SoundExchange Could See Collected Revenue Shrink by $200 Million in 2017: Exclusive

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As Pandora signs direct deals with labels is the middle man getting cut out?

For the past five years, SoundExchange has been one of the music industry's few bright spots in a transitional and contracting market. In that time, the non-profit entity which collects and distributes digital royalties for labels and artists for non-interactive transmissions (i.e. Pandora, SiriusXM and others), saw its revenue collections explode 229 percent from $270 million in 2010 to $888 million in 2015. But according to sources with knowledge of the situation, a recent shift to direct licensing will likely lead to slower growth in 2016 and a precipitous drop next year as collections could decrease by about $200 million, according to Billboard estimates.

The primary reason for this loss is that some of the major satellite, digital radio and cable music players have begun moving away from using a compulsory license for recorded music and are instead signing direct deals with record labels. Under the compulsory license, U.S. regulations say digital services must pay all royalties to SoundExchange, which disburses payments to record labels, (50 percent of royalties); recording artists (45 percent of royalties); and side musicians and singers' unions (5 percent of royalties). Since its creation in 2003, the use of compulsory licenses have dominated the digital landscape for programmed music -- until recently.

“We've been warning SoundExchange for years that direct licensing will eventually impact their business model and they need to get ready for it,” said one source in the digital services camp. While SoundExchange declined to comment for this story, sources insist that the collections organization has been doing just that: looking for new income streams.

This trend of labels and services cutting direct deals mimics what’s been going on in music publishing, where the majors have begun cutting direct deals with Pandora, iTunes Radio and Apple Music. One of the benefits of direct deals for the services is that they cut out any administrative fees.

Beginning in 2014, Pandora cut a direct deal with Merlin, the global indie label rights organization that negotiates and administers licensing deals. Meanwhile, Apple’s radio-like services, including first iTunes Radio and then Apple Music's radio component Beats 1, have never used a compulsory license or paid any royalties to SoundExchange. And in the last two years, SiriusXM has aggressively cut direct deals with indie labels, although the satellite radio broadcaster is still largely reliant on the compulsory license for sound recordings. Sirius has cut deals with about 500 indie labels that comprise about 6% of its plays, according to its filing with the CRB for its ongoing proceeding to determine rates for satellite and cable TV radio for 2018-2022.

Now that Pandora is entering the on-demand streaming business, it too has begun cutting a slew of direct deals with major labels, Merlin and many of the remaining indie labels. Those direct deals are not only covered in its on-demand service slated to launch in 2017, but they also cover its custom radio service started in Q4 of 2016.

While SoundExchange will miss out on collecting and dispersing label royalties from most of Pandora's direct deals, it will still process payments to recording artists and unions, which is why income growth will likely slow slightly for 2016 and fall off more in 2017.

Through the third quarter of 2016, Pandora operated under a compulsory license and paid about $525 million in royalties to SoundExchange, of which about $125 million went to publishing and about $400 million for sound recordings, Billboard estimates. Under the statutory split, $200 million of the $400 million was paid out to the labels and $200 million to the artists and musician unions. Billboard estimates that the major labels and Merlin comprised at least 90 percent, or $180 million, of label payouts from Pandora.

That means that in 2017, if Pandora stays the same size, SoundExchange will only get paid about $200 million for the artist and musician’s share and $20 million for indie labels not affiliated with the majors or Merlin, resulting in SoundExchange losing an estimated $180 million in revenue.

Billboard was unable to estimate the size of revenue that the Sirius direct deals amounted to, nor could Billboard determine which labels had the clout to demand direct payments from Pandora. In 2014 -- before the majors jumped aboard the direct deal wagon -- when Merlin cut its first direct deal with Pandora, SoundExchange refused to administer the artist payments unless it could also administer and get its cut from the Merlin labels, too, sources say.

Changes in Overhead Costs

That revenue shortfall represents a double-edged sword to SoundExchange in that it could impact its overhead expense structure, too. Since 2010, its overhead costs have grown from $18 million in 2010 to $41 million in 2015, which works out to an administrative fee of 4.6 percent of revenue, something that SoundExchange touts at the top of its home page as the lowest in the industry. Performance Rights Organizations like BMI and ASCAP, in comparison, charge an administrative fee of about 13 percent of revenue.

Sometimes the administrative fee is negotiated and determined beforehand, but most often PROs like ASCAP, BMI and other collections organizations total their operating costs and use that number as the numerator, put it against total revenue as the denominator, and that fraction determines the administration fee. So when SoundExchange had expenses of $41 million against $888 million in revenue in 2015, that worked out to the aforementioned 4.6 percent.

But that low percentage is not just a measure of SoundExchange’s efficiency, as others point out; it also represents the explosive growth of Pandora and Sirius, the two digital services paying the most in royalties to the agency. In fact, some sources in the digital sector say SoundExchange has neglected the growth of Pandora and Sirius when taking credit for having the industry’s lowest administration fee of all U.S. collection organizations.

For example, if Pandora had direct deals in 2015, SoundExchange's revenue would have only been $708 million, not $888 million, so its expense ratio would instead have been 5.8 percent of revenue ($41 million overhead/$708 million in revenue), not 4.6 percent. Without the $180 million in revenue, SoundExchange’s overhead costs suffer an $8.28 million shortfall.

Billboard Year in Music 2016

Making Up for Lost Revenues

With compulsory licenses by digital services dropping off, SoundExchange has been pursuing other income streams, like administering Sirius’ two pre-1972 settlements -- the first for the majors and ABKCO; the second for the Turtles -- which combined could add up to $235 million and more than offset the Pandora decline. But while those deals may help the company maintain top line collections growth for 2017, do they pay enough in administration fees to maintain the $41 million level in overhead? And what does SoundExchange do for an encore to offset the defection of Pandora to direct deals?

In addition to those two pre-1972 deals, SoundExchange is now administering 13 other direct deals, sources report, some for digital services that previously used compulsory licenses, but others from deals the PRO normally wouldn’t have handled three or four years ago, those sources say. Also, some suggest that SoundExchange is exploring ways to get into the administration of mechanical royalties. That would represent a whole new licensing sector for the agency

As for Sirius, it's unclear if any of the Sirius direct deals are paying the labels directly, but the satellite radio service could pose another revenue shortfall problem for SoundExchange. It is proposing that the CRB rule that its royalty payments to labels be in the range of 8.1% to 11% for the 2018-2022 term. Sirius says that the 500 direct deals it has cut "fully adjusted suggest a reasonable royalty rate of no more than 9.87% of Sirius revenue," which is less than the 11% rate Sirius is set to pay in 2017. If the CRB Judges agree with Sirius, its payments to SoundExchange going forward may be slightly less than what they are currently.

On the other hand, the challenges posed by direct licensing in 2017 may also be a one-year blip if things go SoundExchange’s way with the Copyright Royalty Board. It is proposing that beginning in 2018 Sirius should be paying Sound Exchange 23% of income which would produce a windfall of $600 million in incremental revenue for SoundExchange, Billboard estimates. If that happens, then Sound Exchange's salad days could be starting all over again.