Pandora is Not the Enemy

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This week Pharrell Williams sent the music industry into a frenzy by announcing that he only made $3,000 from 43 million streams of his massive hit song “Happy”. This made waves throughout the music industry as many people point out what is an apparent imbalance in the market.

However this isn’t a problem created by the streaming services. It was a problem with the way music was priced from the dawn of the digital era. The record labels lost this war a long time ago. Unfortunately a lot of people are just now figuring out what was lost. To point the finger at music sharing services like Spotify, Pandora, Beats and others is to misidentify the problem and the blame.

There are two main reasons that the streaming services are catching unfair flack for this:

The Economics of A Music Streaming Service

The first problem is the fact that streaming music is a tough business to be in.

The fees to join these streaming services are abysmally low – free for the majority of users and only $54.98 for a one year paid subscription on Pandora that allows you to stream whatever you want. The number of paying users is really small and the usage by free users is paid for by ads that they listen to.

We know Pandora makes money off of its free users but how much? We can start to guess if we apply the Pareto Principal which states the vital few pay for the many. In business this is known as the 80/20 rule, 20% of paying customers pay for the other 80% of non-paying customers. This works on the web because of freemium business models where web services monetize the two types of users differently. 

In this case Pandora sells its audience of millions of non-paying users to advertisers. The paid users offer $54.98 per year.  Pandora only has around 3.3 million paying users which at $54.98 add up to around $181.4M in revenue. Of course, not all users pay consistently, or for a full year, but lets agree to keep it simple for the sake of projecting.

We don’t know how much Pandora pays for ads but we do know their revenue in 2013 was $427M. Since we know paying customer revenue, we can subtract that from the total revenue and assume that Pandora pulls in $246M from its advertising revenues. We also know from press statements that around 61% of Pandora’s revenue goes to paying performance royalties. Assuming that number held in subsequent years, it would mean $150M is left to be paid out to the recording artists.

Pandora reportedly had 80,000 different recording artists in its catalogue at the time of its IPO. While, its probably grown considerably, I’m not sure those numbers are public so lets use to old number to be safe. If you divide $150M by those 80,000 artists, you get $1,875 at most they have available to pay out, per artist.

So Pharrell Williams actually earned 62.5% more money than the theoretical average Pandora music artist could possibly make. From Pandora’s perspective Pharrell broke the bank!

The Value of A Stream

For the second problem, thank Steve Jobs and Apple.

In 2003, with the launch of iTunes Apple famously negotiated the ‘fair-market value’ of an MP3 to be $0.99. While, this literally didn’t force everyone to sell MP3s at that price, the fact iTunes won as the platform of choice for the music industry and consumers effectively set this price for everyone in the MP3 selling business moving forward. The other thing this deal did was to allow for the unbundling of the album.  People no longer had to buy entire albums to get single songs. They could get single songs from the album at $0.99. Anyone selling music could sell for less than $0.99 but they couldn’t go above unless they offered more value (in the form of selling WAV files, FLAC files, or other formats that were better quality than MP3s).

But a stream is not an MP3. Streaming a single song from a single source isn’t valuable. An MP3 I can actually buy directly from an artist or music outlet. An MP3 one can ‘own’. In that way (and that way only) they were similar to physical media. Physical media (CDs, Tapes, Vinyl) were different in that they had inherent scarcity and value. The costs of production, manufacturing, distribution, marketing and promotion were all added up and some margin above cost of production set the price of sale.

MP3’s changed things dramatically. The cost of distribution became nominally low while the cost of manufacturing an MP3 essentially went to nothing. This is because the cost to ‘make’ the MP3 is some infinitely small fraction of the cost of owning a computer and having electricity to power it. The rest of the costs stay the same. 

When the Record Industry negotiated with Apple for the cost of digital music, they ultimately took the stance that costs of production were not more than half the cost of sale. CDs used to sell for around $20 each, MP3 albums (on average) sell for around $10 each. The cost of a single MP3 is around $0.99.

So what is the value of something that you can’t ‘own’ like streaming music? Something that you want to have access to from anywhere in the world from any device? Streaming is like the digital equivalent of radio. The record industry negotiated price points that forced Pandora and services like it to adopt radio-like business models.  But so far digital radio ad buys haven’t accounted for the type of revenue that terrestrial radio ads do, resulting in the streaming services having the razor thin margins that they have.

Beyond that, people aren’t used to paying for radio. From their perspective, for the past 100 years its been free. They also aren’t used to paying more than $0.99 per song or more than $10 per album. If the average person used to buy at least 5 albums per or 50 MP3s per year from iTunes, $50 per year is palatable for streaming services. If that price goes to far above $50 per year, people will just go back to buying MP3s because they will feel they are getting more for their money. Buying MP3s may not be the endless supply of all music that streaming is, but owning something still provides an endless supply of enjoying SOME music versus none.

The fact that Pandora raised its prices today is a slippery slope.  If the other streaming services follow suit and raise prices too high, it just sends public demand back to wanting to own their music and the streaming services will screw themselves out of business.

You can blame The Record Industry or you can blame Apple but don’t blame Pandora for a business model that was forced on them.