Pandora CFO: Apple is Our 'Frenemy'

As competition heats up in the digital music space, one of the leaders has found itself under increased scrutiny.  Pandora (NYSE:P), a pioneer in Internet radio, has seen its shares rise and fall since it went public in 2011, trading down 45% in the past year. 

With a market cap of $3.4 billion, the biggest factor weighing on the company’s stock, is the uncertainty surrounding the royalty rate, CFO Mike Herring told At the end of 2015, the Copyright Royalty Board (CRB), will be determining what rate digital radio services will pay artists for each song played over the next five years.

The upcoming decision is creating “a lot of angst in the industry,” Herring said. But “we’re fully engaged in the process” and “we’re confident that we’ll get a reasonable outcome.”

The debate centers around whether the artists are compensated fairly. The Internet brought about a decline in record sales, with consumers opting to purchase individual tracks or listen to songs online.

Herring said no matter what price they pay for the music, there will always be someone who thinks it's not enough.

“We’re paying meaningful royalties to the music industry” and “we think the reasonable outcome is about where we are paying today."

That amount is about $.0014 per song. Pandora says it has spent over $1.2 billion on royalty payments.

“If that went up significantly, it would be harder to be profitable,” Herring said.

Pandora is profitable on an adjusted basis, with net income of $43 million for 2014, on $907 million in revenue.

“No one knows whether it’s going to go,” Mark Mahaney, analyst at RBC Capital Markets, said about the upcoming rate negotiations. But it is a pivotal moment for Pandora because it is a “pretty dramatic part of the cost structure.”

The “artist community will argue that Pandora doesn’t promote their music, they cannibalize their record sales,” Rich Tullo, analyst at Albert Fried said. “The argument that artists should get less instead of more is really a hard to make.” Tullo predicts that the judges will decide on an increased rate of $.002 per song.

While services like iHeartRadio and Slacker Radio have gained some traction, Pandora is the heavyweight in digital radio, with 81 million monthly active users. Spotify also competes for listening hours, and the service has more than 60 million active users. Jay-Z is also introducing a new streaming service called Tidal.

Apple (NASDAQ:AAPL) has a stake in digital music, yet its iTunes Radio service, introduced in 2013, has hardly been a game changer. Still, the company, which found success with the iPod listening devices, is not ready to give up on music and is rumored to be developing a new music service with Beats, the headphone company which Apple paid $3 billion for last year.

“If they lose even 10 million monthly active users,” because of the new Beats service, “it’s a problem for the stock,” Tullo warned.

Pandora, which owes part of its success to the popularity of its iPhone app, has a “frenemy kind of relationship going on” with Apple, according to Herring. “We were part of what made it fun to have an iPhone,” Herring added. While the two companies are “close partners,” it is a “very interesting relationship.”

Although there has been no formal announcement, one can expect that Pandora will be integrated into Apple Watch. And “we’ll definitely be in CarPlay” said Herring, regarding integration into Apple’s new auto dashboards. This would make it easier for users to listen to Pandora in the car and could become a significant part of their business.

But, for now, Pandora investors are focused on costs. Once the royalty rates are determined for 2016 through 2020, some are speculating that Pandora could be an acquisition target.

After its “known where we’re going with the rates then it is a takeover target, but at much lower prices,” predicted Tullo.

“They could also be a takeover target if things go well,” said Mahaney.

Herring added "anything is possible."