Pandora and the Dark Side of the Moon

Right now, tensions between Pandora (NYSE: P  ) and the record industry have never been higher. The company pulled a stunt earlier this month in an effort to reduce its royalty rates, acquiring a terrestrial radio station in South Dakota. Pandora thinks its traditional rivals enjoy far lower costs, putting it at a competitive disadvantage.

Artists have now started to chime in as well. Indie artist David Lowery said his song was played more than 1.1 million times, and he received only $16.89 from Pandora -- less than what he makes from selling a T-shirt. Pandora responded by saying it pays much more than just what the artist receives, and that the rates it pays are set by the organizations that represent artists. Those same organizations accept much lower rates from terrestrial radio stations for the same songs.

Now legendary classic rock band Pink Floyd is stepping into the ring, with the three surviving band members penning an op-ed in USA Today earlier this month. In it, the band argues that Pandora is trying to cut artists' pay by up to 85%. As it is, the average artist receives less than $5,000 annually in royalties from digital playbacks. The members note that Pandora has appealed to artists to support Internet radio, but that the company doesn't detail its efforts to reduce royalties.

Again, Pandora responded in kind, saying that the RIAA and its lobbying efforts actively mislead and agitate artists. The company disputes the alleged "85% artist pay cut." The company says that it pays 4.5 times more than broadcast radio stations in total royalties. However, rivals such as Spotify aren't considered broadcast radio stations. Spotify is estimated to pay nearly three times what Pandora does in royalties.

Because of the hefty licensing costs, standalone music streaming services have never been a good business model. There's no scalability in the business, since costs rise with usage. Content acquisition costs were two-thirds of Pandora's total revenue last quarter. Those costs were up 48% year over year, keeping up with the 49% increase in advertising revenue. Subscription revenue doubled, but the company still ended up losing $28.6 million by the time everything was said and done.

This is why streaming music services are more sustainable within larger companies, which can pay higher rates, since the service isn't the primary business. Google just launched All Access, and Apple is about to launch iTunes Radio. Positioning a streaming music service as a complement to the core business is a far better opportunity for investors.

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