It seems like an understatement to say Pandora Media (P) stockholders have endured a wild ride over the past several weeks.
First, when Pandora announced generally positive third-quarter results just over a month ago, I was initially surprised when the market shunned Pandora stock with a 15% single-day plunge. After all, Pandora not only beat analysts' estimates on revenue and adjusted earnings, but also provided fourth-quarter guidance above expectations.
Unfortunately, Pandora's achievement was overshadowed by fears over deceleration in growth of its monthly active listener base -- which wasn't entirely surprising given the steady rise of competitive services with increasing focus on music curation like Apple iTunes Radio and Google Play Music. And this despite Pandora CEO Brian McAndrews' assertion investors should be placing more focus not on the number of listeners, but rather on their steadily increasing loyalty to the streaming music specialist.
Not until two weeks later did Wall Street finally began to listen to McAndrews, driving shares up 15% after he put his money where his mouth is by purchasing a significant stake in the company.
An even bigger hurdle
But for all the focus on competition, active listeners, and loyalty, Pandora stockholders will soon need to face another much more important concern: changing music royalty rates.
To be sure, Pandora recently held a conference call with investors to defend its stance in the current "Web IV" royalty rate-setting proceeding, which was commenced by the U.S. Copyright Royalty Board earlier this year. In that proceeding, the CRB will determine rates and terms for webcasting to be applied from the beginning of 2016 through 2020 under the license used by Pandora and thousands of other digital radio services.
As it stands, an initial decision in the proceeding is expected from the CRB in its first discovery period by Dec. 15, 2014, after which the involved parties will hold a settlement conference to see if they can come to terms before the end of the year.
The problem? The folks over at royalty collector SoundExchange are requesting the CRB raise royalties to a much higher rate than Pandora says it can afford.
Specifically, SoundExchange is asking for per-performance rates in the range of $0.0025-$0.0029 -- a significant increase from Pandora's current rate of $0.0013 per performance. By contrast, Pandora's submission to the CRB argues for new rates in the range of $0.00110-$0.00129 per non-subscription performance. For each subscription performance, Pandora is willing to pay rates in the range of $0.00215-$0.00240.
Make no mistake, those tiny charges add up; Pandora lost $0.01 per share on a GAAP basis last quarter, and content costs are its largest hurdle to achieving sustained profitability.
"Our ability to improve our bottom line is largely dependent on leverage we can realize on content cost which are significant," said Pandora CFO Mike Herring on the company's last earnings conference call. "For the third straight quarter, Pandora paid more than $100 million in content royalties to rights holders, bringing our total historical payout to more than $1 billion."
What's more, Herring says, Pandora would be forced to reduce the number of hours of exposure to right holders' music by 75% should the CRB accept SoundExchange's proposal, which would result in a $741 million reduction in royalty payments from the current rate. And that's not to mention the long-term negative repercussions of offering a less-diverse set of music to Pandora's currently loyal fans.
In addition, Pandora cited a study it performed by members of its "science team" -- read more on that here -- which showed (among other convincing points) that new and catalog tracks played on Pandora's service enjoy average sales boosts of 2.31% and 2.66%, respectively. Finally, speaking to Pandora's status as a music discovery medium, it noted around 80% of the music it plays is not played on FM radio.
A moot point?
Curiously, Pandora management also offered an alternative. When asked by one investor what would happen if the CRB raises royalty rates in line with SoundExchange's request, they replied (emphasis added), "In order to operate, we have to pay whatever rates are determined. Doing direct deals with labels is always an option."
To be sure, look no further than Pandora's first-ever direct deal announced in August with Merlin, a global rights agency representing over 20,000 independent record labels and distributors. Pandora hasn't disclosed specific terms of that agreement, but did note on the Web IV call that Merlin labels have an opt-in privilege for the partnership. Over 90% of those labels chose to do so. Only a few weeks later, Pandora also announced a multi-year agreement with international music rights management company BMG for its complete BMI and ASCAP catalog of music.
In the end, then, while Pandora investors are almost certain to see more wide fluctuations as the CRB's royalty rate proceeding progresses, it may not matter if Pandora can continue to reach amiable terms with the record labels themselves. From an investors perspective if that turns out to be the case, any such fluctuations to the downside might just prove to be excellent buying opportunities for patient, long-term shareholders.