How Pandora Media Inc. Won a Big Royalty Battle

A few months ago, Industry Focus reported on Pandora's (P) upcoming case with the Copyright Royalty Board and the intense volatility in the stock relating to uncertainty about the decision. Just before Christmas, the case finally wrapped up, with only slight changes in what Pandora must pay in royalties.

In this clip, Dylan Lewis and Sean O'Reily talk about what this ruling means for the company's cost structure, how the stock's performance should smooth out now, and how this case might affect Pandora's rumored plans for an on-demand streaming service.

A full transcript follows the video.

This podcast was recorded on Dec. 18, 2015.

Dylan Lewis: As a refresher, what we were talking about on that show was the volatility surrounding Pandora because of the impending Copyright Royalty Board decision on Webcasting IV, and the large impact that that would have on the company's cost structure.

Sean O'Reilly: Yeah, and if memory serves, this is a big deal for Pandora.

Lewis: Huge. And in the two months or so leading up to mid-December, there have been some pretty wild price swings on the stock, and a lot of it was related to, at first, CRB admitting that the agreement that Pandora had with Merlin, which is an independent label representative body, would be an inadmissible benchmark for the negotiations with SoundExchange. SoundExchange being a more major label representative. So, that was one major thing that's moved things around. 

Secondly, there was also a comment from the CRB that there wouldn't be any distinction between labels and major labels in terms of the ability to collect higher royalty rates on songs. So, there was no strength position there for SoundExchange. So, because of these two things, it seemed, going into mid-December, when we were expecting this CRB decision, that things would be playing out in a more favorable way for Pandora. As it turns out, that's what happened.

O'Reilly: Yay! It was entirely speculative at the time, though.

Lewis: Yeah, a lot of people started reading the tarot cards and saying, "This looks like how it's moving." But, there was always the possibility that there were going to be disappointing results, and I think that's why you saw so much volatility with the stock in the lead-up to this. So, earlier this week, CRB released its official ruling on royalty rates for web IV. Ad-supported free streams will cost Pandora $0.0017. So, that is, 17% of a cent--

O'Reilly: Not quite one-fifth of a penny, there.

Lewis: And subscription streams will cost $0.0022.

O'Reilly: Okay, that's one-fifth of a penny. And this is going to the labels?

Lewis: Yes. Well, it's going to SoundExchange to distribute to the labels. 2015 rates, what they were operating under in their current cost structure, had Pandora paying $0.0014 and $0.0025, respectively.

O'Reilly: We're sorry, folks, we're not used to this many decimal points.

Lewis: Yeah, it's a lot to get through. They usually state these as 100-play metrics ... and that probably would have been smarter for the show.

So, on the surface, this looks kind of disappointing. You look at it, and you say, "OK, these ad-supported free streams are going to cost more, the subscription streams will be costing less, maybe it's a wash." But you saw the stock move, I think, 10% to 15% to the upside this week. So, obviously, favorable market reaction. And I think that really gets into what the bear side of this negotiation could have looked like. Really, I think anything that came in at less than a fifth of a penny per play was going to be good for Pandora, on the free side. So, that's why analysts in the market have had this really favorable reaction.

One of the interesting aspects of this -- and I know you had a particularly interesting take on it, the $0.0017. rate on non-subscription rates being tied to inflation, and that being the escalator year to year.

O'Reilly: Why? How did they pick that?!

Lewis: I don't know.

O'Reilly: The Consumer Price Index is what the federal government uses to figure out people's Social Security checks every year.

Lewis: Yeah, and COLA for raises.

O'Reilly: It's dumb! Janet Yellen talks about it when she's talking about her inflation targets. Correct me if I'm wrong, tech actually usually experiences deflation. Computers get cheaper, software gets cheaper, this stuff gets cheaper!

Lewis: Talent gets more expensive.

O'Reilly: Well, fine. It seems like they picked that in the absence of any other better option. 

Lewis: Yeah. But it plays out extremely well for Pandora. If you look, basically, the escalation of their costs, if you're tying it to CPI, let's say inflation looks like it might be 1.5%.

O'Reilly: No.

Lewis: 2%?

O'Reilly: No.

Lewis: Maybe? In a rising interest rate environment?

O'Reilly: OK, fine.

Lewis: It's probably less. So, that's what you'd anticipate their ad-supported streams will go up by, year-over-year.

O'Reilly: So, we have tons of clarity here. Oodles of clarity.

Lewis: And they were experiencing year-over-year royalty increases of like 9%, prior to this. So, this adds a smoother cost structure for them, which is great. And it's a much more favorable reaction, if you look at what SoundExchange was hoping for in terms of royalty rates, they were looking for about 1/4 of a penny--

O'Reilly: Oh, so they were 40% off the mark?

Lewis: Yeah. And of course, SoundExchange was not pleased. They released a comment saying this will erode the value of music in our economy.

O'Reilly: I almost wonder if the regulators ... who made the decision?

Lewis: Copyright Royalty Board.

O'Reilly: OK. I almost wonder if they looked at -- because they probably want to engender competition, they want to make this work, and I almost wonder if they were like, "OK, what does Pandora need to not die?"

Lewis: Yeah, I think that's an element of it. The online Internet radio business leans on the terrestrial radio model. The royalty rate agreements are slightly different than what you have for the on-demand business. And it will be interesting to see how this plays out for Pandora's rumored on-demand service via the Rdio acquisition. That's something that's tough, because they had this really great ruling here, but they're going to have to go back to those same labels without the CRB.

O'Reilly: "Hi, guys!"

Lewis: And say, "Hey guys, you know how we have this awesome royalty-rate agreement now? So ... what do you want to do on an on-demand basis?" So, that's certainly something to watch. I think rumors have that possibly being in the late 2016, when that comes out. They'd have to set up the entire infrastructure for that. They didn't acquire any of the label agreements, when they acquired Rdio. So, it's a little bit tougher. I don't know that we'll see an on-demand streaming option from them any time soon.