Is Pandora on the Verge of Making a Big Mistake?

IMAGE SOURCE: PRESS.PANDORA.COM.

With its acquisition last year of interactive streaming service Rdio, Pandora Media (P) seems determined to launch a product that lets users pick the songs they want to listen to, putting it in a better position to compete with interactive streamers such as Spotify.

But if one executive from Sirius XM Holdings (SIRI -1.59%) is right, such a move might put Pandora into a position where it's increasingly less likely to ever turn a consistent profit. Sirius XM CFO David Frear is skeptical about the company's direction, and he let analysts know it last month at a conference, saying: "If they're going to need interactive music licenses from the music labels ... I think that's a very tough business plan ... "

Frear has a good point. After all, Spotify, the most popular of the interactive streamers, with 30 million subscribers, has consistently posted larger losses than Pandora. And Spotify's losses have been growing in recent years, coming in at more than $188 million on $2.1 billion in revenue for 2015.

At the heart of the issue are the costs associated with running an interactive music streaming service -- the kind that lets subscribers pick their songs and not just listen along to a station. They are typically much higher than the costs of simple streaming, which has been Pandora's bread and butter since its inception.

Chalk that up to a different system of royalty payments, the mechanism through which the streamers compensate the music companies and artists for the music they serve up to listeners.

Can Pandora really take on bigger costs?

For Pandora, those costs in the last quarter equaled some 58% of its overall revenue -- the company's biggest expense in a quarter where it posted a $109 million operating loss. So investors have reason to question a change in strategy that, based on what the interactive streamers like Spotify have disclosed, could increase those costs by 10 percentage points or more in an effort to better position the company to win more subscribers over its competitors.

It's understandable that Pandora would pursue a model that looks to shift revenue to subscriptions and away from advertisements.

One of the long-term concerns for Pandora is that its subscription service lacks wide appeal, leaving it relying on a much more unpredictable ad-based revenue stream. A subscriber-based business model would offer more reliable revenue and allow the company to generate far more revenue from each of its users. Subscribers make up less than 5% of Pandora's 79.4 million listeners, yet those listeners contribute nearly 19% of the company's overall revenue.

And it's not getting cheaper for Pandora to serve up its music, either to subscribers or free listeners. Content acquisition costs, the line item where royalties are calculated, were up some 36% last quarter, as revenue rose just 23%. That helped Pandora's net loss for the most recent quarter to more than double over the prior year.

Interactive radio costs more

As it's constructed, Pandora operates under licensing agreements that have left it paying out royalties that range from less than 50% of overall revenue in 2014 to more than 60% back in 2012 . How much it pays depends on a number of factors, including how fast its listening hours have grown and what the mix is between free listening hours, which have lower royalties, and subscriber listening, which carries higher rates.

Spotify, meanwhile, has reportedly been paying royalties to the tune of more than 70% of the revenue it generates.

Sirius XM's Frear estimated that between royalties and distribution agreements, interactive streamers face costs that can exceed 80% of gross revenue. "It's really tough to ever make money in that," Frear said. 

So, based on Frear's assessment, Pandora's best bet for turning a consistent profit is operating the business as it has been -- with the less costly licensing agreement and a combination of revenue from ads and premium subscriptions for ad-free listening to existing channels.

Interactive radio is "a very tough business plan," Frear said. "But they certainly seem committed to [launching an interactive service], so we will see how their execution goes."

Is this a valid assessment?

There's reason to be skeptical about opinions such as the one Frear recently offered to analysts. He's an exec from one company publicly sizing up the strengths and weaknesses of a competing business. That usually doesn't result in a glowing review.

But there's also a good reason we should give Frear's opinion credence: Sirius XM has been studying the streamers for some time, not just as competition, but also as potential takeover targets. It's looked hard at Pandora, which may be on the market, and to date hasn't publicly indicated much interest in the popular streamer -- or any of its brethren, for that matter.

As Frear notes, the music streaming business is a tough one to turn a profit in, but if there's one company that's perhaps best positioned to do so, it's Pandora. The company must tread carefully if it pursues an interactive offering that significantly drives up its costs. If a new licensing agreement leaves it paying Spotify-level royalty rates, Pandora might give up its biggest advantage over its streaming rivals.