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Pandora’s Scaling Issues

Posted on Thursday, May 12th 2011

According to the Recording Industry Association of America, the money spent per capita on recorded music for the U.S. fell from $71 in 1999 to $26 in 2009. Digital music services such as single song and album downloads, subscriptions, online radio stations, and mobile phone downloads fundamentally changed the way the industry worked, beginning around 2003. By 2009, Internet and satellite radio was earning close to $0.2 billion in revenues and single song downloads were accounting for over $1.2 billion in revenues. Subscription revenues for the industry stood at over $0.2 billion in 2009, followed by mobile and album downloads, which stood at under $0.8 billion revenues each.  The graph below, courtesy of Business Insider, shows the growth across these services since 2003.

Pandora’s Financials
Among online radio stations, Pandora Media has become a leader. Founded in 2000 by Tim Westergren, California based Pandora combines an innovation, well-thought-out recommendation engine with the Music Genome project to deliver music choices to listeners that they would like listening to. The service also lets users give a song a “thumbs up” if they like it or a “thumbs down” to skip the song if they don’t like it.

The site has more than 80 million users listening to its music radio stations and recently reported its 10 billionth thumb. Listeners can create up to 100 unique radio stations to listen to more than 800,000 songs by more than 80,000 artists on their PCs and mobile devices. Pandora’s mobile app was rated as the top five most-used apps across all four smartphone platforms by Nielsen in September 2010. The service also allows users access, through over 200 connected devices and select Ford, Toyota, and BMW Mini Cooper models. Pandora claims to be among the top 20 stations and networks in the country and commands more than 50% share of the Internet radio listening time.

Pandora’s listeners can choose from a free subscription to listen to ad-supported content or listen to the music free of ads through a paid subscription that costs $36 a year. Pandora has received $56.3 million in funding and recently filed for a $100 million IPO with the SEC. It earned $90.1 million revenues in the first nine months of 2010 and suffered a loss of $0.33 million. Advertisements accounted for 86% revenues for the nine-month period, while subscription and other revenues brought in the remaining 14% share. A year ago, Pandora reported revenues of $31.4 million for the nine months. For the year ended January 2010, the company’s revenues grew 186% to $55.2 with losses of $16.7 million. Listening hours across its service doubled to 2.1 billion in fiscal 2010 from 1 billion hours in fiscal 2009.

Pandora’s Royalty Woes
Pandora has been troubled by the high royalty costs associated with the music industry. The company has had to shelve international expansion plans due to high royalties. For the nine-month period in 2010, Pandora’s royalties remained its biggest cost at $45.4 million. These high costs have eroded margins despite the strong growth. It also appears, according to the IPO filing document, that the company is extremely wary of its profitability. It said:

“[A]s our number of listener hours increases, the royalties we pay for content acquisition also increase. We have not in the past generated, and may not in the future generate, sufficient revenue from the sale of advertising and subscriptions to offset such royalty expenses. If we cannot successfully earn revenue at a rate that exceeds the operational costs associated with increased listener hours, we may not be able to achieve or sustain profitability. In addition, we expect to invest heavily in our operations to support anticipated future growth and public company reporting and compliance obligations. As a result of these factors, we expect to continue to incur operating losses on an annual basis through at least the end of fiscal 2012.”

Despite these problems issues, Pandora is far ahead of the competition in terms of market reach, as was evident in January’s radio ratings published by Pandora recorded more than 522,00o hours, compared with CBS’s 103,000 hours and Clear Channel’s 83,000 hours. By understanding the DNA, so to speak, of its music, Pandora has managed to keep a faithful and a growing registered user base. As I said earlier, it will have to address the challenge of meeting the high content costs while maintaining its highly efficient recommendation engine. Meanwhile, it is expanding its content library by offering archived comedy clips and is also evaluating the possibility of sports, talk, and news shows.

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