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Spotify Has the Bad Business Model, Not Pandora

Stocks in this article: P NFLX

Again, Spotify negotiates deals directly with labels and artists . . . directly with the content owners. That's exactly what Netflix (NFLX) does. The process comes with the same pitfalls in both situations.

It's well documented that Netflix operates at the mercy of content owners. Over the next five years, Netflix counts roughly $5 billion in off-balance sheet obligations for content. It owes roughly $2 billion of that within the next year. And that's just the debt that's off the balance sheet.

While we don't know exactly how much Spotify is on the hook for, we know it's a lot. Just like Pandora. Spotify operates at the mercy of record labels, just like Netflix does with Hollywood programmers. It's an expensive and time-consuming process.

That's a very basic explanation of the differences between Pandora and Spotify on royalties.

Pandora could decide to negotiate directly like Spotify does, but it would hardly help the company's situation. It would make it worse. The product would suffer, plus content costs would likely not change much.

Even if Spotify ended up catching a break on its royalty costs, it's model still doesn't work.

Like Netflix, Spotify relies heavily on subscription fees for its revenue. It's incredibly difficult to continue to scale a business, at least to the level Pandora has scaled and continues to scale, under the confines of a subscription-based scheme. Without scale, you do not have a large enough audience to leverage for advertising dollars.

Even if Spotify could make a compelling case to advertisers, it will have trouble competing with Pandora for revenue.

Over the last two years, Pandora built out a local, regional and national sales force. It's not even close to done. But it has sufficient staff in place in most major markets where it, not Spotify, claims the No. 1 spot among 18- to 49-year-olds across Internet and terrestrial radio.

Local is where it's at. That's the past, the present and the future of radio. Salespeople hitting the street calling on clients. It's the traditional radio model. And it's the traditional radio advertising market that Pandora chips away at as it rapidly grows revenue.

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