A new paper disputes Pandora claims it pays too much in royalties. Written by Dr. Jeffrey Eisenach, "Understanding Webcasting Royalties" shines a light on Pandora's effort to lower its royalty costs. Eisenach is Managing Director at Navigant Economics LLC, is Visiting Scholar at American Enterprise Institute and is Adjunct Professor at George Mason University Law School.
 
The paper was funded by musicFIRST, a national coalition with the mission of ensuring music creators get "fair pay" for the use of their works. Its founding members include SoundExchange and the RIAA, two organizations on the opposite side of the debate over webcasting royalties. The backing of musicFIRST doesn't necessarily negate the paper's argument, but the paper lacks clear objectivity.
 
The paper comes a week after Pandora announced it had purchased a terrestrial radio station in South Dakota to take advantage of the lower ASCAP rates available to companies that own both a terrestrial radio station and Internet radio service. It makes some good arguments, but it fails to acknowledge the differences between Internet radio companies and the traditional businesses to which Pandora is compared.  
 
Eisenach's paper succeeds when it addresses Pandora's overarching strategy of focusing on growth over profitability. Pandora has not posted a profit because "it has followed a conscious (and highly successful) strategy of investing in growth and market share," he writes. Eisenach is also right to call it a "perfectly sensible" business strategy. Pandora has first acquired the listeners -- 70 million a month right now -- that will help its advertising sales team generate revenue.
 
But Dr. Eisenach often misses the mark when he compares Pandora to other businesses like Walmart.  In his view, webcasters "are essentially retailers, and retailers typically pay a high proportion of their revenues for the products they sell." Indeed, Pandora's cost of sales is similar to those of retailers such as Walmart, and they're lower than what iTunes and Spotify pay out to rights holders.
 
Calling Pandora a retailer plays loosely with the definition of the word. Merriam-Webster defines retail as "to sell in small quantities directly to the ultimate consumer." BusinessDirectory.com defines retailer as a "business or person that sells goods to the consumer, as opposed to a wholesaler or supplier, who normally sell their goods to other businesses." Walmart fits the definition of a retailer and exists in the supply chain (supplier, retailer, consumer) described in the definition. Pandora has more in common with Cumulus Media and SiriusXM Radio. 
 
A key difference between Pandora and Walmart is their ability to negotiate. Walmart has purchasing power that it uses to get lower prices from suppliers. Pandora has no power to change its royalties in the short term and little over the long term. From Pandora to Amazon, companies that license digital content do not have the same ability to negotiate lower prices.
 
The paper probably uses Walmart as a comparison because the retailer achieves profitability with tight margins. Walmart had a gross profit margin (cost of goods sold as a percent of sales) of 24.4% in 2012. But low margins are not insurmountable in retail because of the size of the retail market. Walmart had revenues of $469 billion in its fiscal year ended January 31, making it roughly 26 times bigger than the $18 billion U.S. radio market. Needless to say, it's easier to achieve scale in a larger market than a smaller market.
 
Ironically, a comparison to Walmart is actually quite apt because Walmart is famous for doing exactly what Pandora is attempting to do: lowering its costs. Could you imagine Walmart accepting higher prices from a supplier just because its cost of sales was lower than another retailer's? Neither could I. 
 
Businesses that license digital content don't have much negotiating power and don't always enjoy low margins. Pandora actually pays out less for its content, as a percent of revenue, than iTunes and Spotify, which pay 70% of revenue to rights owners. Netflix, which turned out a $17 million profit in 2012, had a cost of revenue of about 73%. On the other hand, SiriusXM also licenses content and it is paying only 9% of gross revenue for its music royalties this year.
 
Rights owners must walk a fine line between maximizing royalties and encouraging growth. Eisenach correctly notes that digital music royalties are not preventing either market participation or innovation. Spotify and Deezer have raised hundreds of millions from investors. Apple will launch iTunes Radio this fall. Google debuted http://www.billboard.com/biz/articles/news/1562280/google-launches-all-access-music-streaming-service-updated a subscription service, Google Play Music All Access, in May. A number of small webcasters, such as Songza to 8tracks, gives consumers more listening options.
 
But the economics of digital music work best when music is complementary to other products. The leading retailers don't specialize in music and often use it as a loss leader. The leading download stores use music to supplement other activities (Apple's hardware sales, Amazon's e-commerce, Google's search business). Netflix is a rare, standalone company that has achieved scale in digital streaming (domestically, not internationally). If music business concedes it would be better off with more standalone services, it will need to be more open to a dialogue about royalties.