Pandora--Is it Still an Unscalable Box?

This Kat would like to briefly consider the relationship between IP and scalability, especially in the business context. It seems that we usually don't consider IP rights in this context. At its heart, an IP right provides its owner with a right of exclusion vis-à-vis third parties. Only if the owner and the prospective user can reach a commercially acceptable arrangement will the owner grant to the third party, i.e., the licensee, the right to use the IP right at issue. Okay, but what has this to do with scalability?

Let's first consider two definitions of "scalability". 1. From Wikipedia:

"The concept of scalability is desirable in technology as well as business settings. The base concept is consistent – the ability for a business or technology to accept increased volume without impacting the contribution margin (= revenue − variable costs). For a business to be scalable, incremental costs must be decreasing — ideally approaching zero." *** 

2. From >sacrecowedung.com:

"[I]t means that the cost of each incremental dollar in revenue must be going down. Nothing is infinitely scalable. So scalability must be defined relative to market size and marketshare projections." 

These variant definitions of notions of scalability came to mind when I read Jennifer Saba's article, "Pandora shares plunge on fears of Apple service", which appeared on 7 September at Reuters.com here. For those of you outside of the US, Pandora may not be familiar, so first a brief description of the Pandora service. As described in Wikipedia (since one is not able to access the Pandora service outside the US, more or less, I am not able to access the website of the company), as follows:

"Pandora Media, Inc. is the operator of Pandora Internet Radio (also referred as Pandora Radio or simply Pandora), an automated music recommendation service and "custodian" of the Music Genome Project whose service in full is only available in the United States, with limited access in Australia and New Zealand. The service plays musical selections similar to song suggestions entered by a user. The user provides positive or negative feedback for songs chosen by the service, which are taken into account for future selections. While listening, users are offered the ability to buy the songs or albums at various online retailers. Over 400 different musical attributes are considered when selecting the next song. These 400 attributes are combined into larger groups called focus traits. There are 2,000 focus traits. Examples of these are rhythm syncopation, key tonality, vocal harmonies, and displayed instrumental proficiency .. The service has two subscription plans: a free subscription supported by advertisements, and a fee-based subscription without ads. There are also advertisements in Pandora Mobile for mobile phones and the Pandora in The Home computer appliance. Most users choose the free subscription [footnotes omitted]."

Pandora was the subject of a much-heralded IPO in June 2011, part of a number of public share offerings of technology stocks last year that were believed to usher in another boom period for online technology companies on Wall Street. So what is the problem for Pandora? In a word -- Apple. As reported by Reuters, Apple appears to be contemplating its own online streaming music service. Just the rumours of such a launch by Apple drove down the share price of Pandora in a double-digit manner. And the reason seems to be that Pandora appears to be a highly unscalable business with respect to the cost of using copyright content on the site.

As explained in the article, Apple enjoys significant leverage over the music labels through its iTunes service. On the other hand, Pandora faces the unenviable position of having to pay more for its music contents, the more popular its service becomes. For example, Pandora saw its active listeners increase by 48% to 55 million listeners in the last quarter and increased its internet radio share to 72% (up from 60%) from the same period a year ago. The problem is that during the last quarter, Pandora found itself paying nearly 60% of its revenue for content, up from 50% from the same quarter last year. This means that the company needs to pay more in royalty fees, the more listeners it attracts. As stated in the article, "[m]ore users equal more costs."

Pandora earns most of its revenue from advertising. It appears, however, that in order for the company to make money from advertising, it still needs to build a local sales force, and the cost in doing continues to increase (this sounds a bit like what is ailing Groupon: see this Kat's comments on Groupon in 2011 here). Indeed, Pandora has yet to turn a profit. As long as this state of affairs continues, it does not seem that Pandora is, or will likely to enjoy, the advantage of scalability any time soon.

What appears to be a potential saving grace for Pandora is that it is doing well in making revenues from mobile, to a degree not yet enjoyed by other, much larger actors in the online space. In fact, 60% of its overall revenues for Pandora in Q2 of 2012 were earned from use of the service on mobile platforms. If this continues, Pandora might be able to downsize its local sales force and thereby have a chance at achieving scalability of its contents (getting the U.S. government to lower royalty rates is another possible way). Until then, however, Pandora seems be in the perverse situation that the burden of paying for copyright content will increase both relatively and absolutely, even as more listeners consume its online service. The search for the Holy Grail of a viable business model for online content, it seems, goes on.