How Pandora thrives in music industry chaos

Tim Westergren, founder of Pandora.
Source: Pandora

Ask Pandora founder Tim Westergren about his entrepreneurial odyssey, and you're bound to hear some version of this: "We really shouldn't be alive."

It's not hyperbole.

Two financial market meltdowns, a drawer full of maxed-out credit cards (11 to be exact), stringent regulations, severe limitations on international distribution and an exhaustive list of highly capitalized competitors are just some of the hurdles Westergren's online radio company have overcome in the past decade and a half.

Existential threats are as routine as breakfast. Oh yeah, and the music industry has at times seemed set on bleeding the company dry.

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But with over 80 million monthly active listeners, Pandora is far from dead. In fact, take a peek at consumer trends, and you could make the case that it's beautifully positioned to benefit from the rapid convergence of mobile devices, streaming technology and content.

Pandora is the most popular music service in the Apple and Google stores and in the top 10 apps across all categories. Car companies are baking the Internet service into their multimedia dashboards, right alongside terrestrial radio. Connected TVs and Roku boxes include it by default as does the Xbox One.

That's the story of yesterday and today. But there's a new theme emerging, one that's quietly gaining resonance within the perennially stubborn music industry.

Instead of lining up to bash the service for the fraction-of-pennies per stream they get paid, artists are increasingly using Pandora as a way to communicate with fans, broadcast promotions and sell concert tickets.

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In what can appropriately be described as music to Westergren's ears, the industry is starting to embrace his baby.

"I think we're moving out of an era where the music industry is looking for enemies and into one where it's now looking for allies," said Westergren, 49, who was chief strategy officer until last year.

At music festivals like Lollapalooza, South by Southwest in Austin and Outside Lands in San Francisco, Pandora is on site with photo booths, charging stations and streaming for fans unable to attend.

Taylor Swift's Spotify dig
Taylor Swift's Spotify dig

It's a message Pandora is loudly promoting and one that's at the heart of its 10-year anniversary celebration this week.

(The company was founded in 2000 as Savage Beast and sought to sell software for music store kiosks. The Pandora name and consumer streaming service were launched in 2005.)

A trained pianist and composer, Westergren created Pandora because of the challenges he and other musicians faced getting discovered.

The core of the service is the Music Genome Project, a collection of 100 musicologists who listen to songs and tag them with up to 450 characteristics to create a robust recommendation engine. When you give a thumbs up to John Legend's "You & I," the next song may be "If I ain't got you" by Alicia Keys. Or if you're a fan of TV On The Radio, you'll likely hear some Spoon and Radiohead.

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It's a costly model. In addition to all the human hours required to analyze 10,000 tunes a month, content is expensive. Pandora pays out close to half its revenue in the form of licensing fees, primarily through a deal signed in 2009 with SoundExchange, the entity that collects and distributes royalties for artists and copyright owners.

Even with 40 percent revenue growth and annual sales poised to top $1 billion, Pandora has racked up losses since its 2011 IPO, including $64.6 million in the first half of this year.

Not that artists have been sympathetic, often portraying the company as a culprit in the collapse of the recorded music business. Annual recorded music sales plunged to $15 billion last year from $40 billion in 1999.

I said we need to do something more like have a big Pandora bus going around the country.
Jo Dee Messina, country singer

Cracker frontman David Lowery called out Pandora in 2013 for paying him all of $16.89, based on 1 million plays of his song "Low." Around the same time, Pink Floyd's Roger Waters criticized the company for waging a legal "campaign to cut the royalties paid for digital radio spins."

That was two years ago.

Pandora is now in a very different position. In June, Mumford & Sons partnered with Pandora to livestream a concert in Maryland, leading 1 million Pandora users to add a Mumford station. Earlier in the year, Pandora streamed a Jack White show from New York's Madison Square Garden, resulting in 700,000 station adds for White and a 41 percent increase in album sales after the event.

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Rising artists frequently show up at Pandora's office in downtown Oakland, California, for what the company calls Whiteboard Sessions. Country singer Jo Dee Messina popped in with her band on a toasty afternoon in late July to entertain over 100 employees. She was in town for a concert at the jazz club Yoshi's.

Messina, whose latest album was funded through a Kickstarter campaign, told the Pandora audience that she'd met with some company representatives at the Country Music Association festival a few weeks earlier.

They suggested she come in and perform ahead of her show. Messina was so taken by the outreach that she wanted to go bigger.

"I said we need to do something more, like have a big Pandora bus going around the country," she said at the start of her half-hour set.

Jo Dee Messina performing at Pandora’s headquarters in Oakland, California.
Ari Levy | CNBC

While the idea was met with laughter, it's not so crazy. Last year, Pandora put on 79 live events, a number that's poised to rise to 120 this year for artists including Wyclef Jean.

Pandora's employee base has swelled to about 1,750, up from 1,300 a year ago.

Westergren's schedule is equally instructive. Rather than meeting with lobbyists in Washington, where he so often found himself in earlier eras, he now spends about half his time with artists, managers and labels, regularly hopping between Los Angeles and New York.

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"I turned a complete 180," said Daniel Glass, founder of independent music company Glassnote, home to Mumford & Sons, Robert DeLong and AURORA. "I was very critical of Pandora in that I felt it was very one-way. They reached out with an olive branch and we've now become huge fans."

Glass attributes the evolution to a change in culture at Pandora. The company hired former Columbia Records executive Lars Murray last year to run industry relations. Jason Feinberg also joined Pandora as head of artist marketing after running digital strategy at independent label Epitaph Records.

There's another difference.

"They come to a lot of our shows," said Glass. "I never got a request from a Pandora person for five years. Now they have two to eight people coming to shows. That's engagement. That's partnership."

Pandora financials

Click to editDec '14Dec '13Jan '13Jan '12Jan '11
Sales Growth (%)40.6253.3055.7099.14149.62
Gross Margin (%)44.8340.5731.9337.5041.26
Net Income-30.41-29.47-38.15-16.22-2.06

Source: Source: FactSet

But don't uncork the champagne just yet. Pandora skeptics (and short-sellers) still abound, and for good reason.

Apple, with 160 times the market value of Pandora, is on a relentless pursuit to win listeners, most recently with its subscription on-demand Apple Music service that starts with three free months. Spotify has paid and free offerings and Rdio recently launched an ad-supported service to go along with its subscriptions.

Global deals are torturous for Pandora. To date, Australia and New Zealand are the only markets outside the U.S. where the service is available.

And the company is constantly skating the line between finding innovative ways to advertise, and annoying users with ad excess. More than 80 percent of revenue comes from ads, with the rest from Pandora's paid subscription offering.

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Meanwhile, this whole make love not war pursuit is still in its infancy. Cracker's Lowery doesn't believe for a second that Pandora is ready to play nice. He sees the company constantly seeking loopholes to lower the royalties it pays artists. For example, in 2013 Pandora bought a South Dakota radio station with the aim of being classified like terrestrial radio companies, which don't pay artists for performance rights.

So when Lowery hears about Pandora trying to help musicians promote themselves, it sounds more like marketing fluff than an honest strategic shift.

"I wouldn't really regard that as offsetting the low pay to all artists," Lowery said in an interview. "I don't think you can have PR events where you partner with certain artists but then across the board you're fighting fair pay to artists in fairly dirty ways."

#2 mobile service in the US: Pandora CEO
#2 mobile service in the US: Pandora CEO

While Lowery isn't a big fan of any of the emerging digital offerings, he has less of a problem with subscription services like Spotify, because there's a more substantial royalty involved.

Westergren is trying to change the conversation altogether.

The CD is dead and it's not coming back, so for the vast majority of artists, business has to be about concerts and merchandise. Pandora wants to use its 15 years of personalization technology and decade of brand building to help them find and communicate with fans. In May, the company added more data tools through the acquisition of music analytics software developer Next Big Sound.

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Pandora knows what people are listening to and where. Age, gender, zip code data and listening habits are attached to every member. That makes it easy to let a Jo Dee Messina fan know when the singer is coming to town, perhaps even with a special offer.

It can also help Messina.

"Their research and stats really show you where your fans are and what they like and don't like," Messina said in an email. "I will be able to use their information not only for getting music heard but to find out the strongest markets for touring."

For shows that Pandora sponsors, out-of-towners can tune into live streams or come back and listen at a later date. That all adds up to additional royalty payments and more exposure.

Pandora promotion for Outside Lands.
Source: Pandora

It's a virtuous cycle and a story Westergren is eager to tell.

"People see that royalties are a piece of it, but it shifts attention away from that to what can we do to help sell more tickets," he said.

For Westergren, even being in this position is a minor miracle.

This is a company, remember, that entered the dot-com crash in 2000 without a working business model, and survived only because Westergren racked up hundreds of thousands of dollars of personal debt, paying employees with the equivalent of promissory notes.

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Later in the decade, the financial crisis struck, forcing another round of belt tightening, including eliminating one-third of its music analyst department on a single day.

Steve Hogan, Pandora's manager of music operations, has been with the company since the early days, overseeing the Music Genome. He's experienced every up and down, and through it all has continued tagging songs, building a portfolio of over 1.5 million tracks.

Now he's getting to hire again, with plans to grow his team by about 10 percent a year.

Like the majority of the music analysts, Hogan is a professional musician, who Bay Area residents can find 35 days a year playing organ at San Francisco Giants home games.

"It's a perfect day job for working musicians," Hogan said of the Music Genome. "Once we hire music analysts, they tend to stay."

Staying power is a cultural staple at Pandora, one that's being tested again on the public markets. The company's stock price has been crushed over the past 18 months, wiping out more than half its value.

The macro environment has certainly contributed, but even before the latest stock market swoon, Pandora investors were in limbo. The existing royalty structure expires at the end of the year, and the Copyright Royalty Board is expected to decide on new terms by mid-December.

Read MoreU.S. streaming revenues overtake CDs

Westergren said Pandora is arguing for status quo. He acknowledges that the issue has created a "big overhang," because Wall Street can't predict future profitability. RBC Capital Markets analyst Mark Mahaney agrees.

"You have no idea what the valuation really is, because the single biggest cost item is the royalty payment," said Mahaney, who has a "buy" rating on the stock. "My guess is there's a relief rally ahead just on removing the overhang, removing the uncertainty."

Westergren continues to play the long game. When not hanging out with musicians and wining and dining their managers, he's cozying up to employees over lunch and recruiting new blood. Pandora spokeswoman Erika White goes so far as to call him the "secret weapon" for his ability to land top talent.

Revamping radio
Revamping radio

He still sweats it out over the competition, watching engagement data to see which services are truly sticky and which have fad-like appeal. Politics and capital markets also pose some concerns.

Despite all that, Westergren has learned to keep things simple.

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People still love radio even with the many alternative ways they can listen to music. Provide the best of radio with the best of the Web, Westergren says, and let your massive subscriber base tell you how you're doing.

"How do you translate 80 million monthly listeners into 80 million monthly consumers and activated fans?" is the question Westergren asks himself every day.

It's a big challenge. But at least it's not a crisis.