The source of Pandora's growing pains

Digital radio disruptor Pandora Media reported its quarterly results this past Friday (AEST), and the results show that despite robust growth in all key metrics the company is challenged by high content acquisition costs, which make it increasingly difficult to turn this user and revenue growth into a profitable position.

For the three months ending 31 March 2013, Pandora generated $125.5 million in revenue for the quarter, up 55 per cent on the same period the year prior. Encouragingly, subscription revenue (where a user pays a monthly fee for an ad free service) was up over 100 per cent to $20.3 million for the quarter.

However, this 55 per cent revenue growth was accompanied by a 53 per cent increase in expenses. The largest contributor – content acquisitions costs paid to record labels, increased 49 per cent to $82.2 million. Unlike radio, which generally pays a small percentage of total revenue to music rights holders in exchange for the right to play their recordings, Pandora has had to negotiate individual deals with the record labels outside of the arrangements covering broadcasters. The result – content acquisition costs alone account for 65 per cent of Pandora’s total revenues – a percentage that remains relatively stable even with significant revenue growth.

But it’s not just the content acquisition costs that are growing. Product development was up 75 per cent year on year, marketing and sales up 74 per cent and general and administrative expenses up 40 per cent. Total costs for the quarter were $153.9 million, resulting in a quarterly loss of $28.4 million.

Wall Street was initially positive about the results, with the stock bouncing 11 per cent in after hours trading on Thursday evening (US time), however on the Friday the stock dipped and closed at $16.43, in line with the zone it has been trading within for the past two weeks.

The main positive aside from strong user and revenue growth was a small increase in what Pandora calls advertising RPM, which basically accounts for revenue per user per 1,000 minutes listening. On the desktop this increased around 5 per cent based on the same quarter the year prior. On the mobile platform it increased over 30 per cent. Advertising RPM is one of the pillars of a profitable Pandora, increasing both the amount of advertising it can serve to users per 1,000 minutes and more importantly, increasing the yield for which it can extract for this advertising. Pandora is betting that the market will find its advertising suite increasingly more appealing than broadcast radio, because Pandora is a registration service it has access to much more granluar user information it can target advertising based on age, gender, location, music preferences, network and device.

An increase in advertising volume and yield should result in content acquisition costs dropping in terms of their percentage of revenue. Part of Pandora’s scaling problem is despite the company seeing significant growth in topline revenue, at the same time it is growing equally strongly in terms of users. This user growth increases the content costs paid to record labels but at the same time revenue per user isn’t increasing as required. It’s almost like Pandora’s current growth is both a gift and a curse. It is likely that once Pandora’s user numbers start to level out, which is increasingly likely given the current size of the service, costs as a percentage of revenue will drop as the ad market increases its migration of radio spend from broadcast to digital providers.

The more difficult task will be curbing the costs paid for content. On one hand you could argue that Pandora is being unfairly treated as it pays a significantly higher chunk of its revenue than broadcaster radio companies to content owners, and that these royalty rates should be uniform across the board regardless of whether the content is transmitted through an internet connection or via a broadcast signal. On the other hand you could argue that Pandora is paying a fair rate to access these sound recordings, and that without these sound recordings Pandora wouldn’t exist as the platform is ultimately only as strong as the music it has access to.

Regardless of the position you take, curbing these costs is essential to Pandora’s profitability. Looking at full-year 2012 numbers, a 15 per cent reduction in content acquisition costs from $258.7 million to $219.8 million would have turned a $37.2 million dollar loss into a $1.7 million profit. Whether or not a $1.7 million full-year profit is in line with what one would expect from a company with a $2.83 billion market cap is another matter, but it would at the very least stop Pandora from burning a hole in its cash reserves.

The difficult part of renegotiating content acquisition costs is that it puts Pandora in a delicate situation – effectively asking musicians and labels, the people and companies its product is designed to celebrate, to accept worse terms to have their content featured on the platform. Some have said that this biting the hand that feeds it. Local music collections body APRA has suggested that while digital music services have stated for the years that the music industry ‘needs a new model’, that maybe it should heed its own advice and look at a business model that doesn’t involve squeezing rights holders livelihoods to turn a profit.

The company is bullish that it can turn its first-quarter loss into a marginal gain in second-quarter gain, with revenues for the quarter projected to be around $155-160 million. Furthermore, the US ad market is traditionally much stronger in the July-December period, so analysts will be watching Pandora carefully to see whether it can turn its likely revenue increases during this period into a profitable position for the year as a whole.