Will the Music Industry End Pandoras Business Model?

By Markets Fool.com

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For investors in streaming-radio provider Pandora , it's been a tough run since its IPO. Shares of the company are barely higher than its IPO price of $16 per share, while the Nasdaq is up 85% during that period. On Friday, the stock climbed higher than the $16 mark as unconfirmed and unsubstantiated rumors about a buyout continue to swirl throughout the blogosphere.

For investors, Pandora has had problems scaling its business. While concerns about content acquisition costs have been addressed by the company growing total revenue at a faster clip than content acquisition costs, the company has embarked on a rather ambitious sales and marketing push to grow revenue. Between those two line items, the company is having problems scaling out of those two costs. For additional perspective, see the table below.

Fiscal Year 2012 2013 2014
Content Acquisition Costs $248 million $342 million $446 million
Sales and Marketing Costs $101 million $182 million $277 million
Total Revenue $410 million $637 million $920 million
Content Acquisition and Sales and Marketing Cost % 83.4% 82.5% 78.5%

Source: Pandora's historical detailed financials.

However, right now, scalability is not even the biggest concern with Pandora's business model. A recent article from The Wall Street Journal points out Pandora's biggest problem -- the music industry no longer wants it to succeed in its current form.

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Supplier power is strong
In an article entitled, "Era of Free Digital Music Wanes" (subscription required), it appears the music industry is rethinking the value proposition of the fremium business model of streaming-based services. As a matter of fact, an unnamed major-label exec was quoted as saying his label made a "mistake" to allow licensees offer on-demand listening features for free. This comes after years of artists complaining about unfair payouts from streaming-based services -- most famously, Taylor Swift recently pulling her catalog off of Spotify.

Major labels are not as powerful as they once were, but they're still a powerful supplier -- and there are no substitute goods for Pandora as far as content goes. In addition, the music industry is an entrenched oligopoly with only three major labels. Therefore, it's a strong possibility that, once one pulls its catalog, the others will, as well, acting in concert to preserve their business interests.

Ironically, the failure of the music industry to adjust to digital downloads, rather than a hard copy, led to Apple being able to exploit their myopia for huge profits with iTunes and the iPod. After the music industry's huge strategic error of losing out on the ability to shape the digital download space to its benefit, you'd assume it wouldn't have conceded the streaming market -- but you'd be wrong.

Want to listen to music? Pay for it!
It's not like the music industry wants Pandora, Spotify, et al., to fail; it just wants streaming-based services to limit the fremium model. Where Pandora and Spotify look to monetize the free streaming side with ad-based revenue, music executives appear to want these companies to treat free streaming as a trial period in order to induce users into subscriptions. Obviously, that's more lucrative for Pandora, as revenue per 1,000 listener hours is nearly $77 dollars for a subscriber, and $42 for an ad-based user.

However, there's just no guarantee Pandora can entice enough users to make the jump. Last fiscal year, Pandora reported only 20.4% of its revenue from subscriptions. If the music industry wants Pandora to try to transition all users into subscribers, it could wreak havoc in its top line.

But that's what it appears the music labels want, according to another label executive: "If they're not serious about having a paid tier and improving monetization, we're going to be less interested in working with them." This could all be negotiation bluster; but in the event labels withhold content from Pandora, the investment could suffer greatly.

The article Will the Music Industry End Pandoras Business Model? originally appeared on Fool.com.

Jamal Carnette owns shares of Apple. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple and Pandora Media. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.