By Andy Fixmer, Bloomberg Businessweek 

Pandora Media (P), the rapidly expanding Internet radio service, has a problem: The faster it grows, the bigger the financial hit it takes on royalty payments.

In the first 10 months of 2012, Pandora paid $182 million in music royalties, or 60% of revenue. With the music streaming company forecasting a fourth-quarter loss, and competition intensifying from Sirius XM Radio (SIRI), Spotify and Apple (AAPL), Pandora's stock was off 10% for the year while the tech-laden Nasdaq Composite Index ($COMPX) had advanced nearly 15% as of Dec. 26.

Joe Kennedy, Pandora's chief executive, says his company is getting a raw deal on the fees it pays for song-playing rights because of what he calls an arbitrary and piecemeal music copyright and royalty-setting system that treats various digital radio formats differently.

Pandora will pay more than half its sales in royalties this year, yet satellite radio services will shell out on average 7.5% of their revenue, and cable only 15%, Kennedy said when he testified on Nov. 28 before a House committee in support of the Internet Radio Fairness Act.

"Pandora pays more in absolute dollars than any other company, including SiriusXM -- a company with eight times our revenue," Kennedy said.

The bill aims to close the gap in song royalties.

Listening is free (mostly)

Most listeners pay nothing for access on their PCs and mobile phones to Pandora's 100,000-plus artists, from Frank Sinatra to the Foo Fighters. The company pays $1 million a year in royalties to vocalist Adele, for instance, and $3 million to rapper Lil Wayne. Users create personalized radio stations focused on a particular singer or band, and Pandora's algorithms search out artists with similar musical styles.

The site is ad-supported, though premium subscribers pay $36 a year to get commercial-free music. Pandora enjoys a 74% share of the U.S. online radio market, according to new media research firm Triton Digital. On Dec. 10, Pandora launched its service in Australia and New Zealand.

With 175 million registered users, including 62.4 million active ones, Pandora sees growth ahead given the estimated 250 million Americans who listen to radio in the car, at work or at home each week, says Dominic Paschel, vice president of corporate finance.

"Only recently has the Internet become as ubiquitous as radio waves," Paschel says.

That growth will come with a steep price tag. In the U.S., the royalty fees that radio stations pay to artists and record labels are set every five years by three judges who serve on the Copyright Royalty Board, an arm of the Library of Congress. The panel follows guidelines in various copyright laws that were passed as new radio formats developed over past decades, and it has become stricter as a result of aggressive music industry lobbying.

Traditional broadcasters pay royalties only to songwriters -- not to performers and record labels as do satellite, cable and Internet radio services. Royalty rates for satellite broadcasters such as Sirius take into account lawmakers' goal of maximizing the availability of a creative work and earning a reasonable income for the copyright user.

Fees for webcasters such as Pandora follow the "willing buyer-willing seller" guideline. Translation: whatever price the market will bear.

Competition intensifies

Digital radio services can negotiate their own deals with individual record labels, but Pandora in 2009 opted for a comprehensive, industrywide arrangement offered by the royalty board. Each time Pandora streams a song, it pays a royalty fee to SoundExchange, a Washington-based trade group that collects royalties and distributes them to recording artists and music publishers. The online music service paid 11 cents a song in 2012; that will rise to 14 cents in 2015. The royalty board has yet to reset rates for 2016 and beyond.

Pandora's push for royalty parity faces opposition from, among others, the powerful National Association of Broadcasters and Songwriters Guild of America. The bill, if enacted, may reduce Pandora's royalties by as much as half, according to Richard Tullo, an analyst at broker Albert Fried. Instead of lowering Pandora's royalties, SoundExchange President Michael Huppe says, SiriusXM should pay more to "provide fair compensation" to artists and labels.

Pandora faces stepped-up competition. Music streaming services Spotify and Rdio have sold equity stakes to recording labels in exchange for access to their music libraries.

As for reports that Apple may launch an ad-supported streaming service in the first quarter of 2013, Paschel says the Apple service won't match Pandora's personalized radio capability. "They aren't trying to do what Pandora does today," he says.

Pandora already runs on Apple's iOS as well as Google's (GOOG) Android and Windows Mobile operating systems, he says.

Apple appears to be working directly with record labels, Paschel says, rather than negotiating a comprehensive contract like Pandora's. With individual deals, Apple may get more flexibility but would pay 10 to 15 times more in royalty payments than Pandora, according to Paschel, citing trade industry reports. Apple isn't commenting. Then again, it has about $121 billion in cash. Pandora doesn't.

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