How Smart Is Pandora, Really?

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There's never a dull moment in the world of Pandora. So far in 2013 Pandora has had the angels on its side, its stock gaining as much as 110 percent.

Remarkably, investors continue to pile money into Pandora even as rival services from Google's All Access and Apple's iTunes Radio have emerged. Unlike previous years, Pandora seems to have developed bulletproof resistance from concerns that would have otherwise punished the share price.

While I don't disagree that Pandora's management has been pushing all of the right buttons, I wouldn't advise investors to press their luck too much. Rising content costs is still a major issue here. Also, I don't believe that Pandora has effectively addressed its ability to monetize its business model.

That said, I will give Pandora credit for being smart enough to at least think "outside the box" to mitigate the impact of these costs. But how well will it work?

(Read More: Here's Why Pandora Shares Rose on Apple's iTunes Radio)

Last week, when I read on that Pandora had acquired KXMZ-FM, a South Dakota radio station, I thought it was a joke. I immediately went to the Securities and Exchange Commission Web site to make certain that it was real. Sure enough, it was. But what would Pandora, an Internet radio company, want with a terrestrial radio station?

Terms of the deal have not been disclosed so I couldn't scrutinize the financials the way I wanted. However, I can say that contrary to popular opinion, this deal had nothing to do with Apple nor, for that matter, was this deal influenced by competitive positioning with Spotify or Slacker or Sirius XM. Was it bizarre? Absolutely! It was also pretty darn smart.

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Pandora saw this move as a way to combat the American Society of Composers, Authors and Publishers (ASCAP), a no-profit performance-rights organization that protects musical copyrights of its members. ASCAP is able to do this by monitoring public performances of its music—regardless of how it's broadcast.

Essentially, ASCAP is an overseer of licenses and music royalty rates, ensuring that its members are compensated accordingly. While that's great for the artists and the rights holders, it's painful for companies like Pandora that rely heavily on content, especially when Pandora has to cut a check each time the music plays.

Meanwhile, terrestrial radio stations have something that is akin to a union called the Radio Music Licensing Committee (RMLC). This body is large enough where it has negotiated with ASCAP to reduce royalty rates for the likes of CBS (CBS) and Clear Channel Communications.

Clearly, this proves there is some truth to the notion of "strength in numbers." But it also validates previous claims made by Sirius XM and Pandora that there are, in fact, discriminative practices in this industry regarding royalties and licenses. They've complained about being forced to overpay.

It's also worth noting here that the reduced royalty rate that Clear Channel enjoys by virtue of its association with RMLC has also extended to Pandora's rival iHeart Radio, which is owned by Clear Channel. Did this present iHeart Radio with an unfair advantage? Maybe and maybe not. But Pandora felt it was time to get aggressive.

By acquiring KXMZ-FM, Pandora has become "unionized." It's unclear how much more effective KXMZ-FM will make Pandora's fight to lower its costs. But it's nonetheless an important chip Pandora can use at the negotiating table or in the court system. Pandora had no choice here, especially given the market share it had amassed over the past 12 months in some very important radio markets. Its growth has been both a good and a bad thing.

"Growing" means the company is gaining more listening hours, which helps the company negotiate better deals with advertisers. The bad news is that ... well, the company is gaining more listening hours, which means that Pandora has to pay more in royalties. This has always been the quirky nature of this business model and the main reason that I've stayed away from the stock.

(Read More: ZenoRadio, a Poor Man's Pandora, Is Booming)

The company, however, seems determined to change its tune. I don't believe that buying KXMZ-FM will immediately do that. But I do feel a little bit better about management's ability to make money down the road, even though Pandora has downplayed the near-term impact—suggesting it expects less that 1 percent saving in acquisition costs.

It's interesting, though, how some people who claim Pandora is "good for musicians" are quick to ignore how often Pandora tries to circumvent paying musicians for their work. The fame is not enough—it never will be.

For now, I believe the stock is fairly priced. Although there could be more long-term value in these shares, it's too risky to dive in blindly without knowing, at least for a couple of quarters, what impact these recent new entrants like Apple and Google will have on this "musical chair" business model.

By Contributor Richard Saintvilus.

Additional News: Broadcast Music Sues Pandora Media Over License Fees

Additional Views: Damage Control: Pandora CFO Downplays 'iRadio' Reports


At the time of publication, the author was long AAPL.