Content Costs Stream Higher at These Companies

It's really quite astonishing how little I spend on home entertainment. Services like Netflix (NASDAQ: NFLX  ) and Hulu keep my eyeballs sore, while Pandora (NYSE: P  ) and Spotify keep my eardrums pounding. I have a plethora of content available to me in an instant for a low monthly fee.

But the content providers (i.e., Netflix and Pandora) are spending more to keep me entertained than they did a couple years ago. These companies face fierce competition, causing content costs to rise and margins to diminish. Only one of these companies will be better able to manage the issue of rising content costs than the others.

Facing the music
Pandora has long complained that its royalty rates are unfairly high. It's even gone so far as to purchase a terrestrial radio station in a petition to pay lower rates. Currently, Pandora pays 0.12 cents per song played. That's actually one of the best rates in the Internet radio business. 

Clear Channel, with its 850 terrestrial radio stations, still pays nearly twice as much for most of the songs it plays on its iHeartRadio music streaming service. Apple (NASDAQ: AAPL  ) pays 0.13 cents per song in addition to a percentage of ad revenue for its iTunes Radio service. The Wall Street Journal reported Apple is offering music labels more than twice as much in royalties as Pandora.

Although Pandora has a temporary cost advantage over the competition, it's still seeing its cost per user increase every year. From the end of its 2011 fiscal year (January 31, 2011) to the end of its 2013 fiscal year (January 31, 2013), the company saw its average cost per user increase from $2.79 to $4.43.

I expect to see that continue to rise as Pandora's cost of content accelerates. Pandora will pay 0.14 cents per song play in 2015, and the royalty board has yet to set a rate for 2016. We could see that rate climb significantly in 2016 because Pandora is facing competition from big companies with a lot of cash and multiple revenue streams.

Apple isn't making a profit on iTunes radio. It's a loss leader designed to keep people in the Apple ecosystem, increasing the chances that they'll buy one of its high-margin products. Google is doing the same thing to keep people hooked on Android with its Google Play Music All Access service. Both Apple and Google are willing to pay what's necessary to improve the success of their big money makers. Pandora needs to fight for every penny just to make a profit.

Another trend working against Pandora is that, as more people turn to these streaming services, fewer are buying music in stores or through digital downloads. The number of streams in the first half of the year increased 24%, but digital downloads fell 4.6% year-over-year. With streaming costs as they are, a listener would have to play a song almost 600 times on Pandora to make up the $0.70 labels gets for an iTunes download. I expect labels will start to demand more from Internet radio.

It's this trend that led Apple to start its own Pandora competitor. The company controlled 63% of the digital download market last year. Although it likely won't make up for the lost revenue from iTunes downloads, iTunes Radio will keep users engaged with the Apple ecosystem, which is significantly more important to the company.

The problem for Pandora is there's not much it can do about the rising cost of content. Unless it can significantly increase ad-rates, subscription numbers, or subscription fees, it's going to be a long time before it's making a consistent profit -- if it ever does.

Curating content
Netflix is facing similar problems. Between fiscal years 2010 and 2012, its cost of revenue per customer increased 9%, despite total subscribers climbing 77%. Although that statistic is not as bad as Pandora's, it's troublesome nonetheless.

The company also faces increased competition from companies with multiple revenue streams like Amazon and Hulu (co-owned by 21st Century Fox, Disney, and Comcast). By Reed Hastings own admission, these companies are responsible for bidding up licensing rights for TV shows and movies in recent years.

But Netflix has a couple things Pandora does not. For one, it can opt not to buy the rights for content it believes is too expensive. Two, it's able to negotiate for exclusive rights to certain content.

Pandora, on the other hand, is stuck paying 0.12 cents per song play, per its deal with the royalty board. What's more, it's practically impossible for it to gain exclusive access to content. There's no precedent for such a thing.

Netflix has a lot more options in how it manages the rising cost of content. It started distributing original shows last year, and that trend is expected to continue picking up steam. It's now licensing more content exclusively compared to previous years.

Overall, the company expects to license less content, but of higher quality, while keeping content costs in check. It's curating the best content for its audience. In that way, it expects to remain the leader in online video streaming.

Still, I won't be investing in Netflix either. The trend is not its friend in this case. It's just able to manage these issues better than Pandora.

It's a sellers market
There's no doubt that Pandora and Netflix are revolutionary companies with market leading positions. Unlike most companies, however, their costs per user are increasing. I expect these costs to continue to rise, which will either result in cutting into margins or a less attractive product than in the past.

Movie and television studios are going to milk Netflix for all it's worth, or just take their wares to Amazon, who has demonstrated a willingness to buy almost anything Netflix doesn't. Meanwhile, music labels and artists are fighting for more money while Pandora wants to pay less. With so many other willing buyers, I think the labels will win this battle.

Simply put, it's a sellers market for these two buyers.

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