What’s Going On With Free Streaming?

Earlier this week Soundcloud’s financials revealed that the company was haemorrhaging cash (even before it had to start worrying about content license fees). Now news comes that Pandora is working with Morgan Stanley to meet with potential buyers. Back in Q4 2014 free streaming got a stay of execution when the majors decided to put their weight behind freemium after a period of many executives seriously considering canning the model. In 2015 free streaming was the growth story, with YouTube out performing everyone. Now though free streaming looks to be in seriously troubled waters. So what gives?

Pandora’s Problem Is Wall Street

Probably the biggest problem of all that Pandora has is the story it tells Wall Street. Every year Pandora accounts for a little bit more of total US radio listening, builds ad revenue and steadily strengthens its business. But that’s not the sort of story Wall Street expects from a streaming media company. Investors expect dynamic growth. But Pandora is, along with Rhapsody, the granddaddy of streaming and had 10 million users before Spotify was even launched in Sweden, let alone the US. Pandora long since passed its dynamic growth stage in the US and is now a mature business that is going about sensibly building a sustainable business.

The standard thing to do at this stage for streaming companies is to roll out internationally and find new markets where you can start a new dynamic growth story. This is exactly what Netflix is doing now that US subscriber growth has slowed. The approach has also served Spotify well. But the unique compulsory licensing structure in the US the underpins Pandora’s business model does not exist elsewhere. There is no global landscape of SoundExchanges for Pandora to plug into. With the exception of Australia and New Zealand Pandora has not been able to negotiate rates that it launch internationally with.

Actually, Slowing Growth Is A Problem Too 

All of which explains why Pandora has gone down the acquisition route, buying Next Big Sound, Ticket Fly and Rdio in a bid to become a full stack music company. The problem is that Wall Street either does not buy it, or simply does not get it. In fact, Wall Street does not really make much of a distinction between semi-interactive radio or on-demand streaming. The pervasive view among the investor community is that Pandora is being out competed by Spotify, regardless of the fact that there is only partial competitive overlap in terms of value proposition, target audience and business model. The net result is that Pandora’s market capitalization has fallen from $7bn to $1.8bn and to make matters worse it had to raise $500 million in debt, with revenue growth slowing.

Pandora Needs A New Wall Street Narrative

In just the same way Apple needs a new Wall Street narrative, so does Pandora. Even if just to maintain some market value while it finds a buyer. The full stack music strategy should be central to that narrative, even though the real story is that Pandora is the future of radio. Unfortunately that story will take a decade or more to play out and most investors do not have that kind of patience. (Spotify, these are the sorts of problems you’ll be having to worry about this time next year). And, to be precise, it is the Pandora model that is the future of radio, not necessarily Pandora itself.  Though the odds are still on Pandora playing that role, in the US at least.

If Pandora really does not have the stomach for seeing out the long game it should not find it too difficult to find a buyer, if the price is right. Exactly because Pandora is the future of radio, some of those big radio incumbents are likely buyer. Hello iHeart Media.

 

Pandora’s Rate Ruling Reveals The Cracks In Streaming Economics

The much anticipated outcome of yesterday’s Copyright Tribunal decision was a 20% increase of Pandora’s ad supported stream rate from $0.0014 per non-interactive stream to $0.0017. The result was roughly equidistant between the two parties’ preferred rate: Pandora wanted $0.0011, SoundExchange (the body that collects the royalties on behalf of the labels) wanted $0.0025. As with any good compromise neither party will be truly happy, though on balance Pandora probably came out slightly better. Both the rate and the whole rate setting process shine a bright light on the economics of streaming, especially when contrasted against on-demand services.

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Pandora’s semi-interactive radio service operates under statutory rates in the US that are set by the Copyright Royalty Board for a few years at a time, with inflation baked in. This means a continual rise in rates (see figure). It also gives Pandora a degree of certainty over its mid term future but prevents record labels from negotiating for better rates (publishers however are able to strike direct deals with Pandora). Spotify, and other on-demand streaming services, negotiates deals directly with multiple record labels, publishers and rights bodies. Deals typically come up for renewal every couple of years, involve large upfront payments and Minimum Revenue Guarantees (MRGs). They also run the risk of core product features being threatened in renegotiations – as we saw with the labels’ dalliance with killing off freemium this time last year.

The most significant difference between the models is how the per stream rate works. For on-demand services a royalty pot as a % of revenue is determined. This is then divided between rights holders based on plays in a given period and allocated on a per stream rate basis. Thus royalty payments remain a comparatively constant share of revenue, assuming of course that the service hits the MRG targets – if it doesn’t the share increases, often above 100% of revenue. This model also implies a clear ceiling to the potential profit an on-demand service can earn. By contrast Pandora pays out on a (largely) pure per stream basis. The direct consequence of this is that Pandora is able to increase it revenue per play faster than its rights cost per play which in turn creates the potential to grow margin (see next figure).

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Between 2009 and 2014 Pandora’s content acquisition costs per listener hour increased by 27% from $17.52 to $22.29. This reflects both the CRB set rate as well as deals with rights bodies and publishers. But over the same period Pandora’s revenue per listener hour increased by 114% from $21.48 to $45.97. Now clearly, an increase in revenue per hour does not inherently mean increased profitability, or even profitability at all. Indeed, Pandora’s continued losses have been a perennial bugbear for investors. But Pandora has chosen to invest its increased revenue to grow its business, building out regional ad sales teams and making acquisitions such as Next Big Sound, Ticket Fly and Rdio. In short, Pandora could have been profitable for some time now if it had so chosen. Instead it is chasing a bigger prize, namely to become the single biggest revenue driver in US radio. To get big it needs to spend big.

Pandora’s Core Strength Is Being Able Increase Profitability Per User

The underlying principle is clear: while on-demand services have little meaningful way of increasing revenue per user with the current model, Pandora has more than doubled revenue per user in 6 years while rights costs have declined in relative terms. Content acquisition costs fell from a high of 82% of revenue in 2009 to 48% in 2014. That rate will increase in 2015 due to direct deals struck with publishers and the $90 million pay out for the pre-1972 works ruling. But it still remains well south of Spotify’s 70%+.

On Demand Services Have Similar Fixed Costs But Tighter Margins Because Of Royalties

While there is a clear case for semi-interactive radio rates being markedly lower than on-demand rates many of the fixed costs of both types of streaming business are the same.  Both have to commit similar amounts to product development and tech, bandwidth, data analysis, reporting marketing, customer care, management. This puts on-demand services at an operational disadvantage compared to webradio services.

If paid-for streaming services are going to become commercially sustainable there is going to need to be pricing and product innovation to both reach more mainstream users (cheaper tiers) and to drive more revenue from high value users (more expensive tiers and bolt ons). Right now there is relatively little commercial incentive for on-demand services to innovate upwards as profitability will remain largely the same. There is an opportunity for labels to offer Spotify and co a Pandora-style pure per-play license structure for all products launched above and beyond the standard 9.99 tier. This would give the services the ability to follow Pandora’s path of growing revenue per user faster than rights costs per user, thus improving commercial sustainability and allowing them to invest more in product innovation.

Rights Frameworks Need To Engender Commercial Sustainability

Pandora is one of the few stand out, independent success stories of the entire history of digital music. It has become one of the world’s biggest music services despite being largely constrained to the US, it has built a commercially viable model and it has delivered a big return for investors via its IPO. Only Last.FM, Beatport and Beats Music can genuinely lay claim to having delivered big returns for their investors. There are many mitigating factors, but the unique licensing structure Pandora operates under is the single most important one. Do songwriters and labels feel that they’re getting short changed? Absolutely. But it is in the interest of every music industry stakeholder that the economics of digital music are structured in a way that enables standalone companies like Pandora, Spotify and Deezer to thrive. Otherwise there can be no complaints when the only options left on the table are companies like Apple, Amazon, Facebook and Google whose interest in music all stems from trying to sell something else. That’s when artists and songwriters are really at risk.