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"Sirius XM's (NASDAQ:SIRI) royalty rate is low! And rightfully so!"

It could be a great chant to shout while marching down the street, to get the message out. Sirius XM is different when it comes to paying royalty rates on its music content relative to its peers such as Pandora (NYSE:P). And yes, I use the term "peers" lightly.

And why does that word need to be spread? Because there are seemingly misinformed individuals out there that need to understand one basic thing : Sirius XM's content is not comprised entirely, or even primarily, of music.

Consider the New York Times article from September 23rd written by Ben Sisario. Ben does a fine job of reporting the current goings on with the Internet Radio Fairness Act, which was submitted to Congress on Friday, September 21st.

In referring to the bill, Ben States :

The battle flared up again on Friday with a new Congressional bill, the Internet Radio Fairness Act. Introduced in the House by Jason Chaffetz, Republican of Utah, and Jared Polis, Democrat of Colorado, the bill would move so-called noninteractive online radio services like Pandora and Clear Channel Communications' iHeartRadio app from the "willing buyer, willing seller" standard to the one used to determine rates for Sirius XM Radio.

That model would let the panel of federal judges that set the rates consider evidence both on the value of the music and on the effect the royalty rate would have on the industry over all. Pandora and its supporters believe that standard would yield lower rates.

Are lower rates justified for Pandora? Are they justified for Clear Channel's (CCMO) iHeart radio? The bill aims to potentially level the playing field between internet radio and satellite radio, but something which is important to consider, is that each platform has its own inherent costs and expenses. Beyond this, each platform has a completely different model, and again, each platform has very different content.

Sirius XM delivers a myriad of content, streamed through a satellite feed, available anytime, anywhere. If you'd like to see everything the company offers to subscribers, take a look here. In addition to commercial free music channels you will notice talk, sports, comedy, news, and exclusive content like Howard Stern that you can find solely on Sirius XM.

It becomes readily apparent looking at the list of stations that only around 25% of these channels are music based. This is the first important thing to consider. I know why I personally subscribed to Sirius XM in the first place, and that was for Howard Stern. The music channels, for me, were a nice bonus. I split my listening now during the day between Howard, some news and talk, and music. I would say a fair estimation of my usage actually falls around 25% of my listening time going towards listening to only music. Am I the average user? That's up for debate, but useful to use in this example.

Given that Sirius XM pays 8% in revenue as a royalty rate on music, and that 8% is taken from my entire subscription, from a theoretical standpoint Sirius XM is paying 8% times four, or a 32% royalty rate on what I would consider to be the portion of my subscription revenue which goes towards my listening of music. While this still does not match the royalty rate paid by Pandora :

"Pandora pays a fraction of a cent each time a user listens to a song, and the total must be a minimum of 25 percent of its annual revenue; last year it paid about half its revenue to labels and performers."

One must also consider that this is 8% (or 32% of my music only portion) of revenue. Satellite radio has certain expenses that simply do not exist for Pandora and other internet radio companies. Satellites and terrestrial repeaters cost a significant amount of money to build, launch, erect, and maintain. The broadcast spectrum satellite radio uses costs money and has value. Because of these costs, there are inherent expenses in the business model which must be covered before the first song is even aired. Were satellite radio saddled with a 50% of revenue royalty rate, the repeaters would shut down, and nobody would make a dime. Subscription rates would have to increase by 84% (42% X 2) to cover the increased royalty costs alone.

There are significant differences between Sirius XM's business model and Pandora's. Pandora's costs are a great deal less as is the case with any IP delivered product. Considering mobile usage, which is what it seems Pandora's target audience is, the bulk of the delivery cost is the responsibility of the consumer and their willingness to use their data plan, or pay for increased data usage.

Pandora is software (the Music Genome Project), run locally, that generates "smart" playlists based on user's song choices and likes and dislikes. Other than some select comedy channels, it is almost 100% music based, and thus the entire service could be said to be centered around the music it provides to users. Revenue comes in marginally from subscriptions, but the majority of Pandora's revenue comes from advertisement supplied between songs. As stated by Mr. Sisario above, Pandora paid about 50% of its revenue in royalties last year, with a minimum possible rate of 25%.

Is the current playing field level and fair? I don't think it's possible to even ask that question when each team is obviously playing on a completely different field. When looking at the percentage of total revenue that each service pays it should be quite clear why there are differences, and therefore arguing that Pandora should pay the same amount of revenue in royalties as Sirius XM pays on its satellite delivered and diverse content is foolish and uninformed.

Ted Kalo, executive director of the MusicFirst coalition, said it quite well :

"There's nothing fair about pampering Pandora, with its $1.8 billion market cap, at the expense of music creators," Mr. Kalo said in a statement. "Going from a fair market, 'willing buyer, willing seller,' rate to a government-mandated subsidy will break the backs of artists, while Pandora executives pad their pockets."

And as Mr. Sisario states :

Throughout the music industry there is a wide belief that Pandora could solve its financial problems - the company, which went public a year ago, has never turned an annual profit - by simply selling more ads.

And this is exactly the case. This is how terrestrial radio has done it for decades. An advertising model is supported and paid for by advertising. Listeners have the opportunity to listen for free simply by listening to "a word from our sponsors." Pandora's solution? It should be to sell more advertising or decrease the number of songs delivered per hour in some way, just like terrestrial radio stations have done. Users who wish to listen to Pandora for free should understand that the extra advertisement per song they are subject to will be going towards paying for the music content they are enjoying at no cost to them.

Regardless of your feelings on the matter, this will be a very important issue for investors of both Sirius XM and Pandora to pay attention to. A lowering of rates, governmental influence or otherwise, could send shares of both companies up considerably, and likewise a loss on this front could weigh upon each in the same fashion. It's far too early to tell which way the wind will blow on this one, and that's exactly why investors in both companies need to stay tuned in.

Source: Sirius XM's 8% Royalty Rate Is Lower Than Pandora's, And Rightfully So