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Pandora: The Definitive Look Back and Look Ahead

NEW YORK (TheStreet) -- It's interesting, if not dismaying when a music writer, immediately upon release of the most recent Pandora (P - Get Report) earnings report, pulls the most important piece of information. But that's what Glen Peoples of Billboard did a couple weeks ago when Pandora's Q3 stats hit:

Not one Wall Street analyst or financial media scribe went right to the "royalties accounted for just 48% of revenue" tidbit. As has been the case since Pandora went public, they all flocked to the traditional metrics they're most comfortable with. In the process, they fail to even acknowledge, let alone understand, the story line that matters.

The way royalties have shook out at Pandora speaks to the rest of the story.

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At the beginning of 2013, for the period ended Jan. 31, content acquisition costs ($76,695,000) accounted for 61.3% of revenue ($125,089,000). That number increased to 66% three months later and dropped back down to 52% three months after that. At 48% in the most recent quarter, Pandora generated $180,376,000 in revenue, while paying out $86,989,000 in music royalties.

So the raw dollar amount shelled out for content continues to increase, however the percentage of revenue drops because sales continue to increase, led by Pandora's first $100 million mobile revenue quarter. Add to the mix, the moderation of listener hours, as predicted and anticipated by Pandora two years ago and you have the very situation I wrote about two years ago (!), over at Seeking Alpha, playing itself out:

Undoubtedly, the royalties Pandora pays (referred to as "content acquisition" costs) have skyrocketed over the years. For FY 2008, content acquisition costs totaled roughly $6.4 million. For FY 2012 that number increased a whopping 2,223% to about $148.7 million. During the same period revenues soared by approximately 1,819%.
In this analysis, you have to consider the reasons why each number expanded at such a stratospheric pace. You can associate the increased content acquisition expenses with a massive uptick in users and listener hours. Pandora expects those numbers to naturally moderate, which should result in a leveling off of content costs. That said, they'll still eat a more-than-comfortable share of the company's revenue, at least until Pandora can strike new, and more favorable, royalty deals.
The revenue growth coincides with Pandora stepping up its game with relation to advertising and subscription dollars. Between FY 2008 and FY 2012, advertising revenue increased by a stunning 1,702%. Subscription and "other" revenue exploded by 3,391%. It's remarkable to consider the fact that the company is in the infancy stage of its multi-platform audio, video and display advertising efforts. And it has yet to introduce ways to increase subscription revenue outside of the $36 annual fee it charges for an ad-free version of its service.

I wrote that in April 2012.

I referenced Pandora "expect(ing)" users and listener hours "to naturally moderate" pursuant to an interview I published with the company's CFO at the time, Steve Cakebread:

(Pandora) feels that, over time, the number of listeners and hours listened will hit a certain level and sustain, slowing and, ultimately, stopping the growth of royalty payments. As Cakebread put it, they're not going to keep growing to 100% market share.

That's from January 2012. If you were paying attention and doing the work then, nothing that has happened between then and now (or will happen in the future) should come as a surprise. Let the uninformed alarmists make wholly ignorant claims; I -- and presumably you -- have no time for that.

So that's where we were, which leads us to where we are now. But, where does Pandora go from here? The answer exists in an area that, interesting and dismaying in reverse, the music media does a relatively poor job covering.

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