In a Dysfunctional Industry, Pandora Seeks an Algorithm for Profitability

Pandora Media, the largest Internet radio company, has managed to grow into a juggernaut with more than 70 million users as of the first quarter of this year — accounting for more than 7% of all U.S. radio listening, according to the firm. But its biggest feat may be thriving within an often-dysfunctional music industry and the convoluted royalty system that goes with it.

The company’s success is a story of survival under adverse circumstances in many respects, according to observers from Wharton and elsewhere. Pandora has amassed an impressive customer base, despite opposition from many within the music industry. The tension between the two is so bad that Pandora recently acquired a terrestrial radio station just so it can pay lower fees to stream music online. But while experts believe there are plenty of opportunities available to Pandora and other major players in the burgeoning Internet radio sector, they question whether Pandora is nimble enough to react to future shifts in the industry, or to achieve the financial model that has made traditional radio such a behemoth.

Pandora announced in June that it had made a deal to purchase KXMZ-FM, a Rapid City, S.D., radio station for an undisclosed amount. The deal allows the online music company to qualify for the lower royalty rates outlined in the so-called Radio Music Licensing Committee (RMLC) agreements.

Pandora assistant general counsel Chris Harrison wrote in a blog post published on The Hill that owners of terrestrial stations (including direct competitors like Clear Channel, which owns 1,200 radio stations but also the online service iHeartRadio) were given “preferential treatment” in a January 2012 agreement between the RMLC, the American Society of Composers, Authors and Publishers (ASCAP) and Broadcast Music Inc. (BMI).

The numbers appear to back Harrison’s case. Broadcast radio pays no royalties for use of music, and SiriusXM pays 9% of revenue for its transmissions. Pandora’s content acquisition costs were 55.9% of revenue for fiscal 2013 ending January 31, according to the company’s annual report. For fiscal 2013, Pandora reported a net loss of $38.15 million on revenue of $375.2 million.

“To put this in perspective, at least 16 of the top 20 Internet radio services that compete with Pandora operate under the RMLC license that has not been made available to Pandora,” Harrison wrote. Pandora filed a complaint in federal district court last November seeking the same terms provided under the RMLC’s 2012 agreement with ASCAP and BMI.

In a filing with the Securities and Exchange Commission, Pandora said it “believes that qualifying for [RMLC] royalty rates could provide the Company with modest savings (less than 1% of revenue) in content acquisition cost compared with the rates it is currently paying.”

On June 12, Pandora chief financial officer Mike Herring explained the move while speaking at an investor conference. “[Buying a station] became something that we needed to do now,” Herring said. “Last year, we paid to ASCAP and BMI about 4.3% of revenue. Recently, some publishers have begun to either pull out, or announce they are going to pull out, of these organizations and charge Pandora higher rates outside of what they charge all our competitors. Because we are purely a streaming service … [publishers] were able to separate Pandora … for different treatment.” Buying the radio station, Herring added, “essentially levels the playing field back between Pandora and all of our competitors in terms of the licensing costs we pay to publishers.”

‘A Horrendous Sector’

The reaction to Pandora’s terrestrial radio purchase was swift. The music industry royalty organizations widely panned Pandora’s move as an end run around paying its fair share. Two days after Pandora announced the purchase of KXMZ, BMI filed a lawsuit against the company asking that BMI’s members get more money for their work. ASCAP said in a statement July 3 that it wants Pandora to succeed, but the company has been trying to limit what it pays artists for years. “We’ve negotiated deals with plenty of other music streaming companies and see no reason why Pandora should be entitled to special treatment,” according to the ASCAP statement. “After all, Pandora isn’t a struggling start-up anymore — it’s a Wall Street-traded company that is making millions of dollars streaming music created by songwriters and composers. They can and should pay a fair market rate.”

Pandora officials have said they prefer to be included in broader radio licensing terms instead of negotiating individual content deals like other music players, such as Google and Apple, have. “It’s remarkable that Pandora has gotten as big as it has and has survived a horrendous sector,” says Wharton marketing professor Peter Fader, who adds that Pandora could have managed the messaging around its radio station purchase better.

Indeed, Pandora has thrived in many ways. In the first quarter of this year, the company reported $125.5 million in revenue, four billion listening hours and 2.5 million subscribers to its ad-free Pandora One service. In addition, Pandora employs 248 advertising salespeople around the country and is now participating in the ad buying systems used by terrestrial radio, which allows Pandora to grab a larger piece of the radio advertising pie. But Pandora has yet to become profitable, in part because more than 60% of its revenue goes toward acquiring music.

Pandora recently capped free mobile listening hours (80% of the company’s listening hours are from people using smartphones), a move Herring said was designed to manage royalty fees. “We pay for content as it streams on a fixed basis, essentially a cost per song,” Herring noted at the investor conference. “As [users move beyond] 40 hours of free listening, it is harder and harder to monetize those excess hours.”

Research firm eMarketer estimates that Internet radio ad spending in the U.S. will reach $970 million in 2013 and grow to $1.31 billion by 2016. By comparison, terrestrial radio revenue was $3.5 billion in the first quarter of 2013 and $16.48 billion in 2012, according to the Radio Advertising Bureau.

“Music companies have hamstrung Internet radio for years by demanding unreasonable royalties and limiting flexibility,” Wharton legal studies and business ethics professor Kevin Werbach notes. “For example, Internet radio stations can’t give listeners total freedom to select their music, or they will run afoul of copyright restrictions. And webcasting rates have been set in ways that don’t reflect differences in the online environment. Companies like Pandora are paying millions of dollars in webcasting fees to record labels, but the market could be much bigger.”

Knowledge@Wharton technology and media editor Kendall Whitehouse says that the lack of equivalence in royalty payments between terrestrial radio stations and Internet streaming companies is an issue, and adds that artists should be better rewarded for their work — something many artists have argued isn’t happening through Pandora or companies covered by the RMLC agreements. “Unless the system rewards creative artists appropriately, it’s not sustainable,” Whitehouse notes.

David Pakman, a partner at venture capital firm Venrock and former CEO of eMusic, says the music industry needs a new licensing model since the current ecosystem is unhealthy. Pakman notes that the music industry depends on two companies to sell music at scale — Apple and Amazon. “The first question the industry has to ask itself is whether it has a healthy ecosystem. If there are many licensees, there’s an ecosystem. If [there are] just a few, it doesn’t bode well for the future,” explains Pakman. “The music industry was healthiest when there were 1,000s of stores selling CDs.”

Moreover, Pakman points out that Apple and Amazon are able to take the financial hit because the companies don’t have to make money selling music as long consumers keep buying their other products. But the current model doesn’t work for smaller players that are trying to make money from streaming music. “The music industry needs to price royalties correctly so licensees can stay in business,” says Pakman, adding that companies like Pandora and Spotify should be paying less to the industry. “If it’s fair for Internet streaming companies to pay 60% to 70% of revenue to the music labels, shouldn’t the labels pay out 60% to 70% to the artists?” he asks. “The labels pay out more like 17%.”

As a result of royalty mispricing, Pakman suggests that music sales will continue to shrink. Meanwhile, he says artists would be well advised to take control of their own catalogs and collect royalties themselves. Pakman isn’t hopeful about change. “The music industry has fought the digital revolution for years, and I don’t think they’re going to change now.”

Name that Genome

Pandora, which was founded in 2000 by composer and musician Tim Westergren (now the firm’s chief strategy officer), has benefited by becoming an early mover in online radio, building a critical mass of users and featuring technology that pieces together recommendations based on a genre or a song’s “music genome.”

The sector has since become more crowded with competitors including iHeartRadio, Spotify and Rdio. This fall, Apple will launch its own streaming service, iTunes Radio. Apple spearheaded a sea change in the music industry when it launched the original iTunes store in 2001, selling individual songs for just 99 cents. But recent figures from Nielsen and Billboard show that attitudes toward music ownership may be changing. While sales of digital singles were down 2.3% during the first six months of 2013, digital streaming — in which users can buy subscriptions for unlimited or ad-free listening but typically can’t buy songs or albums — was up 24% from the same period last year.

According to Wharton marketing professor Eric Bradlow, while the growing field of similar services represents a threat to Pandora, first-mover advantage matters. “Every company with a copyable business model is somewhat vulnerable. However, people should never underestimate the value of a strong brand name,” says Bradlow. “To defeat Pandora, some other provider is going to either have to be better than Pandora on the existing online radio attributes or change the conversation so that the attributes that matter to people become different.”

Spotify is likely to be one of Pandora’s most potent rivals, Werbach notes, but “Spotify, Pandora and other ventures can coexist by offering different value propositions,” he says. “That’s the power of online content delivery; everything doesn’t have to be locked into the same format like traditional radio.”

One of Pandora’s biggest differentiators is the algorithms it uses to recommend music. At the June investor conference, Herring noted that Pandora began with an effort called the Music Genome Project, which breaks down every song in the company’s database into attributes such as melody, beats, harmony, rhyme, genre, artist and instruments used. “Each one of these things is laid down and put into a database, so that we can connect songs that have similar patterns from a very organic place,” he said. “We can connect a single song to many hundreds by using our Music Genome.”

Herring added that the Music Genome is then combined with human listening patterns and data to come up with optimal playlists for users. “A competitor can offer the same content, but it’s harder to create something comparable to what Pandora does,” says Werbach. “Pandora is more than a traditional radio station because the experience is dynamically generated for each user.”

The Netflix of Radio?

Some analysts have called Pandora the “Netflix of online radio,” the implication being that the company could become as dominant in its sector as Netflix has in the streaming video arena. Although Netflix, too, faces several competitors — including Hulu and Amazon — the company has managed to become a threat to broadcast networks and premium cable channels alike, as evidenced by the 14 Emmy nominations it recently scored for the original programming offered on the service.

But Fader says Pandora in many ways is cut from a different cloth than Netflix. “Pandora was founded from a passion for music; it’s all about the music…. Netflix was built around an opportunity. First it was shipping DVDs, then streaming. Netflix is about finding a nice opportunity that fits with its business drive.”

In other words, Fader notes that Netflix and its management can be effective in any opportunity they seek out, similar to the way Amazon was able to successfully morph from a bookseller to a multi-category empire that, among other things, offers web services to corporations. “Pandora’s ‘music first’ approach means it may be less savvy and miss new opportunities,” Fader adds. “Pandora lacks the killer instinct of a Netflix.”

One common thread between Pandora and Netflix, however, is that both “illustrate the collision of new media with traditional media,” says Whitehouse. “In industry after industry, we’ve seen an economic disparity between old and new media [business models]. In many cases, the Internet startup has had the economic advantage. But with music delivery, the situation is more complex. “

Just as Pandora has tried to navigate the thorny economics of the music industry, Netflix has grappled with the demands of media companies from which it licenses it content. “A fundamental difference between watching video and listening to a streaming music service is that with video, you select each individual program you watch,” Whitehouse notes. “In radio — terrestrial or Internet — consumers typically select a genre or an artist and then content plays automatically. These differences in content selection have different licensing and revenue models.”

Monetizing Pandora

To approach the revenue and earnings scale of terrestrial radio, Pandora needs to manage its licensing costs, grow subscription revenue and expand its local advertising efforts, experts state. One challenge for the company is that most of its listeners access the site with mobile phones, which generates less income from display advertising. Herring said during the investor conference that Pandora plans to deploy multiple business models to increase its advertising reach, including online and mobile advertising, subscriptions and local ads based on user data and zip code.

Herring also outlined how he thinks the company’s monetization efforts should be judged — by revenue per 1,000 hours, or RPM. “Desktop [listening] is about $48 at about 60% gross margin for the first quarter. Mobile was at $26. Our cost per 1,000 hours is about $20. So we are at about a 20% gross margin on mobile, but growing quickly,” Herring said. “We are up to 248 salespeople around the country, 72 [of whom] are selling local radio advertising, [and] 28 specific high-value markets. And we crossed 2.5 million subscribers in the first quarter. That is a relatively small number of our users, but it is by far the largest streaming subscription service in the United States.”

Wharton experts note that Pandora has the flexibility to try out all of the different revenue models and let users decide which they prefer. After being free for decades, terrestrial radio would find it extremely difficult to start charging subscription fees. Meanwhile, subscription-only services such as SiriusXM would face cannibalization if they suddenly became free. “I don’t think Pandora has to decide on a model,” Whitehouse states. “Pandora has two dials it can control — it can adjust the ad frequency of its free service or modify its subscription fee. This gives the company multiple options to generate revenue.”

Analysts say that Pandora will have to walk the line between finding ways to make more money and bogging down its service with ads. “The company is confident about increasing mobile RPM, perhaps doubling it over a reasonable period of time, bringing it even with desktop RPMs today,” Stifel Nicolaus analyst Jordan Rohan said in a research note. “Pandora believes it can accomplish this not solely by increasing ad load, but primarily by better monetization of existing inventory.”

According to Werbach, rather than picking just one option and sticking with it, consumers are likely to hop between an FM station, SiriusXM, Pandora and other music services, such as the new offering coming from Apple, depending on which is the best fit for their activities at any given time. “People listen to music and other audio content in many different ways,” Werbach notes. “There is room for a variety of models — some ad-based, some subscription and some using other means.”

But Bradlow suggests that Pandora will need more subscription revenue to gain better control of its destiny. “I think the ability for people to listen for free or at a low cost to a large variety of music [through advertising] has gone extremely well. But for a model to become everlasting, a subscription-based approach is the only way to generate stable revenue growth,” says Bradlow.

However, it’s no sure bet that Pandora can garner more subscriptions. For more than a decade, the music industry has revolved around iTunes, a service where songs are bought as singles for roughly $1. “Part of the music industry’s dysfunction stems from handing the keys to Apple,” says Fader, who noted that Steve Jobs once predicted that no one would ever want to rent music and invented an ecosystem that set subscription models back for years. “À la carte models killed the industry. The artists are not reaping the rewards of creating music, and no one will buy an album.”

Fader notes that it would behoove the music industry to support services such as Pandora and Spotify if only to offset Apple’s dominance with the iTunes store. “Technology keeps changing, and the music industry doesn’t know whether to align against services like Pandora and Spotify or support them,” he says.

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