The Price Pressure's on Pandora Media Inc.

Pandora's new app update. Source: Pandora.

Despite all the complaints from artists claiming Spotify doesn't pay enough in royalties, 70% of the music streaming company's total revenue goes to publishers, songwriters, and artists. There's no way around that for Spotify: Even if it increases its subscriber base or ad rates, it's only going to keep 30% of revenue to pay for operating expenses.

Comparatively, Pandora Media pays a flat rate per song "performance" that it negotiated with digital performance rights group SoundExchange. While the company also pays a percentage of revenue to songwriters, that percentage is just 1.85% for ASCAP and 4.1% for BMI, far from the 70% of total revenue Spotify pays out.

Overall, Pandora's content acquisition costs as a percentage of revenue are far lower than those of Spotify and other on-demand music streaming services (with YouTube a possible exception). But with the sudden increase in music streaming and the recording industry's reliance on streaming royalties for revenue, how long can Pandora's advantage last?

A question mark hanging over Pandora's headPandora's performance royalty fee paid to SoundExchange is set for 2015, but 2016 and beyond remain up in the air. SoundExchange is asking for a hefty raise from the Internet radio streaming service, which has grown its listener count and share of the radio market significantly since the last round of negotiations.

Last year, Pandora paid out about $1,370 in total royalties per 1 million spins, according to a blog post by founder Tim Westergren.That rate rose slightly in 2014, and will increase again in 2015 based on a performance rate increase of $100 per million spins each year.

For 2016, SoundExchange proposed a rate of $2,500 per million spins, a drastic increase in royalty rates from the 2015 rate of $1,400, and it expects to increase the rate by $100 per million spins per year through 2020.

Pandora has proposed significantly lower rates that range from $2,150 per million spins in 2016 to $2,300 in 2020 for songs being enjoyed by subscribers. The company, along with other webcasters, will present its case to the Copyright Royalty Board, which is expected to make a decision in December 2015.

What would higher royalties look like for Pandora?At a rate of $0.0013 per spin and a constant percentage of revenue paid to songwriters, Pandora paid out 46.5% of revenue in content acquisition costs last quarter. For the first nine months of 2014, it paid out 50.7% of revenue.

So far this year, revenue growth is outpacing licensing costs. Last quarter, revenue per thousand spins, or RPM, increased 12%, well ahead of licensing costs. However, the last two quarters have seen slower growth in RPM compared to 2013, when the company posted RPM growth of 27%.

The question becomes whether Pandora could increase RPM faster than the proposed increase in licensing fees from SoundExchange. Under SoundExchange's proposal, its fee in 2016 would increase 78.5% per spin from 2015's performance rate. There's practically zero chance Pandora can keep pace with that rate. Analysts expect Pandora's total revenue to increase 31.5% next year. Naturally, RPM increase will be lower as Pandora increases listener hours.

The result, should Pandora's royalty rates increase even half as much as SoundExchange proposes, is a significant earnings hit as the company's gross margin declines to levels when it had lower revenue.

Pandora could always sidestep SoundExchangeShould the Copyright Royalty Board ruling go poorly for Pandora, the company could work directly with labels to negotiate royalty rates. This is what Spotify does. Considering that Spotify's service is somewhat different from Pandora (on-demand versus radio), Pandora ought to be able to negotiate more favorable rates than Spotify.

There's no guarantee, however, that the record labels will offer anything significantly better than the CRB ruling.

In the end, Pandora is caught in a game in which there's no clear path to profitability. Every five years it faces uncertainty in how much it will have to pay for content. Thus, it is working diligently to grow revenue by increasing its local ad sales forces. However, increasing revenue makes it easier for SoundExchange to demand more in performance fees.

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Adam Levy has no position in any stocks mentioned. The Motley Fool recommends Pandora Media. The Motley Fool owns shares of 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.

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