BofA Securities looks at Internet royalty rates
Banc of America Securities Entertainment & Broadcast Research Analyst Jonathan Jacoby hosted a conference call Wednesday, "Where Will the Dust Settle from Higher Internet Music Royalty Rates?," that included Joe Kennedy, CEO & President, Pandora.com and Kurt Hanson, CEO, RAIN/AccuRadio.com.
Highlights from the call:
Pandora uses the Internet to enable consumers to have a much more personalized music radio experience. You can go to Pandora, type in the name of a favorite artist or song and Pandora will launch a station that explores that part of the music universe. Users can create up to 100 stations and do a variety of interesting things with them rate songs, find out about the artists and songs that are playing, buy the songs from iTunes or Amazon, mix the stations together in kind of a shuffle mode etc.
Said Kennedy: "In terms of business model we believe this category is predominately about ad supported, free to the consumer. Our ad model has been well received by advertisers and our revenues have been growing nicely fueled really by a strong interest by major national brands, players like Toyota, Verizon, Apple, Nike etc. The Internet opportunity is really about national advertising at this point for a player like us...At the royalty rates that were in effect prior to this decision making money in Internet radio was certainly no lay-up it required highly affective monetization and tremendous scale both of which we have been track to achieve but at the proposed new rates as we get into it's pretty simply there is no radio Internet service large or small that can sustain itself at these rates."
Said Hanson: "AccuRadio is aimed primarily at 25-54 year old at work listeners and we think we are maybe the leader in the space that's specifically targeting that one demo. We have for those people 320 channels of rock, jazz, classical, pop standards, Broadway, blues, Celtic music, cabaret music. We have American music, Chinese pop and a variety of other genres and sub-genres. Like Pandora we believe that the opportunity here if for all webcasting is really primarily as afforded. We have three or four different rep firms out trying to sell our inventory and did last year. With an audience of almost a million unique listeners a month and lots of rep firms selling it we were able to bring in, this is kind of a bootstrap operation not pc funded, we were able to bring in about 400 grand in revenues. Under our old royalty rates there was a small commercial web caster rate where we were paying about 12% of revenues. Under the copyright royalty board decision that we're here to talk about today our retroactive royalty for 2006 is 600,000 dollars; which is 150% of our total revenues and 10,000% of our profit for the year. It certainly holds concerns for not only for us but I think for the whole industry that there are virtually no firms with a business model that can survive this new royalty rate decision if it stands."
The retroactive rate that goes back to the beginning of '06 was .0007, the new rate for '06 will be .0008 of '07 goes up to .0011 and by 2010 it steps up to .0019. This is per song, per listener. What were you paying before so we understand what you're paying now and sort of how do you see this changing your model completely?
Said Kennedy: "In an ad-supported service a large ad supported service such as ours had two options previously. It could pay on a per track basis at the .000731 figure that you sited or 1.17 cents per hour. Actually all of the large players go with the per hour figure for reasons that aren't all that important to go into it. If people skip a song you don't have to end up paying for a song that someone listens five seconds to. We were previously paying 1.17 cents per hour and under the new rate structure if you translate per track into per hour at what virtually any player would do you come up with a number that is a little bit over three cents per hour in terms of cost and that's just an extraordinarily large number. That would be an extraordinarily large number even versus say the nine cent that I believe broadcast radio is able to generate in terms of its broadcast advertising which is probably the best case radio will ever see in terms of FCC license kind of old duopolies market by market and incredibly intensive advertising efforts and extremely heavy commercial loads.
The best case for Internet radio is some fraction of that nine-cent per hour that broadcasters have historically gotten. The advertising opportunity for us we have been primarily focused on graphic ads for two reasons. One is that's really where the ad money is online. There isn't that much advertiser money chasing audio ads on the Internet and second what advertiser money is chasing audio ads on the Internet is an extremely low CPM in your numbers of kind of 2.00 gross and on a net basis even less than that in terms of the CPM."
Kurt, how do you view sort of the current landscape of the new rate regime?
Said Hanson: "I agree with almost everything Joe said. Our audience is a little bit more patient perhaps of audio ads. We have really had no trouble running a couple of in stream spots per hour and it doesn't seem to hurt our listener ship when we add them versus the weeks when we don't have them. Right now our official limit is two spots an hour. One spot per break, two breaks an hour. We'd prefer 30's but we'll take 60's if that's all our rep firms can sell. We're ah the CPM's and Joe is right they are significantly lower than for broadcast or even network radio at the moment. I think the reasons these royalty rates don't work is that the copyright royalty board really never looked at the state of the advertising economy in 2006 or 2007 to see if it was possible to sell enough ads at this point in history to cover the royalty rate."
If you would have looked out five years perhaps under the old sort of rate structure, what type of operating margins or capital returns did you see your business doing?
Said Kennedy: "Under the old rates and this is does sort of apply to Pandora, but I think it would also apply to virtually any other site the Internet radio business is a very small margin business on a per customer basis. The key is grabbing a significant piece of what is the good news is it's a very large market. Just to give people some feel like what success might look like for an Internet radio service three to five years down the road under the old rate structure is generating something like a couple cents of margin per listener hour of two cents of margin per listener hour multiplied by hundreds of millions of listener hours per month. That begins to get you generating millions of margin on a monthly basis; which allows you to cover fix costs and begin to generate some profitability. Obviously the key is that tremendous of scale, but again, even under the old rate structure a good margin would be the order of magnitude a couple cents per listener per hour and that's why these new numbers they sound like so small like how could those rates be a problem?
But the difference in this business between hang a royalty rate of one cent an hour and paying three cents per hour is the difference between having some margin to multiply through listenership, again, and having no margin and essentially no prospects for profitability."
Said Hanson: "We're running maybe three or four million hours of listening per month. I think in a year or two the way the industry is growing that could have gotten up to 20 to 30 million hours a month and even at a penny per hour margin it shows that it's a viable business especially for us that would be a fine business. There is just no way to get from here to there if at these rates we're looking at not being able to claw revenues above, it's not even clawing above profitability it's clawing above the royalty rate. We can't get total company revenues and that in stream audio, that's banner ads on the player, that's a video spot when you launch the player each morning, that's Amazon CD sales commissions, that's donations from listeners all of those things combined don't seem like they are going to add up to covering the royalty rate much less any of the other costs of running a business."
What type of rate increase would have you accepted to still maintain a profitable business?
Said Kennedy: "Honestly I think everyone in this business, large players and small, was really looking for no worse than the current rate and a lot of discussion about some decrease versus the current rate or the previous rate whatever you want to call it. Again to give you a feel I think a large sophisticated player might be able to generate something like four or five cents per listener per hour of revenue in this business. So at the old rate, which was 1.17 cents per hour you're talking about a royalty rate for the sound recordings, again this BMI and ASCAP fees on top of that you know they were already in the 20 to 25% range for excellent monetization players. As Kurt said I think there are a number of players who would struggle even to get to the four to five cent range, but I'd say we're fairly confident that that kind of range is attainable. Again, the old rate already consumed 20 to 25 % of that. Broadcast radio pays zero percent, they pay nothing in terms of sound recording royalties and the satellite guys pay about 7%. So there is just kind of a massive disconnect both in terms of the sentimental economics of the business as well as kind of from a kind of equity parody standpoint. As technologies converge here having different royalty rates for different forms of delivery just doesn't make any sense at all. That's why there's kind of pretty clearly here some work for Congress to kind of sort through this and give some guidance to get all forms of radio on a more equitable basis going forward. I don't think a whole lot of people think that the sound recording royalties exemption for broadcast radio is going away but to have the satellite guys and the Internet guys paying different numbers and wildly more than broadcast it just doesn't make any sense."
Joe you mentioned sort of what needs to be done can you discuss the alternatives that the Internet broadcasters have to address the CRB rates. Is it the appellate court? Is it legislative action? Is it renegotiation with the RIAA SoundExchange? Is it a combination?
Says Kennedy: "There are kind of multiple things that will be happening so there is a little bit of complexity here. The first thing that will happen is that you will see various players on Friday of this week or Monday of next week ask for certain issues to be addressed by what's called a rehearing. It doesn't seek to change decisions in any big way cause you can't like ask the same three guys to just like well come up with a different answer because we didn't like the first one. You may well see issues that are more like mistakes. Like some people may have heard about this 500 dollars per station fee that's out there that is expressed in such a way that it doesn't make any sense given that there are numerous services from Live 365 to Yahoo to Real Networks to Pandora that have more than 10,000 stations. The 500.00 per stationing was intended to be a minimum administrative fee in case someone didn't end up using the service. So they kind of made a mistake in the way they expressed this minimum fee. That will likely be the subject of rehearing again submissions within the next week and likely outcomes addressing those in some number of weeks or maybe a couple of months. After that process is done there is likely to be appeals to the US Federal Court of Appeals in DC. That will address the more substantive issues of kind of fundamental errors in thinking and approach that it's widely believed this copyright royalty board made.
Simultaneously with all that will be actions to attempt to get a bill sponsored and passed in Congress that remedies kind of the fundamental issues which is there is actually different rate standards for Internet radio, different rate standards for satellite radio and obviously no sound recording royalty for broadcast. I think there will be a lot of focus on Congress with saying, 'Hey, as technologies converge this doesn't make sense, you need to come in and have a more unified rational basis for sound recording the different forms that radio takes.' There will also be a great deal sort of grassroots support kind of behind that congressional effort. There is always the possibility of negotiation with the RIAA and SoundExchange. There have been negotiations kind of throughout this process. It should be noted this process that just kind of burped out an answer in the last ten days here has been going on for about a year and a half. Throughout that arbitration process there were various side discussions negotiations; which may or may not continue during this time period as well. The congressional action and the US Federal Appellate action those will take months. We're not sitting here thinking this issue is going to be done in a few weeks or even in a few months."
Curt what do you think motivated the RIAA SoundExchange to be so aggressive?
Said Hanson: Well I think this is typical music industry behavior. They are very aggressive with legal work that the RIAA in trade association level and even within labels in doing deals with artists for example. They are just kind of aggressive, try and win big kind of guys that's the mindset of the industry. I have a feeling at the label level and certainly at the performer level most of the music industry realizes the value of Internet radio. Internet radio is one of the best things that has happened for the music industry this decade giving voice to dozens of genres of music that can't get AM or FM airplay and thousands of artists that can't get AM or FM airplay. At those levels of sales and marketing within a label or the performers involved here the lawyers have been working across purposes.
This is not the first time that overly aggressive record company lawyers have done stuff that was not in the best interest of their industry. You will recall five or six years ago they got Napster shut down and the whole world warned them don't do this. If you shut down Napster all that will happen that they regulatable peer to peer file trading service that you can theoretically work with if you shut it down you will open up all sorts of uncontrollable peer to peer networks. By God they shut down Napster and that's exactly what happened they made the situation 10 times worse. They have done this before just being overly aggressive. The music industry as I understand it from observance, they care about control and control sometimes trumps practicality and beneficial-ness."
He adds, "Let's talk about this from the point of view of the terrestrial broadcasters. We could go at that from a couple different angles. I guess one of them is at these rates the question is will broadcasters continue to offer streams of their terrestrial stations? I think that's a questionable issue if they see it being a money sink for the next five years I'm not sure they will. A second issue in this game is the record industry is going to be coming at them for a sound recordings performance royalty before probably the end of this year."
I'm sorry to interrupt but aren't they grandfathered?
"Well there's nothing to say that under the current law there is no, under the current law yes but there I believe the record industry has announced publicly their intent to try to get new legislation to apply sound recording royalty to AM and FM broadcast. So they certainly do have a dog in this hunt and if they, I have a feeling broadcasters may be a little bit sitting on their hands thinking that well if Pandora and LaunchCast and AccuRadio are driven out of business you know maybe that's not so bad for us. That's thinking ahead a month rather than thinking any longer perspective. Thirdly, and maybe this is most importantly as Internet radio plays out, I think we're seeing new media and new media delivery systems end up creating new forms of content and the new forms of content that work for Internet delivery of radio seem to be based on the properties that are having success seem to be national not local brands, multi-channeled, multi-format brands not focusing on single musical genre and with some personalization elements.
That's what consumers seem to be embracing. Broadcasters right now could compete in that space if they chose to. There is no reason any of the major broadcasters that you cover couldn't launch an initiative to build such a brand. In Canada, Standard Radio for example has built a relatively successful Internet only brand called Iceberg Radio. If this royalty rate decision goes through they will be as constrained from doing that as Joe is or LaunchCast is or I am and if that won't stop listeners from seeking out that kind of product they will just get it from Australia and then European and Asian webcasters. Right now they have an opportunity to compete in the space which might be their long term future as wireless ubiquitous broadband Internet gets into people's cell phones and into their cars and throughout their homes. Great potential and they will be frozen out of competing in that space if this goes through."
