Pandora Ups The Stakes In A Brewing Royal(ty) Battle

By Stephen D. Simpson, CFA | June 12, 2013 AAA

Life is seemingly never boring for Pandora (NYSE:P). If investors (or, more likely, sell-side analysts) aren't openly fretting about mobile monetization and listening hours or the threat that is (or isn't) Apple (Nasdaq:AAPL), they're worried about Pandora's content acquisition costs. While there of course many uncertainties regarding what Pandora will look like in a few years' time, the company is not just sitting back and waiting for the future to arrive. As seen in the company's decision to buy a terrestrial radio station, Pandora is willing to take off the gloves and get its hands dirty to build a viable long-term business.

SEE: Key Players In Mergers And Acquisitions

Going Local To Get Fair Treatment
Pandora announced via a regulatory filing and a post on TheHill.org that the company is acquiring KXMZ-FM, a radio station in Rapid City, South Dakota. On first look, this would appear to be a strange move for a large and growing internet radio service, particularly as there's no reason to believe that Rapid City is suddenly about to burst onto the national scene as a population center.

This deal is all about the company's battles with ASCAP over licenses and royalty rates on music.

Terrestrial radio stations belong to the Radio Music Licensing Committee (RMLC) and use that body as something like a union – a large, common body that can sit down at the table with ASCAP and negotiate from a position of much greater strength than individual station or network owners could achieve on their own. To that end, traditional radio operators like Clear Channel (which operates as CC Media Holdings (OTC:CCMO)), CBS (NYSE:CBS), and Cumulus Media (Nasdaq:CMLS) pay less for their music than Pandora, and that benefit extends to non-traditional outlets like Clear Channel's iHeart Radio.

Gearing Up For The Long Fight
Although Pandora said that it expects only token savings to acquisition costs (sub-1%), I believe that is only true for the short term. Investors need only consider ASCAP's whining after the announced purchase to see that there's more to it than a less-than-1% change in costs. ASCAP claims Pandora is "trying every trick in the book to brazenly and unconscionably underpay” music rights holders.

I've long since learned that there are three sides to every issue (Side A, Side B, and the truth), but it's not hard to see why Pandora is getting more aggressive. Pandora claims that ASCAP discriminates against internet radio (and Pandora's content acquisition costs would seem to support this), and that ASCAP has used strong-arm tactics like allowing member publishers to withdraw their catalogs and seek separate contracts with Pandora and withdrawing unspecified music rights (potentially exposing Pandora to copyright infringement for playing a track they didn't know had been withdrawn).

Ultimately, buying this station is a logical move to increase Pandora's bargaining power and make it harder for ASCAP to discriminate against them (if that is what ASCAP has been doing) on the basis of not owning stations and/or belonging to RMLC. As Pandora grows, this battle will get increasingly interesting, but “interesting” isn't often a good thing for shareholders, as it introduces more uncertainty into the picture.

SEE: Analyzing An Acquisition Announcement

Apple Is Much Ado About Not A Whole Lot
Following up on a separate recent Pandora piece I wrote for Investopedia, it's also worth noting that Apple did in fact introduce iTunes Radio at its recent developers conference. There really weren't many surprises here – it will only work on Apple products, it will be ad-supported, and it will allow listeners to refine the music selections that they hear. The only real surprise is that Apple seemed to go low on pricing – offering one-year ad-free subscriptions for $24 (against $36 for Pandora). I still don't believe this will be a major threat – maybe newcomers go with Apple and stick with it, but I don't see why Pandora users (apart from maybe the highest users) would abandon the service in large numbers.

The Bottom Line
In more directly challenging ASCAP, Pandora is definitely poking the bear. Sometimes that leads to the bear backing down (which would mean fairer treatment for Pandora and lower content costs), but sometimes it leads to a mauling. Still, it's a battle that I think Pandora has to fight and one that it will, eventually and on balance, win.

I continue to believe that Pandora is modestly undervalued, but that it's rare to find a company with Pandora's growth potential trading below fair value. Accordingly, it's still an interesting stock to consider at these levels.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.-

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