Boxing in Pandora

It was an eventful week for internet radio service Pandora.

On Tuesday, Apple announced the official launch of iTunes Radio,which will go live September 18 as part of Apple’s iOS 7 rollout and will add a formidable new competitor to the streaming music business. On Wednesday, Pandora announced the appointment of Brian McAndrews as its new CEO. The former head of aQuantitative, McAndrews is regarded as a rock star in the world of digital advertising and his appointment sent Pandora shares up by more than 12 percent. On Thursday, Clear Channel Communications, which owns Pandora-competitor iHeartRadio, announced a groundbreaking licensing deal with Warner Music Group that could rewrite the rules on music performance royalties — a critical factor in determining Pandora’s future profitability.

While the latter development didn’t move Pandora’s stock one way or the other, it could prove the most challenging for its new management to deal with in the long run.

The essence of the Clear Channel-WMG deal is a swap: Clear Channel has agreed to pay Warner performance royalties for playing records by Warner artists on the air from its 850 broadcast radio stations, something artists and record companies have been clamoring for unsuccessfully for decades (unlike with musical compositions, Congress did not create a public performance right for sound recordings when it extended federal copyright protection to recordings in 1971). In exchange, Clear Channel was able to negotiate a lower performance royalty rate for its digital platforms, including its web simulcasts of its broadcast stations as well as iHeartRadio (Congress did create a public performance right for sound recordings on digital platforms in 1995 but never extended it to broadcast stations).

The deal has drawn praise from many quarters, including Capitol Hill, because it appears to have cut the Gordian Knot of conflicting demands for legislative action to create a formal broadcast performance right for sound recordings and for lower statutory royalties for digital performances. Like most broadcasters, Clear Channel has long opposed creating a performance right for sound recordings that would require payment of royalties for on-air play. At the same time, Clear Channel has also been an ally of Pandora in its effort to roll back the statutory per-stream royalty that internet radio stations must pay to artists and record labels for performance of their recordings.

While Warner is the first major record label to sign such a deal (about a dozen independent labels have signed similar deals with Clear Channel) its arrangement with Clear Channel is already being looked to as a template for a broader detente between the record companies and broadcasters. Presumably, Clear Channel will now pursue similar deals with the other two members of the Big Three labels, Sony Music and Universal Music Group, which account for about two-thirds of the recordings sold in the U.S.

It may not be a template Pandora can follow, however. As a digital-only broadcaster it has no over-the-air bargaining chips to offer in exchange for a lower digital royalty burden, which could eventually leave it at a competitive disadvantage those with multiple broadcast interests.

It could also face a related challenge in trying to compete with iTunes Radio. Though Apple has no over-the-air interests, iTunes Radio relies on multiple revenue streams, including an integrated download buying option on all streamed tracks as well as advertising and an ad-free subscription tier.

Last year, Pandora paid out over half of its $427 million in gross revenue in royalties, by far its largest expense. Since those royalties are calculated on a per-stream basis, moreover, its largest expense line grows in direct proportion to the growth in usage of its service.

One way or another Pandora needs to figure out how to increase revenue faster than costs. While all music streaming services face that same challenge, Pandora increasingly finds itself facing off against competitors with more negotiating room than it enjoys.