Where Internet radio stands financially
Spotify continues to lose money, and even though Pandora just reported its biggest quarterly profit, both companies have cited high royalty costs as a major factor in financial performance. Pandora and similar non-interactive Internet radio providers are in a bind of growth: The more listeners tune in, the more Pandora must pay to performing artists and publishers. Royalties paid by Pandora in 2012 amounted to about $230 million, more than half their total revenue of $427 million. In 2013 its content acquisition costs reached $343 million; the company reported $638 million in 2013 revenue. In its just-released quarterly earnings, revenue from subscriptions was $39 million and from advertising was $162 million, but cost of content acquisition also increased, from $71 million to $94 million year over year.
Pandora guidance for 2014 was below expectations, and costs continue to grow. CEO Brian McAndrews said in a statement that the company will continue to "aggressively invest" this year to sustain audience growth. "Our bias will continue to be toward revenue growth and capturing additional market share," he said. Pandora CFO Mike Herring told Reuters that in addition to content acquisition costs, Pandora plans to build up its sales force in local markets to go after ad dollars that typically go to radio. "It's not a time to try and optimize profitability," he told the wire service.
Under their current royalty structure effective through 2015, Pandora's ability to achieve profitability "depends on our ability to increase our revenue per hour of streaming through increased advertising sales across all of our delivery platforms" the company has stated. Advertising revenue currently accounts for more than 80 percent of all total revenue from Pandora.
"The landscape around content licensing is complex, and we are addressing that in a variety of ways," the company said on the earnings conference call. Pandora recently signed an agreement with the Universal Music Publishing Group rather than pulling impacted UMPG songs from service. "The agreement marginally increases cost," the company said.
Pandora has lobbied Congress to change the federal laws involved in setting royalty rates. According to Pandora regulatory filings, separate legal battles are currently under way between Pandora, ASCAP and BMI to determine publishing royalty rates after the current rates expire in 2015. That legal battle led to the separate deal with Universal. It's been reported that Spotify has been trying to renegotiate with major labels since last year.
On the continuing battle with ASCAP, CFO Herring said on the conference call, "It's less of an issue in the short term. It's more that there's two years left in the relationship, and the publishers have been deemed not able to withdraw that kind of going-forward basis, at least through the end of that time frame. BMI is left clear along the way, but right now I think the short-term noise has kind of occurred, and it's really going to be a series of these things that we'll have to deal with on a one-off basis, because the industry's trying to solve the right way to manage rights in this environment. And every day kind of presents a new challenge from that perspective."
Spotify's revenue relies on the size of its paid subscriber base (it has recently added a free mobile service that includes advertisements). Spotify currently has more than 6 million paid subscribers globally, a number that has grown steadily year on year. However, royalty payments continue to grow: Spotify reported that it has paid more than $500 million in royalties in 2013, almost half the amount of total royalties paid since inception.
Apple's radio service, iTunes Radio, pays $0.14 cents per play and 19 percent of net ad revenue (after a year of service), which is a higher rate than Pandora pays, according to a report in the Wall Street Journal. However, Apple is primarily using iTunes Radio as a tool to develop their iAd platform and to direct more music sales into iTunes.
The newest entrance to the streaming-music field is Beats Music—maker of the popular Beats headphones, and headed by music industry legend Jimmy Iovine.
Pandora CEO Brian McAndrews said during Wednesday's earnings conference call, "We will continue to focus on managing our cost of content. We will increase our engagement with people across the music and radio industry, including artists, labels, and competitors, to ensure that we are building a relationship and staying abreast of all key developments in this rapidly changing royalty environment. ... We may not always agree with others in the ecosystem, but it's important that we understand each other's objectives and work to find common ground where we can."
He added: "It's very complex. And it's an ongoing, changing landscape. It's different today than it was a month ago today, than it was six months ago today, and certainly a year ago today."
—By Roy Luo, Special to CNBC.com