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Pandora's big spending ways: Behind the music

Internet radio and streaming-music providers, including Pandora and Spotify, are growing quickly. So is the ire from musicians about royalties and the sustainability of the streaming-music model when it comes to paying a decent "wage" to the recording artists on which the streaming businesses are being built.

Artists, including Thom Yorke of Radiohead (who used some choice language), David Byrne of the Talking Heads and Beck have lashed out at Spotify for paying artists a tiny amount compared to record sales and other alternatives. Other artists, including British folk rocker Billy Bragg, have said artists should still point their finger at "the man" (i.e., the record labels).

What's the truth of streaming-music economics? It's important to tune out all of the rhetoric and first understand the main costs that Internet radio and streaming music providers pay. It's also a battle reflected in the results just reported by Pandora after the market close on Wednesday and its executive commentary.


Royalties
Within the music industry, royalties are usage-based payments made to performing artists, songwriters, publishers and other organizations. U.S. law establishes only the right to a royalty. In addition, the Library of Congress's Copyright Royalty Board maintains statutory rates. However, royalty rates are still free for negotiation, according to SoundExchange, the performance rights organization that collects digital performance royalties.

Music sales—both physical and digital—have traditionally been a large source of royalties for songwriters and performing artists. The two types of royalties relevant to Internet radio are publishing and performance royalties. These royalties are administered by the performance rights organizations, or PROs, who handle the distribution of royalties from licensees to performers and song owners.

ASCAP (American Society of Composers, Authors and Publishers) and BMI (Broadcast Music) handle the payment of publishing royalties to copyright holders, namely songwriters and publishers. SoundExchange collects only the digital performance royalties and distributes them to performing artists and copyright holders. All three are important organizations in setting the royalty rates that Internet radio providers pay.

How Internet radio providers pay royalties now
Because of the Digital Performance Rights in Sound and Recordings Act of 1995, performing artists earn royalties when their songs are played in a "digital arena" that is "subscriber-based" and "non-interactive." The performing-artist rates that Pandora—and also tech heavyweights in the streaming-music market, including Apple iTunes Radio and Google Play Music—pay to SoundExchange are statutory, or negotiated per-play rates, while the publishing rates are negotiated individually, according to Pandora's website. Tim Westergren, founder of Pandora, wrote on the company's blog that Pandora currently pays about $1,370 for a million plays, based on 2013 data and agreements.

By federal law, SoundExchange gives 50 percent of the performance royalties (after administrative fees) for a song to the song's copyright owner. Forty-five percent goes to the featured artists, and 5 percent goes to a nonfeatured artist fund. If the artist is 100 percent independent, they get 100 percent of the royalties.

Pandora is a radio model, under which you cannot select your own music or replace ownership of music. That is different from Spotify, MOG, Rdio—and other selectable music services which let users pick songs—and as a result they don't fit all three criteria in the Digital Performance Act (they are interactive rather than "non-interactive") and thus negotiates all royalties individually with record labels and distributors. Spotify explains on its website that it pays publishers or independent artists a percentage of total revenue generated based on listener traffic share instead of on a per-play basis. According to Spotify, around 70 percent of revenue goes directly to rights holders, which include "labels, publishers, distributors, and, through certain digital distributors, independent artists themselves." Only independent artists receive a direct royalty payout. Artists signed to a label must negotiate with that label for payout rates.

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

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