Pandora's Cost of Music Isn't the IPO Problem Critics Think

Pandora's IPO is set for today. Unlike LinkedIn (LNKD) or Demand Media (DMD), the company has yet to be profitable and doesn't expect to be so until next year. But that alone isn't what makes some industry watchers down on the company. Instead, the issue is cost of music.

Such people as my BNET colleague Jim Edwards and Rolfe Winkler in the Wall Street Journal are sure that Pandora is permanently screwed by "crippling" royalty fees and a "lack of operating leverage." Scary stuff for a business, except that it's not true. Yes, Pandora is still losing money, but things are moving in the right direction and the cost of acquiring music is actually falling.

Not pretty is different from ugly
There is basis for criticism. After all, Pandora has been losing money steadily since it started, as the table from the company's latest S-1 revision below shows, and that's never a happy place for a business (click to enlarge):

The most cited culprit I've seen is the cost of royalties paid for the music -- content acquisition costs, which are royalties, and cost of revenue, which includes streaming, infrastructure, music delivery, and third-party ad server costs. And, no doubt, they've been high. But here's a chart I put together that looks at Pandora's costs as percentages of revenue. I include something I call total revenue cost, which is the combination of content acquisition and cost of revenue (click to enlarge):

On the whole, all costs as percentages of revenue have trended downwards. Is the total revenue cost (including royalty payments) a burden? Absolutely. Last year, it effectively left Pandora with gross margins of 41.3 percent. For an Internet business, that's bad, particularly as it entails the variable cost of royalties. But in general, there are plenty of industries that would love to have that level of gross margin, and any tech hardware manufacturer works by having to pay more cost for every new product it sells.

Royalties rise, but financial burden shrinks
As Edwards notes, Pandora's royalty rates are set to increase through 2015, at which point the industry will negotiate a new royalty agreement. The total jump will be about 37 percent for ad-based customers who don't pay subscription fees and almost 65 percent for the subscription customers.

And yet, rising royalty rates are nothing new. According to the pureplay rate chart that Pandora gets from SoundExchange (the board that sets royalty rates), the equivalent of the non-subscriber rates went up by 15.5 percent between 2007 and 2010 (three years). The amount that the new royalty rates will climb in the equivalent time is 27.5 percent.

The broadcaster rates, which are the same as the subscriber rates that Pandora listed, went up by 45.5 percent between 2007 and 2010. The amount the new royalty rates will climb in the next three years is 35.3 percent.

Non-subscription royalties will climb faster in the next few years than they did, while subscription royalties will climb more slowly. A challenge, certainly. But see how overall royalty payments have fallen over time (click to enlarge):

That's an 18.7 percent drop just between 2010 and 2011. The blended drop was 35.2 percent between 2007 and 2011.

To put it differently, there is some complexity in the royalty payment calculations that the critics are missing. Even as use went up and and royalty rates increased, the percentage of revenue that went to royalties decreased. The variable costs appear to get more efficient as time goes on. It isn't a simple case of every new customer representing a proportionate amount of new cost. There is a provision for a flat 25 percent of revenue, depending on the amount of music consumed.

Perhaps one of Pandora's customer categories is under that rate, or maybe use per customer is down. In any case, it's clear the assumption that costs will escalate linearly or faster with the increase in customers and revenue is questionable. Maybe there's a sound reason that Pandora expects to be profitable in 2012. Certainly the decline of costs as a percentage of revenue suggests it could be true.

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