What Pandora should really be worrying aboutDecember 6, 2012: 11:38 AM ET
Pandora's CEO blamed the company's grim forecast on "uncertainty" caused by the stalled fiscal-cliff talks. But it's another political fight that may decide whether it rocks or rolls over.
FORTUNE -- In issuing a glum fourth-quarter forecast on Tuesday, Pandora (P) CEO Joe Kennedy pointed a finger at the stalemate over the "fiscal cliff," which he said has created so much "uncertainty" in the marketplace that advertisers are hesitating to make buys.
There might be some truth to that, though several analysts also noted that the increased competition is a likelier reason for Pandora's slowing revenue growth. But even if it is 100% true, there's an even bigger political issue that might not merely crimp a quarter for Pandora, but could potentially determine its ultimate fate: The debate over the Internet Radio Fairness Act, which would cut Pandora's costs by a huge margin.
As it is, about 55% of Pandora's revenues are eaten up by the royalty fees the company pays to music labels. The current setup has the music service paying a royalty every time a user plays a song, a little more than a tenth of a cent per play (which is set to increase to 0.14 cents over the next three years). That doesn't sound like a lot, but it represents that vast majority of Pandora's costs. Listening hours rose to over 1 billion in November, up 58% from a year earlier. Content acquisition costs, mostly royalties, rose 75%.
If the IRFA (or something like it) isn't passed, Pandora will likely remain a low-margin business, and its stock will likely fall further. It fell 18% on Wednesday after the company issued its forecast after trading closed on Tuesday. The bill, which likely won't be voted on until next year, would cut the royalty rate by about 85%. Needless to say, the music labels and many artists -- including some big names like Billy Joel and Rihanna -- oppose it.
Exacerbating the situation is the growth in mobile, which now represents nearly four-fifths of Pandora's usage. It's harder to sell mobile ads, and they sell for less. Though mobile revenue rose 112% in the third quarter, mobile ads are selling for just $21.56 per 1,000 listening hours, while ads for the desktop service sell for $55.18. Pandora is ramping up its in-house sales efforts, and moving away from using third-party services, and that helps. But for now, margins are falling fast.
A few years ago, Pandora founder Tim Westergren warned that Pandora might have to shut down because the royalties it was then paying were too much to bear. That's when the company negotiated with SoundExchange -- which collects royalties for the labels -- to get the rates it pays now. But as the service grows, and as users increasingly switch to mobile listening, the costs only become more burdensome.
Pandora wants something more like the rates satellite provider Sirius XM (SIRI) pays -- about 5% to 7% of gross revenues. SoundExchange, meanwhile, is trying to get Sirius XM to double what it pays. Broadcast radio still pays no royalties for recorded music -- it was decided long ago that radio provided free promotion to artists and labels. That's Pandora's main argument for the IRFA. It says that if the bill passes, there will be an explosion of new Internet radio services, and artists and labels will get that much more promotion and sales.
That might well be true, but it's hard to know for sure, and as it stands, artists are already getting a pittance from Pandora. If the bill passes, that pittance would be even more meager.
And Pandora faces yet more challenges in the form of competition, not only from satellite, but from other services such as Spotify (which negotiates separate royalty deals with each label, and has a much smaller selection). The nature of perhaps the biggest threat to Pandora is not yet known: Apple (AAPL) is said to be in heated negotiations with the labels for its own Pandora-like service.
In fact, if Pandora's fate doesn't end up being decided in Washington, it could end up being decided in Cupertino.