TECH
02/14/2011 01:56 pm ET Updated May 25, 2011

Pandora's Big Challenges: Fees And Foes

Pandora, the Internet radio service which filed for an initial public offering late last week, has a music library that contains more than 800,000 songs by some 80,000 artists and boasts more than 80 million listeners.

But there is another number that dwarfs those milestones: 50 percent, the share of Pandora's revenue the company pays in copyright fees to royalty collection agencies representing composers, songwriters, publishers and copyright holders. That figure underscores the major challenges standing between the U.S.-based Internet radio service and future success.

Pandora grew revenues nearly 200 percent in the first nine months of fiscal year 2010, but it has yet to become profitable, due in large part to the significant costs of securing the rights to stream Gaga and Guetta.

As it pushes forward with plans to become a public company, the online music streaming service must prove it can prosper even while saddled by immense and growing copyright fees, and while expanding beyond laptops and phones into cars and living rooms and keeping its users from defecting to a growing field of competitors.

Pandora's biggest, most important asset is also its biggest, most important problem: content. Pandora aggregates third-party content using its own recommendation engine that allows users to create personalized music channels and stream songs in the style of whatever artist they choose.

Like Netflix, Pandora "leases" but does not own the content that it provides to listeners. For the privilege of delivering the croonings of Madonna, Nina Simone and other artists to its users, Pandora must pay huge sums in licensing fees to four different organizations: SoundExchange -- which claimed 45 percent of Pandora's revenue from the nine months ending Oct. 31, 2010 -- as well as Broadcast Music Inc., SESAC and the American Society of Composers, Authors and Publishers, which together received 4 percent of Pandora's revenue during the same period.

Pandora was nearly felled by content-acquisition costs in 2007, when the Copyright Royalty Board hiked reimbursement rates to a level that was unsustainable for the company and many of its competitors. Though Pandora renegotiated the cost of the copyright fees in 2009, the rates it pays to rights holders are set to rise every year through 2015 -- when the agreement expires -- and will likewise increase with every new listener Pandora gains and every song its streams.

"The more those music streams increase, the bigger [Pandora's] payment will be to the record companies," said Steve Gordon, the author of The Future of the Music Business.

Expanding abroad will also mean grappling with an entirely different set of regulations, rights holders, and fees.

While confronting its considerable content costs, Pandora must also face a growing number of competitors for the advertising dollars on which it relies. Pandora has long touted its Music Genome Project engine as unparalleled in its ability to deliver playlists personalized to each users' taste -- "the most sophisticated taxonomy of musical information ever collected," the company brags. But experts counter that besides good marketing and buzzwords, there is little to distinguish Pandora's recommendation engine from other services.

"There's been a lot of publicity given to Pandora's 'secret formula,' but I don't think that's the key to its success," Gordon said. "They're getting a lot of publicity for the Music Genome Project, but ... it doesn't take rocket scientists to plug in Jay-Z and get other rappers in the same vein as Jay-Z."

A slew of Pandora-like startups such as Last.fm, Slacker and Rdio are moving in on the company's territory, to say nothing of behemoths like Google and Apple, which are rumored to have their own music streaming services in the works. The rise of these rivals could imperil Pandora's ad revenue, which currently accounts for 86 percent of the site's income.

"The differences between Pandora, a social media site on which people post links, and a music blog will continue to erode, and Pandora, which is currently the number-one music streamer on internet, will continue to have to find ways to differentiate itself from the myriad other avenues through which online consumers will get music," predicted Aram Sinnreich, an assistant professor at Rutgers University's School of Communication and Information. "The domain which Pandora currently rules going to become much larger and much more competitive."

Yet there are two big bright spots for Pandora, which has a head start into unconquered frontiers of cars and televisions. The company has already inked deals with Toyota and Ford to stream Internet radio from the road, and has become nearly ubiquitous in the new breed of Internet-connected "smart TV" devices launched by companies like Google, Boxee and Roku. Moving beyond browsers and phones offers Pandora an enormous number of new users and avenues for advertising.

If Pandora can replicate in cars and living rooms its phenomenal success in the mobile space -- the company doubled its daily number of signups when its iPhone app launched -- it will have a better chance of becoming a music-industry mainstay, even with licensing fees on the rise.

"They're way beyond web browsers," said Paul Resnikoff, publisher of Digital Music News. "Pandora wants to be integrated into every single dashboard in the future. It's not just a car, it's not just a smartphone, it's not just a PC."