Pandora Media (P) has put itself in a box.
The world's largest Internet radio service wants to pay artists as little as possible for their songs. But it also needs their support -- and music -- to keep expanding beyond the U.S.
"The lower the royalty rate, the better it is for Pandora's business," Paul Verna, a media analyst at eMarketer, said in a phone interview. "But there's also a flip side, which is that it risks exacerbating perception problems with musicians that Pandora's rates are already too low."
Streaming services have run into a buzzsaw of criticism from music labels and some musicians who have charged that they're siphoning off revenue from CD sales and digital downloads.
Later this month, the three-member U.S. Copyright Royalty Board will set music streaming fees for the next five years. The ruling is expected around Dec. 15. Pandora has actually been paying royalties below rates set by the board since 2009, part of a settlement withe industry that was authorized by Congress. That agreement will end with the board's new ruling, means Pandora could be forced to pay more to artists and music labels.
But for Pandora, it's probably worth it. With 78 million unique U.S. monthly listeners, Pandora is keenly aware that it has all but saturated its home market and needs to bring its Internet radio service global, to the U.K., France and Germany as well as Japan, South Korea and even China. (Pandora's curated music platform is currently available only in the U.S., Australia and New Zealand.)
To expand, Pandora needs to make peace with the music industry over royalties -- even if it's expensive in the short term. Pandora shares have tumbled 29% in 2015 partly out of investor concern that it will have to pay royalty costs that account for more than its current level of 48% of its revenue.
"Pandora will have a good relationship with the industry when the industry feels like it's getting a reasonable or fair market rate," said the independent music label executive. "The lower that number, the more the industry will think it's not being treated fairly, and there will be very little good will."
Either way, it will remove an unknown that has prevented the Oakland, Calif.-based company from negotiating directly with music labels for international streaming rights, and for a subscription-based platform that it is building to rival Spotify and Apple (AAPL - Get Report) Music.
But the Big 3 -- Sony (SNE - Get Report) Music, Warner Music and Universal Music, a division of Paris-based Vivendi (VIVHY) -- as well as the world's largest independent labels have been loath to negotiate international pricing with Pandora for fear that such settlements could influence where the Copyright Royalty Board sets rates for music streamed in the U.S.
"For a service like Pandora that wants to have a worldwide footprint, it has to be in negotiations with copyright owners," said Ron Gertz, chairman and founder of Music Reports, a Los Angeles-based copyright fulfillment agency, in a phone interview. "The CRB's decision will ultimately lead to opening up a worldwide licensing marker, and the parties will figure it out."
Up until recently, Pandora and the world's largest music labels have mostly clashed over royalty fees. Pandora currently pays music labels 14 cents for every 100 songs it streams, a rate that is actually lower than fees that the Washington-based CRB, a department of the Library of Congress, set for the past five years.
The industry agreed to the lower rates in 2010 so that Pandora could avoid insolvency. A Big 3 media executive, who spoke on condition of anonymity because he wasn't authorized to discuss the matter publicly, said the industry "saw value in building their service and getting people accustomed to using streaming."
But in the years since that agreement was signed, Pandora has sought to lower its royalty fees even further. Soon after its IPO, Pandora pushed for passage of the Internet Radio Fairness Act, which would have classified online streaming platforms as similar to terrestrial radio stations, which only pay songwriters.
In 2013, Pandora purchased KXMZ-FM in Rapid City, S.D., with the goal of being classified as a terrestrial radio operator. Under certain federal guidelines, ownership could provide Pandora with access to lower royalty rates. The Federal Communications Commission approved the deal in May.
"They weakened or lost a lot of alliances with creators and the labels when they were working on IRFA," said an independent music label executive who also spoke on condition of anonymity.
Despite its differences with the music industry, Pandora's business has grown as its listener base has mushroomed. By its own estimate, Pandora's share of all U.S. radio listening reached 9.5% in September. Sales climbed to $311 million for the recently completed third quarter from $38 million during the same period in 2011, shortly after the company held its initial public offering.
While Pandora has paid out more than $1.5 billion in royalties during its 10-year history, music labels are clamoring for a larger cut.
In recent months, Pandora has appeared to be trying to smooth things over.
In October, it agreed to a $90 million settlement for its past use of pre-1972 music, and for its continued use of that music. Federal law was never particularly clear about royalties for artists who released music prior to 1972, leading to long-simmering enmity between Pandora and major labels for use of music by the likes of the Rolling Stones, Bob Dylan and Janis Joplin.
"That was like an olive branch," said a music industry executive. "Pandora was clearly saying, 'Let's get this contentious issue off the table.'"
And then last month, Pandora struck a multi-year music licensing deal with Sony/ATV Publishing, the world's largest music publisher, which is owned by Sony and the estate of Michael Jackson. The agreement was significant because Sony/ATV CEO Martin Bandier had been one of Pandora's biggest critics.
The Sony/ATV deal was also significant because Pandora will need the music publishers on board if it is to expand internationally.
For Pandora, keeping royalty fees at 48% of revenue or less is integral to building a company that CEO Brian McAndrews has said can help the industry offset declining CD sales and digital downloads that have fallen by 33%, or about $2 billion, in the six-year period that ended in 2014, according to the Recording Industry Association of America.
Toward that end, Pandora in October announced plans to spend $450 million to purchase TicketFly, the concert promotion site, so that artists can better publicize their live performances directly with users selecting their songs. In November, it paid $75 million to acquire the assets of Rdio, which it plans to use to build an international on-demand service to compliment its existing "non-interactive" service of curated music that introduces listeners to artists they may not know.
In testifying before the CRB, Pandora Director of Public Affairs Dave Grimaldi said the company sought to emphasize that the more money the company is able to invest in these services -- concert features and other tools for artists to connect directly with fans -- the more that labels and artists will be able to grow their own businesses.
"Pandora presented a comprehensive case with experts and witnesses, and are confident in the positions laid forth in our filings and trial presentations to the CRB judges," Grimaldi said in an e-mailed statement. "We discussed the additive, promotional value of Pandora, and demonstrated that we are a non-interactive service. We have planned for a range of scenarios, and are excited about Pandora's ability to deliver long-term growth no matter what outcome the court decides."
The CRB's ruling won't directly affect Spotify or Apple, which operate on-demand services and have already negotiated directly with labels, large and small. Nonetheless, the rate-setting decision will establish a benchmark that will likely remake the global music industry for years to come.
"We all have to sit still and see what the CRB says before we talk directly with Pandora," said a Big 3 music industry executive. "After they rule, we can start to have those conversations."