Does Pandora Need Government Help to Survive?

A bill introduced in September may be vital for the company's future.

John Divine
John Divine
Oct 20, 2012 at 10:00PM
Technology and Telecom

In September, a Congressional bill was introduced that would reduce the amount Internet radio providers will have to pay in royalties. It's not entirely unreasonable, as the current laws stipulate a royalty structure astronomically higher than cable or satellite radio. Pandora (NYSE:P) easily stands to gain the most if the bill goes through, but the question is: Does the very future of Pandora rely on this piece of legislation?

Why Pandora needs help
Before even looking at the royalty issue, let's take a step back and examine the competitive landscape. Frankly, Pandora already faces intense competition; its rivals range from some of the biggest tech players in the game to specialized music services just beginning to get popular.

Sirius XM (NASDAQ:SIRI), while a satellite-radio company, has decided to jump in the ring with Pandora and will begin offering its customized Internet radio service within the next few months. Sirius has always been seen as a threat, but the threat becomes much more immediate with this move. 

Microsoft (NASDAQ:MSFT) is also making a serious charge into Pandora's space, launching its Xbox Music initiative earlier this week. If executed properly, the service could be a major boon to Microsoft, and a serious threat to Pandora. Xbox Music enjoys a potential customer base of 67 million Xbox owners, not to mention customers who buy Windows 8 and Windows RT products, which include Microsoft's new Surface tablet. Not only is Microsoft offering a catalog of 30 million songs for free streaming, but the service will also be replete with monthly subscription options, downloadable content, and cloud storage come 2013.

Last but not least, Apple (NASDAQ:AAPL) decided last month to enter the personalized streaming music industry as well. Not because Apple thinks it will be an enormously lucrative enterprise, but because, according to fellow Fool Rick Munarriz, Apple just wants to take market share from Google's (NASDAQ:GOOGL) Android operating system! Add to that list Spotify and iHeartRadio, two newer personalized music services springing up as challengers to Pandora's throne, and suddenly the area looks quite crowded.

The fact that the announcement of what amounts to an Apple side-project caused Pandora to shave 20% off its market cap in a single day tells me that Pandora is a very fragile company in an area with almost negligible barriers to entry. Which is why its future may lie in the hands of Congress.

My sincerest apologies to Pandora shareholders.

How the bill would be a bailout
Pandora, sadly, is a victim of its own success. Listeners played more than 1.15 billion hours of music in September, 67% more than last year, while total listeners surged nearly 50% to 58.3 million. For any normal business this would be great news. Unfortunately, under the rules governing Internet radio, Pandora has to fork over about $0.02 for each hour of music played on its site -- either that, or 25% of its revenues, whichever is higher. As it turns out, those pennies add up to more than 25% of revenues -- a lot more. Pandora shelled out about 50% of its revenues last year to pay royalties under the current rules. 

Contrast that with satellite radio, where royalties are capped at 8% of revenues, and cable music, where the caps are 15%. Sirius pays only about 6% of gross revenues to content royalties, while AM and FM stations don't pay direct royalty fees at all. You can see why Pandora founder Tim Westergren himself says the current dynamic "is not a recipe for a sustainable industry," and that the fee structure has a "destructive stranglehold" on Internet radio. He's right.

The only way to change that -- remember, it's the law -- is through legislation, and the bill in question isn't up for discussion until 2013. Still, if the bill passes, it would be a huge win for Pandora and would level the playing field significantly. But if investors want to play for a team that doesn't need fourth-quarter Hail Marys to stay in the game, they should start looking elsewhere.