Pandora's box of music royalties

Leading US internet radio provider Pandora is positioning itself for a very public battle against musicians and songwriters. A fierce battle has been brewing ever since Pandora's founder, Tim Westergren, blogged in early October that the company was planning to lobby US Congress to reduce royalty rates paid to artists and record labels for the use of their sound recordings.

If that was not enough to raise the ire of the many artists already questioning their share of royalties from new digital streaming offerings such as Pandora, Spotify and Rdio, Westergren also bragged in the same post that the company had already paid royalties of over $US1 million to artists such as Coldplay and Adele. The fight begun in earnest last week, when the first Congressional Hearing on the US Internet Radio Fairness Act was held amidst protests by musicians on the steps of Capitol Hill.

But looking to secure its business model – and deliver the profitability its shareholders seek – by reducing the royalties it pays artists, Pandora could be biting the hand that feeds. Publicly, it also sends a very dangerous message as the industry looks to curb piracy by encouraging listeners to embrace evolving digital streaming services, both paid and advertising-supported.

Although Pandora now has over 50 million users in the US, it still represents just 6.5 per cent of radio listening nationally. And even though the company's value hit over $US4 billion just after its IPO in June 2011, it is still yet to turn an annual profit. It also expects to make another loss this year.

The company's financials make it easy to see why artist royalties are in the firing line. Last year, if Pandora reduced its overall royalty costs by less than 10 per cent the company would have delivered its first annual profit. Even so, with content costs only about half of all costs, similar reductions elsewhere could also have led to profitability. The company, however, is focused on reducing the royalties it pays to artists in its search for profitability.

For Pandora's part, it argues that reducing sound recording royalty rates from the existing statutory rate – set for internet radio by the US government – will drive market growth, creating a significantly bigger revenue pie for artists overall. How much bigger that pie would be – and how much would flow to artists – is still unclear. Such a scenario, however, would see Pandora begin delivering profits to its shareholders.

But Pandora is not just taking aim at sound recording royalties. Separately, earlier this month, the company also commenced action against ASCAP – the not-for-profit organisation that represents around half a million US songwriters, composers and lyricists across all genres of music – to reduce its publishing royalty rates.

In contrast to the sound recording royalty – which is directed towards artists and record labels – the separate publishing royalty is directed towards the writers of the music and lyrics. For example, although Whitney Houston performed the hit "I Will Always Love You” the song's publishing rights lie with Dolly Parton, the writer of the song. These royalties are already so low as to represent around only 4 per cent of Pandora's total revenues – a source of much discontent within music publishing ranks.

Although publishing royalties are generally overlooked in ongoing music piracy debates – with plummeting sales and earnings from recorded products such as CDs taking centre stage – these royalties are often referred to by those in the music industry as "the musician's superannuation”. Putting further downward pressure on such royalties in the digital environment does not bode well for the future of those writing the songs that drive the billion-dollar plus NASDAQ valuations of services like Pandora.

Indeed, much is at stake. In Australia, APRA|AMCOS has distributed over $100 million directly to songwriters from digital channel collections to date – just a small fraction of the overall $1.5 billion distributed to songwriters from all sources since digital services were introduced. In the last decade, even as annual recording industry revenues declined from around $650 million to just over $380 million, copyright-based collections on behalf of songwriters have grown every year, up from $121 million in 2002 to $257 million last year.

Maintaining the ability for songwriters to monetise their work in the digital future is crucial for their survival – particularly as the large-scale shift from the physical to digital world occurs on the back of services such as Pandora.

While these services are certainly key to the growth of the music industry in the digital future, squeezing music royalties to validate current business models appears short-sighted. Although technology players have been telling the traditional music industry to "find a new business model” for the last decade it is quickly becoming apparent they should heed their own advice. As music services like Pandora face increased competition from both new entrants and giants like Apple, looking beyond current models – just as technology players looking to shake up the music industry did over a decade ago – will become crucial to their future success.

Although Pandora is clearly taking aim at music royalties, the company's recent deal with Microsoft to offer an ad-free service on all Windows 8 smartphones for one year looks like a more promising direction. Under that deal, Pandora's premium offering will come pre-loaded on all devices, with Microsoft reportedly paying retail price for the service. At current rates, if Microsoft can ship 10 million units it would represent an annual revenue opportunity to Pandora of around $360 million – more than last year's revenue of $274 million. Innovative approaches such as this to grow the market are preferable to cutting artist royalty rates.

Even though the experience of licensing new digital services in Australia, including Pandora, has been extremely positive to date, the pending US proceedings could set the tone for future pressure on digital royalty rates around the world. This is indeed a worrying precedent for artists.

But for Pandora to make headway with its current approach it will need to cut through increasingly high-profile protests from musicians and songwriters. And this will not be an easy path, particularly if the recently re-elected boss in The White House is called upon by his ASCAP-member campaign buddy – the one that has been The Boss for much longer than he has.

Andrew Harris is Principal Analyst at APRA|AMCOS, The Australasian Performing Right Association and Australasian Mechanical Copyright Owners Society (AMCOS).