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Sirius XM
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==Pandora Faces Very Competitive Landscape Even as It Pivots to Podcasts== The second and newer segment of Sirius XM is headlined by Pandora, which was acquired in February 2019 for $3.5 billion in all-stock deal. Pandora launched one of the first internet radio services in 2005, which still provides the majority of revenue for the segment. The internet radio service, which creates playlists based on the user's selection of an artist or song, generates revenue primarily via advertising. There is a subscription option, Pandora Plus, for $5 per month that offers advertising-free streams, unlimited skips, and offline listening. In 2017, Pandora launched an on-demand premium music offering called Pandora Premium that is similar to Spotify, Apple Music, Tidal, and other streaming competitors. This service charges $10 per month for the same features as the Plus tier along with the ability to make and share playlists. Despite these changes, advertising remains the primary driver of revenue (Exhibit 10). Even with the addition of subscription options, Pandora remains a small player in the streaming music landscape within the U.S., the only market that it serves. According to the Recording Industry Association of America, revenue from digital subscription and streaming services totaled $10.1 billion in 2020. Pandora generated $1.7 billion in 2020, implying a market share of roughly 17%. However, the RIAA only counts the distributions from SoundExchange, the non-profit performance rights organization for digital music as designated by the U.S. government, as digital and customized-station music revenue. So, the total revenue from Pandora overstates the firm's importance as the RIAA is effectively only counting the royalties that Pandora and its digital and customized-station streaming music peers pay from their ad-supported services as part of the overall $10.1 billion revenue generated in 2021. Combining the content costs for the ad-supported service with the revenue from the subscriber services provides a more accurate representation of Pandora's size within the U.S. music landscape, though possibly slightly underestimating its importance. Using this methodology, Pandora's "RIAA revenue" for 2020 came in at $1.0 billion or roughly 10% of the $10.1 billion RIAA estimate for U.S. digital subscription and streaming service revenue. In contrast, Spotify's U.S. revenue hit $2.9 billion for 2020 or 29% of the total. Given the weak advertising market in 2020, Morningstar thinks that the 10% share for Pandora likely underestimates the importance of the service. However, Pandora has lost market share every year from 2016-20 due to the much faster growth of paid subscription music streaming (Exhibit 11). The rise of subscription services with on-demand music selection has led to a sharp decline in total hours of usage on Pandora, which have fallen 40% from 2016 to 2021 as total monthly active users dropped from 81.0 million to 52.3 million. Offsetting this decline has been an impressive growth in advertising revenue per thousand listener hours (RPM), up from $54.94 in 2016 to $102.74 in 2021. This growth has been the result of more impressions per hour and better ad targeting. As a result, total ad-supported listener revenue has expanded by 11% over the same time frame, as seen in Exhibit 12. While ad-supported revenue has grown slowly over the last five years, subscriber revenue has more than doubled to $530 million. However, the total subscriber base remains relatively small, with only 6.4 million paying users at the end of 2021 versus 4.4 million at the end of 2016. In comparison, Spotify ended 2021 with over 52 million paid subscribers in North America versus 16 million at the end of 2016. The difference in the paid subscribers and net additions over the last five years demonstrates the issues that Morningstar believes Pandora faces in competing in a very crowded market. Pandora likely claims only a bit more than 1% of the total global streaming market by subscribers. '''Podcasting Could Turn Into an Expensive Misadventure for Pandora''' In an attempt to differentiate its service, Pandora has made a number of investments in content and technology. These included the 2020 purchases of Stitcher, a company focused on creating, distributing, and monetizing podcasts, for $266 million and Simplecast, a firm that offer hosting, distribution, and analytics to podcasters, for $28 million. Pandora also owns AdsWizz, a digital audio advertising platform that focuses on placing ads across music and podcasting platforms. Many of the podcasts hosted by Pandora are available to SiriusXM subscribers and vice versa. The focus on generating advertising revenue from non-music listening has started to bear fruit as Morningstar estimates that Pandora generated over $350 million in non-music advertising in 2021, up sharply from around $50 million in 2019. However, the podcasting market is becoming increasingly competitive with multiple media and technology firms entering the space and spending significant money. Spotify is one of the most prominent players and has signed a number of major podcasts, including Joe Rogan for a reported $200 million over five years. Spotify has also acquired a number of podcast firms, including two podcast marketing and ad attribution companies in 2022. The two largest radio station owners in the U.S.—iHeartMedia and Audacy (the fruit of the Entercom/CBS Radio merger)—both operate large podcasting platforms, as well. Multiple media firms including the New York Times, Vox Media, ESPN Radio, and NPR, create and host podcasts. Amazon jumped into the space in 2020 by acquiring Wondery, a podcast network, under its Amazon Music service and made numerous deals to obtain exclusive or early access to shows. HBO Max launched its own podcasts in 2021 that are only available within the service. YouTube has recently begun to offer money to specific podcast shows and networks to film shows and put on them on the service. One of biggest potential podcast players, Apple, is deeply involved in the space but in a non-exclusive manner. Apple Podcasts is one of the largest and most popular apps for listening to podcasts. The service offers access to both free and subscription podcasts but doesn't offer any exclusive content or ad placement. Apple provides marketing and measurement tools to help with monetization, and it added in-app subscription options in 2021. Morningstar thinks that Apple could easily increase its involvement in the market due to the popularity of the app and to better compete with the increasing number of Apple Music competitors like Spotify, Pandora, and Tidal that are using podcasts to differentiate their service. Given the firm's staggeringly deep pockets, Apple could buy the tech and people required to move deeper into podcast advertising and create a ton of exclusive content. However, Apple appears comfortable with its current level of involvement and may not see the need to jump into a relatively small market (estimated to hit $1.3 billion in 2021 in the U.S. by the IAB U.S. Podcast Advertising Revenue) for a company that generated revenue of almost $386 billion in fiscal 2021. Even without Apple jumping fully into podcasting, Pandora and SiriusXM are both facing a very large amount of competition in the U.S. Additionally, firms like Spotify are attempting to place podcasts behind subscription walls. While this tactic may work for established shows, podcasts based on well-known content like Marvel, or ones hosted by celebrities, Morningstar thinks many newer shows will have a harder time gaining an audience. Additionally, placing shows behind a paywall automatically lowers the size of the potential audience and thus the advertising opportunity. Although certain podcast libraries may have some longer-term value, particularly with the advent of dynamic ad insertion, Morningstar believes that many podcasts will have a limited shelf life similar to unscripted filmed content. As a result, the investment in podcasting by Pandora is unlikely to help the service differentiate and compete with peers like Spotify. While the investment in podcast can help SiriusXM, Morningstar doesn't believe that the increased investment in podcasting will generate significant top-line growth or spark subscriber growth. '''Sirius XM's Cost Advantage Drives Its Narrow Moat''' As discussed above, Sirius XM like any another business that uses music to generate revenue must pay out recording royalties. Modern music generally contains two copyrights: the first covers the sound recording itself (known as the master) with royalties paid to record labels, publishers, artists, and songwriters. The second covers the underlying composition (musical composition or publishing rights) that includes the lyrics and the musical composition, with a publishing royalty paid to the recording artist, songwriter, publishing house, and any other copyright holders. The person or persons who are compensated depends on the distribution platform and the copyright law. For SiriusXM, Pandora, and any of their streaming competitors in the U.S., content cost, especially music royalties, represents one of the largest expense categories, if not the largest one. In terms of master or sound recording royalties, as a satellite radio broadcaster, the SiriusXM satellite service pays a fixed 15.5% of its gross revenue to sound recording copyright holders. This rate was set by the Copyright Royalty Board in 2018 and will be held at this level until 2027 as a result of the passage of the Music Modernization Act in 2018. Pandora and other streaming rivals generally pay either on a consumption basis or as a percentage of revenue. On the publishing side, SiriusXM and Pandora along with platforms as disparate as Spotify and terrestrial radio all pay performance royalties to musical composition copyright holders. Spotify, the on-demand version of Pandora, and most streaming music platforms must also license reproduction or mechanical rights to offer interactive features like songs on demand. These rates and other musical composition rights are negotiated with the performing rights organizations (PROs) for respective countries, which in the U.S. includes Broadcast Music, Inc. (BMI), American Society of Composers, Authors and Publishers (ASCAP), SESAC, and SoundExchange. SiriusXM generally pays fixed installments over the term of its agreements with PROs, while Pandora makes variable payments based on usage and ownership of a royalty pool. While the SiriusXM satellite service faces a number of additional costs that the streaming platforms do not (including a revenue share with car manufacturers), the segment has generated a gross margin above 60% over the last five years, well above the average gross margin of Pandora (34%) and Spotify (25%) during the same period. Drilling into the components of cost of revenue for these three services illuminates the cost advantage moat source at SiriusXM. SiriusXM and Pandora break out cost of services into four categories, including "revenue share and royalties." For SiriusXM, this category includes the royalties paid to both sound recording and composition copyright holders as well as the revenue share agreements with certain automakers and talent on non-music networks such as Howard Stern. As a result of the fixed sound recording royalty rates and its fixed installment agreements with PROs, SiriusXM pays out a lower percentage of its revenue in music royalties than its on-demand streaming competitors. This level of payment does not directly corollate to usage by listeners. As shown in Exhibit 12, revenue share and royalties expense for SiriusXM has averaged 25.2% of estimated gross revenue over the last three years. Gross revenue is defined as advertising revenue combined with subscriber revenue excluding connected vehicle services revenue. At Pandora, the revenue share and royalties category includes all royalty costs and payments to third-party ad servers as well as payments to podcasting talent. Pandora has signed direct license agreements with most major and independent record labels that cover the majority of songs streamed on the service. Depending on the agreement, Pandora pays sound recording royalties on either a per-performance fee, based on the number of streams, or a percentage of revenue. In certain agreements, Pandora has consented to pay minimum amounts per subscriber. While Spotify does not offer further detail into its cost of revenue, the category is likely dominated by royalty payments. The other pieces it puts in this category include payment processing fees, customer service, specific employee compensation, cloud computing, streaming, and facility and equipment costs. A growing piece of the category is the amortization of podcast content assets. Even with this growth, Morningstar expects that a significant majority of the cost of revenue remains music royalties. The other major difference with SiriusXM and Pandora is that Spotify is available in over 180 countries while the other two are U.S.-only, which means that Spotify's royalty structure is considerably more complex with numerous different types of agreements in many countries and regions, creating complex payment calculations. Even with these caveats around comparability, the cost advantage enjoyed by SiriusXM over its streaming rivals is significant (Exhibit 13). Revenue share and royalties as percentage of revenue for Sirius XM has only increased to 23.1% in 2021 from 22.1% in 2016 despite the sharp rise in the sound recording royalty rate in 2018 to 15.5% of gross revenue from 11% previously. Spotify continues to diversify its platform away from music toward podcasts, which has helped to drive cost of revenue down from 86.4% in 2016 to 73.2% in 2021. However, Morningstar expects that a large part of the margin expansion potential from this shift has occurred and that cost of revenue will only fall to 67% of revenue by 2031. As discussed above, SiriusXM charges its customers a music royalty fee on most of its plans with music channels. This fee is intended to cover all the royalty fees paid by the firm, not just the sound recording fee. The fee can range from $0.44 to $7.49 per month. In response to a higher sound recording royalty rate in 2018, the service increased its own U.S. music royalty fee to 19.1% from 13.9% on most of its plans that offer music channels. While the increased rate could have driven up churn, there doesn't appear to have been any long-term lasting effects (Exhibit 6). SiriusXM treats the fee as an additional charge and keeps it separate from the base price of its plans, obscuring the charge in the same way that pay-television providers have in recent years with regional sports network or broadcast network fees. In contrast, the streaming music platforms tend to have very simple plans with slight discounts for families or students. Spotify has been in subscriber acquisition mode for the majority of its lifespan thus far and raised prices in the U.S. for the first time in 2021—and then only on its family plan. The premium plan in the U.S. has been priced $9.99 per month since launching in 2011. As a result, Spotify has yet to post positive net income (though Morningstar does expect that to change in 2022). Similarly, Pandora reported net losses in every year prior to being acquired by Sirius XM in 2019. Neither service nor any of their competitors in the U.S. to Morningstar's knowledge, have ever even attempted to pass on content costs to their customers. The U.S. music royalty fee increase is one of the reasons that revenue share and royalties expense as a percentage of revenue has and will likely remain relatively steady at SiriusXM in the coming years. The passage of the Music Modernization Act in 2018 by the U.S. government set the royalty rate for SiriusXM at 15.5% of gross revenue (subscriber and advertising revenue) from 2018 to 2027. While a sharp rise from the previous 11% rate, the firm still enjoys a cost advantage over its streaming rivals.
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