This Could Change Everything For Pandora

Great service. Terrible business.

That's been the knock on Pandora Media (NYS: P) since its market debut last June and, with a decline of 40% from its $16 IPO, that statement may well be justified. Despite a listener base that would make most rivals envious, the company has been unable to turn a consistent profit, as royalty costs have outpaced revenue. Detractors regularly make this point when they pooh-pooh the stock, but they seem to mistakenly make the assumption that this imbalance is unchangeable.

There are a number of imaginable ways that Pandora could overcome this obstacle, but a new development now makes that possibility seem more likely than ever before.

Washington think tank The Brookings Institution generally stays within the political realm in its research, but John Villasenor, a senior fellow at the organization, has just released a paper entitled, "Digital Music Broadcast Royalties: The Case for a Level Playing Field," which calls for the standard for webcasting royalties to fall in line with satellite radio's.

Trying to make a dollar out of $0.15
Before delving into Villasenor's argument, let's go over some background on the issue.

Starting in the mid-2000s, royalty rates for music delivered by satellite, Internet, or digital cable have primarily been determined by the Copyright Royalty Board, a group of three judges selected by the Librarian of Congress. The royalties imposed are paid and distributed by SoundExchange, a non-profit organization representing recording artists.

For abstruse reasons having to do with the Digital Millennium Copyright Act of 1998, a different rate gets applied to "preexisting" satellite and digital cable services, such as SiriusXM Radio (NAS: SIRI) , Muzak, and Music Choice, from the one imposed on newer listening services, like Internet radio and broadcast simulcasters. The newer group of rates are set by the Copyright Royalty Board, and are required to represent prices that "would have been negotiated by a willing buyer and willing seller," but they also consider other information, such as the promotional benefit to the artist.

The bifurcated system protects the grandfathered services against competition from the likes of Internet radio. The CRB has imposed oppressive costs on Pandora and its ilk, resulting in a drastic disparity. While Pandora pays over 50% of its revenue in content acquisition costs, SiriusXM pays only 8%. Music Choice pays even less, at 2.5% of revenue.

We don't need no more troubles
Villasenor's argument for equal standards has found at least one important ally. Representative Jason Chaffetz of Utah is working on a bill called the Internet Radio Fairness Act of 2012 that would apply the older 801 (b) standard to Internet radio companies and, therefore, lower royalty rates for businesses like Pandora.

Not surprisingly, Pandora's management has also been demanding such a change. Founder Tim Westergren has called for "the discrimination against Internet radio to come to an end," and even testified before Congress, saying the current system is "fundamentally unfair and indefensible," and urged legislators to "level the playing field."

For Villasenor, the issue boils down to two simple tenets of capitalism: innovation and progress. He says:

The current copyright royalty landscape creates significant inequities among current market participants. It also furnishes a strong disincentive to potential market entrants and to the introduction of innovative new business models for delivering digital music.

Foolish final thoughts
Like the battle for collecting internet sales taxes that's revolved around, the inconsistency in the royalties system seems ultimately untenable. No one can say for sure if and when Congress will act but, as the popularity of Internet radio grows, this issue will only become more pressing. Allowing dated models, such as terrestrial radio, to have such an unjustified advantage seems unwise and inexcusable.

With royalties eating up more than half of Pandora's revenue, a reduction in the rates could mean potentially huge profits for a company now struggling. In the Internet DJ's most recent quarter, content acquisition costs took up nearly 70% of revenue, leading to a $0.12 loss per share. Cutting royalty costs down to near Sirius range at 10%, for example, would have led to near a $0.10 per-share profit, if you assume a reasonable tax rate. At that level of profitability the company would sport a reasonable valuation considering its growth potential.

Investors will get the latest details on royalty costs when Pandora reports second-quarter earnings on August 29. Analysts are expecting a loss of $0.03 per share.

Unlike Pandora, shares of Sirius XM have reached new heights lately, thanks to strong subscriber additions and a takeover attempt from Liberty Media. Some analysts are revising their price targets up to $3.00, but our own in-house Sirius XM expert, Rick Munarriz, has also weighed in on the controversial matter. Now you can find out what Rick has to say in his brand-new, in-depth, premium report all about Sirius XM. This detailed analysis digs into the opportunities and risks facing the satellite radio provider, and gives you all the information you need to know about the unique competitive landscape facing the media giant. Better yet, it comes with a year's worth of updates, so you can easily follow along with John Malone's takeover bid, Howard Stern's future, and Sirius's push towards 25 million subscribers. If you're a shareholder, or thinking about investing, you can't afford to miss it. Just click here right now to get started with our full package today.

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