NEW YORK (TheStreet) -- Pandora Media (P) slid lower Friday after a federal judge ruled against the Internet radio service in its battle with music rights agency Broadcast Music over royalty payments.
Pandora shares were down 43 cents, or 2.3%, at $18.38 shortly after noon EDT Friday.
On Thursday, United States District Court Judge Louis Stanton ruled that Pandora must pay 2.5% of revenue for playing songs in BMI's vast catalog. The previous rate was 1.75%, but BMI had sued Pandora in 2013 to raise it.The ruling, which Pandora says it will appeal, is just the latest development in the music streamer's struggle over royalties, which threaten to undermine the company's profitability prospects.
Royalties are a big expense for Pandora. Analysts say Pandora's total content acquisition costs amounted to 49% of its adjusted revenue in 2014, of which 42% went for the performance rights fees, and the balance was for other rights, such as publishing.
But musicians, record labels, music publishers and songwriters want more, and their demands are at the heart of several government proceedings and various lawsuits.
The Department of Justice is soon expected to propose changes to decades-old music industry regulations known as consent decrees that govern the way royalties are paid to BMI and the American Society of Composers and Publishers, which collect royalties on behalf of songwriters and publishers such as Sony's (SNE) ATV, and Vivendi's (VIVHY) Universal Music Publishing and EMI Music Publishing.
Those changes could saddle Pandora and other streaming companies such as Netflix (NFLX) with higher royalty costs to the tune of millions of dollars annually.
The DOJ declined to comment on the review, which began in June 2014, but industry observers expect the agency to offer proposals to two federal court judges in New York who are attempting to resolve a series of disputes between recording companies and streaming services.
"We want to change government regulations that enable music streaming services to shortchange writers and publishers," said Paul Williams, who penned hits like We've Only Just Begun and is the president of ASCAP.
"If streaming is the future of music, and it is, how can songwriters sustain careers, feed our families? That's why we've asked DOJ to review and change the system to meet the realities of the changing marketplace," said Williams.
ASCAP has said 1 million streams of a song on Pandora pay only $99 dollars in songwriting royalties divided up between writers and publishers of a song. BMI has also said its members are underpaid.
Pandora, with more than 80 million users, has opposed changes to the consent decrees, saying they would give music publishers too much clout.
"The ASCAP and BMI consent decrees provide key protections against the type of anticompetitive behavior detailed by Federal Judge Denise Cote," said Pandora representative Dave Grimaldi.
Grimaldi was referring to a case last year in which Cote, a federal rate court judge in New York, ruled against ASCAP in a closely watched case and found that SONY/ATV and Universal Music were in violation of the consent decree after they tried to cut their own deals with Pandora. The ruling was considered a win for Pandora.Last week a federal appeals court in Manhattan rejected ASCAP's appeal in the case, and the decision was seen as another defeat for publishers and songwriters.
In her ruling, Cote had left unchanged the royalty rate Pandora must pay ASCAP to use its music, at 1.85% of Pandora's revenue. ASCAP had wanted a rate of 3%.
Under the consent decrees, ASCAP and BMI cannot refuse licenses to music outlets that request them, and their rate agreements are subject to approval by two federal judges in rate court proceedings in the event of a disputes.
According to industry sources, the DOJ is considering modifying the consent decrees to give publishers such as SONY/ATV and Universal more flexibility to partially withdraw and negotiate directly with services such as Pandora to seek higher payments.
"Our payments to songwriters are the fastest-growing segment of Pandora's royalty payments, increasing by 49% in 2014, and we expect those payments will be far greater in 2015 as we continue to rapidly monetize our business," said Grimaldi, who said songwriters garner great promotional value from having their music on Pandora.
Although publishing royalties pose a challenge for Pandora, the company pays most of its royalties to music labels and recording artists to broadcast their music -- which is at the heart of a Copyright Review Board proceeding, which in December 2015 will set royalty rates covering Internet radio services from 2016 to 2020.
Record labels, represented by SoundExchange, proposed a roughly 25% percent increase in the official rate, to 25 cents to 29 cents per 100 streams, while Pandora proposes it pay significantly less.
Barton Crockett, FBR has a price target of 11 for Pandora, and said this in a note:
"While we think that the service has solid revenue potential, we also see meaningful risk of a much higher cost structure emerging from the Copyright Royalty Board process that will set performance royalty fees from 2016 to 2020. Pandora's proposed rate is close to its current rate, which would allow Pandora, over time, to hit its target for content costs at or below 40% of revenue. We believe, however, that there is a reasonable likelihood that rates get set substantially above Pandora's expectations, which could cause a significant decline in equity value, prompting our cautious stance."
James Goss, analyst with Barrington Research, said increasing royalties for Pandora, which recently reported a first-quarter loss $48.3 million, or 23 cents a share, could strain the company further.
"Royalties are Pandora's biggest cost," said Goss. "Moving too far away from the current structure may not be a desirable outcome for the artists either if something too onerous were to occur to Pandora and put it out of commission."
Casey Rae, chief executive officer of The Future of Music Coalition in Washington, warned against changes that could hamper Pandora's growth. "For songwriters to get paid, the music has to be played. If Webcasting is not viable, there's a whole side of the marketplace that will evaporate," he said.