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SEC: Pandora Is "Unsustainable" Due to Reliance on Legal Strategy

The SEC told Pandora (P) in March that its music licensing agreements make its "current business plan unsustainable," according to copies of correspondence disclosed by the company. The disclosures underline BNET's earlier report that a crippling rise in Pandora's music fees is set to kick in in 2015, making it highly unlikely the company can survive without some sort of miracle performed by its legal and lobbying teams.

After Pandora filed its IPO offering in February, the SEC reviewed the filing. In March, the SEC asked Pandora to make it more clear that it was highly dependent on its lawyers, and that it would go out of business if it couldn't renegotiate its music license fee schedule:

In order to provide greater balance to your summary, highlight that:
You currently operate under a business plan strongly reliant on lobbied concessions and federal court and federal agency consent decrees and settlements, setting reduced royalty and licensing rates that expire in 2015 and that ordinary rates, not subject to such extraordinary measures, to which you may be subject upon the expiration of these exceptions make your current business plan unsustainable, as discussed in your risk factors on page 15 and 16; ...
Pandora did disclose its fee schedule in June, but it represented its fees-per-song as fractions of a penny. The maximum it will pay to serve one song to a listener is 0.0025 cents.

It is only when you convert those penny fractions into percentages that it becomes obvious Pandora's costs are about to go through the roof. They will rise between 37 percent and 47 percent when its current agreement with licensing body SoundExchange expires in 2015. In Q1 2011, license fees at Pandora were $29.2 million, or 57 percent of its $51 million in total revenue. The company lost $6.7 million as a result.

Obviously, the music industry will have to be persuaded that Pandora should get generous, special terms if artists want it to stay in business and continue receiving money from the company. (Sirius XM (SIRI), by contrast, is profitable on the current terms.) In its most recent S-1, Pandora admits it is "unsustainable" if it cannot negotiate reduced fees in the future:

We do not know what rates will be available to us following that period and there is no guarantee that the royalty structure that emerged from the negotiations with SoundExchange pursuant to the Webcaster Settlement Acts will be available after 2015. The CRB, which still has rate-making authority over us upon expiration of our agreement with SoundExchange, has consistently established royalty rates that would, if paid by us, consume an unsustainable percentage of our revenue. If we are unable to reach a new agreement with SoundExchange for the period after 2015, our operating costs may significantly increase, which could harm our financial condition and inhibit the implementation of our business plan.
That renegotiation appears to be the only hope for Pandora, as CEO Joe Kennedy recently told Bloomberg that there was a lack of demand for ads on its mobile service, which now constitutes 60 percent of all Pandora's listeners. Pandora closed at $13.41 Aug. 3, down from both its high of $20.04 in July and the $17.42 it closed at on its first day of trading in June. A message left for Pandora last night was not immediately returned.


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