stark detail.
Click to enlarge
I know, I know, I can sense you yelling at your screen... "this is not the result of piracy, what about CD's being replaced by the IPod and digital downloads?" O.K. let us take a look at the following image illustrating digital downloads of albums and singles over the same period.
Click to enlarge
Wow! Now that chart looks encouraging doesn't it? Well, lets combine the two images to view the current trend, but this time let us go back to 1990 to gain a better perspective, shall we? Indeed we shall.
Click to enlarge
I know, I know, I can hear you again..."CD's and downloads were not the only formats being sold during those years!" O.K. hold your horses sparky! Let us now combine all formats and go back even further to 1980, this should help.
Click to enlarge
O.K. now can the effect of piracy be any more clear? I think not. It is estimated that content theft costs the U.S. economy $58 Billion, 373,000 American jobs and $16 billion in lost employee earnings every year, and $2.6 Billion in lost Tax revenue. The latest information has revealed a slight increase in sales in the first half of 2011, the first since 2004, the increase (in my opinion) is related to the shut down of Limewire. As traditional sources of revenue decline, artists and labels must begin focusing on the new growing areas of income that are happening now, namely performance royalties coming from radio performances, but it is not from this revenue stream that artists receive the most pay.
"He who joyfully marches to music in rank and file has already earned my contempt. He has been given a large brain by mistake, since for him the spinal cord would suffice." -Albert Einstein
The following chart illustrates the fact that for the average artist a strong back and an ability to tour while performing the song "live" remains the best chance to make significant money. The reality is that most artists do not have the physical or financial ability to mount a lucrative touring schedule. Short of loading up your uncle's primer-painted van and schlepping the map on a steady sandwich diet of "baloney on hand" supplemented with freeze dried noodles and room temperature Red Bull, you could perform all of the jobs necessary to succeed by yourself, but consider (if you will) realistically, the additional individuals needed to create a successful tour.
A band, a manager, a booking agent, a sound engineer, a road crew, a publicist, a fan street team, a webmaster, a graphic designer, a merchandiser, an accountant and an attorney. None of which will work for free. So royalties are potentially the only continuous stream of income a non-touring artist can expect to collect for the creation of a song.
Click to enlarge
"The payment for sins can be delayed. But they can't be avoided." -Shawn Ryan
Pandora's first mistake was offering music for free, for once you have beguiled a user based on the premise of music for free, any deviation from "free" becomes nearly impossible to justify to a user accustomed to getting something for nothing.
When the current rates for performance royalty payments were negotiated, our country was in the darkest days of the great recession and therefore, the rates were made artificially lower to lessen the burden caused by a shrinking economy. For Pandora the payment of royalties currently is based on either 25% of revenues or a per song fee of $.00102, whichever one is higher. The per song fee will increase by 10% each year through 2015 when new rates will then be renegotiated. Pandora is in the unenviable position to never be able to pay the 25% option due to the sheer enormity of songs streamed resulting from the individual customized stations of each user.
Let us now take a closer look at what this means. In Pandora's most recent quarter we learned that Pandora's users logged 1.8 Billion listening hours in 3 months. In order to arrive at the royalties due, I will ask your indulgence to agree with me that on average a typical song is 3 minutes long. Pandora announced that they have 37 Million active users. So if we we take the 1.8 billion hours and divide it by the the 37 Million active users and divide it further by the 90 day quarter we arrive at a 1/2 hour of listening per day per active user. Based on my assertion of an average song length of 3 minutes, this works out to be 10 songs a day per active user. 10 Songs X 37,000,000 active users = 370,000,000 songs per day. 370,000,000 songs per day X 365 days a year = 135,050,000,000 songs per year. (You ask why unlimited data is going away?) The current per song rate is $.00102 X 135,050,000,000 = $137,751,000 in royalties due this year divided by 4 quarters = $34,437,750 per quarter in royalties payable. The projected annual revenue for Pandora currently is $268,000,000. If we take the unachievable 25% of revenue "option" we arrive at $67,000,000 per year or $16,750,000 per quarter, roughly half of the per song fee. Pandora would love to choose this option, but remember the option is based on whichever number is higher.
"I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things." -Benjamin Franklin
When it comes to Sirius XM a different royalty model is used. It was designed for subscription services that are non-interactive and are not also purely "music only" services. Currently the royalty payments are for 7.5% of revenues increasing to 8% in 2012. These rates were also negotiated at a time when the economy and the very existence of satellite radio was in question. The CRB (Copyright Royalty Board) consisting of 3 judges, determined that the appropriate "market rate" was to be 13% of revenues, Sirius XM's counter offer was 1%!!! (so much for Sirius XM valuing the contributions of musical artists...but then again, at this point, who the hell does?). At $3,000,000,000 in revenues the royalties due will be $225,000,000 in 2011 and at 8% in 2012 based on projected revenues of $3,300,000,000 the royalties due will be $264,000,000. The reasoning behind a percentage of revenue over a per song fee should be quite obvious, and if it is not, allow me to illustrate. Sirius XM currently has 71 non-interactive, non-customizable commercial free music channels. Using my assumption of a 3 minute song, each channel plays 20 songs per hour. 20 songs X 71 channels = 1,420 songs per hour X 24 hours = 34,080 songs per day X 365 days per year = 12,439,200 songs per year. (3.3% of the amount of songs Pandora streams daily!) If we were to apply the Pandora per song fee to Sirius XM, the royalties due would be $12,687.98.
"If you do not change direction, you may end up where you are heading." -Lao Tzu
I have spent countless hours listening to radio in my 41 years on this planet, be it AM/FM, Sirius XM or internet radio. The first 35 years were spent listening to FM, which I thought I enjoyed until I was exposed to uncensored, crystal clear, commercial free satellite radio and to a lesser extent my personalized Pandora stations. I read every article, try every service and engage in the unending debate of which is better. I am opinionated and I believe I know the deal when it comes to radio, much like everyone reading this article does today. I know that the main reason I love satellite radio is the fact that they offer NO commercials on the music channels. I know that the reason I continue to pay for satellite is the value I perceive in receiving great entertainment while remaining free from spastic advertisers. I know that I love satellite radio because it is simple to use and is great for commuting and long trips. I know that I love satellite radio for the ability and option to hear the non-music offerings, namely talk, news, sports and comedy. I know the main reason I love Pandora is because it is customizable and free. When I hear bloggers explore the insanity of adding commercials to Sirius XM to lower the price or increase revenues, I am convinced they have no idea how much most people HATE commercials. In this way terrestrial (AM/FM) forced the creation of satellite by inundating the listener with a unrelenting bombardment of mindless advertisements that consumed 1/3 of an average listening hour. This is the problem with being a subscriber of a service that I also invest in, most suggestions from investors and analysts are intended to cut costs or increase revenues without the consideration of the impact on subscribers. Conversely, I assume the suggestion of paying for Pandora Radio is equally offensive to heavy fanatical users.
"Music is everybody's possession. It's only publishers who think that people own it." -John Lennon
Many have pontificated that Pandora is so important to artists and labels that after 2015 the royalty rates will be negotiated down, the same is now being said about Sirius XM. The trend in revenue declines for music sales and other economic factors almost guarantee that the royalty rates will in fact increase. This is my belief based on the explicit evidence provided above. I might be wrong, but I seriously doubt it. Let me make the comparison on which company (Sirius XM or Pandora) is more valuable to artists and labels. At 12,439,200 songs played per year at $225,000,000 Sirius XM pays $18.08 per song played in performance royalties. At 135,050,000,000 songs played per year at $137,751,000 Pandora pays $.00102 per song played in performance royalties. In plain terms the royalty costs will indeed be higher and satellite and internet radio will fight vigorously to pay as little as possible, but don't take my word for it, read what SoundExchange wrote on 8/11/11 in a statement regarding Sirius XM's attempt to make an end run around SoundExchange and negotiate directly with labels. "We have long been preparing for this proceeding, and are planning to seek a substantial increase in the statutory rate. In other words, we plan to seek rates well in excess of the 2012 rate of 8%." Consider the following quote from the same statement. "SiriusXM is one of the most significant payers of performance royalties to SoundExchange and as such, to you. In that regard, we have every interest in seeing satellite radio’s success continue. But that success must be fairly shared with those who make the music that forms the very core of SiriusXM’s business."
It is purely speculation at this point, but I am confident that similar plans await Pandora. Consider as well that the popularity of Pandora has forced Iheart Radio (Clear Channel) and Sirius XM to both offer customizable channels and on demand listening. These new offerings will soon expand the songs played per year on Sirius XM and Iheart Radio exponentially, which will only further justify higher royalty rates. The most important difference between Sirius XM and Pandora and the reason why I continue to invest in Sirius XM and never Pandora is the fact that Sirius XM has already convinced their subscribers that paying for music is worth the expenditure, and with a price increase and additional features on the way, they will be able to grow regardless of a royalty rate increase. Pandora on the other hand, must either convince more users to subscribe to Pandora One at $3 per month or increase the amount of advertisements to the point of driving the users away. I love both services, and hope that both survive well into the future, for what is the alternative? Clear Channel? Never, ever again! The Iheart Radio App is nothing more than a "under new management" sign on an unpopular restaurant (NYSEARCA:FM), which I always read as "We no longer spit in your soup!"
"Without music to decorate it, time is just a bunch of boring production deadlines or dates by which bills must be paid." -Frank Zappa
In conclusion, (and for a little fun) as some have labeled Sirius XM "old school" I must admit my love and appreciation for the old school be it music, clothing, architecture, movies, celebrities, cars... all better than today. Consider the following chart illustrating a significant rejection of all things digital and ephemeral. The sales of vinyl records are continuing to grow...I absolutely love this. More vinyl LP's were sold last year than in 1990! The latest reports show vinyl increasing an additional 55% in the first half of 2011. Welcome back, welcome back, welcome back!
Click to enlarge
Disclosure: I am long SIRI.