Investors in two consumer internet services, Netflix and Pandora Media, are facing a conundrum.
They have to decide if either of these popular companies - Netflix for renting and streaming movies and television shows and Pandora for music - can ever be very profitable, with each in a business where costs rise the more popular their services become.
This dilemma was in evidence last week for both companies.
First, Netflix announced a big pact with Walt Disney Co to offer first-run action and animated films from Disney studios, starting in 2016. While the deal was seen as a big boost to Netflix's content offerings, and its shares jumped 14 per cent on Tuesday, Wall Street's biggest question was, "How much did Netflix pay?"
Then after the bell, Pandora reported third-quarter earnings that surpassed expectations. But its fourth-quarter forecast, which took into account weaker advertising spending, disappointed investors, fuelling a drop in its shares in after-hours trading on Tuesday, and an almost 18 per cent plunge on Wednesday. Netflix, too, suffered in a bit of a hangover on Wednesday, losing nearly 4 per cent.
The companies have slightly different revenue models. Netflix charges its subscribers a monthly fee, based on the type of service a customer is getting, starting at US$4.99 (Dh18) a month for its lowest cost option. Pandora generates the bulk of its revenue from ads on its service, much like terrestrial-based radio. It also offers customers an ad-free premium service, but its subscription revenue still remains a small portion of the total.
Pandora's user statistics are improving, with its focus on mobile users also paying off as well. Total listener hours grew 67 per cent in the quarter. But as those users spend more time listening to Pandora, its royalty costs jump.
Pandora's discussion of the looming fiscal cliff and its effect on internet advertising was instead the bigger theme on the conference call on Wednesday. As the Maxim Group analyst John Tinker noted, Pandora is still continuing to fight what appear to be unfairly high royalty rates compared with the rates paid by other forms of radio, such as satellite, cable and terrestrial.
"Pandora is expected to pay more than 50 per cent of its revenues as royalties in fiscal year 2013 [January 2013], compared to 8 per cent by satellite radio and 15 per cent by cable radio," Mr. Tinker wrote.
For Netflix, growing royalty costs are also a concern for investors.
Some on the Street believe the Disney pact is going to be very expensive for the company. Tony Wible of Janney Capital Markets speculated that the looming cost of the Disney deal, part of which doesn't actually start until 2016, was the reason it was done three years in advance.
Both companies clearly need to work on lowering content costs to enhance the bottom line.
For Pandora, the challenge is to get the music industry to see it as a viable alternative to terrestrial radio - and a big promotional opportunity for new music - and therefore still be of value to the industry at a lower royalty rate. Netflix, for its part, must convince the Hollywood studios that it is a formidable outlet for movies and television shows.
But until each company starts to make headway is lowering content costs, they will weigh on the bottom line. And investors have to decide if they can live with that scenario for some time into the future.