Forget About The FCC And Focus On The CRB

| About: Sirius XM (SIRI)

As most investors in Sirius XM (NASDAQ:SIRI) know, Liberty Media (LMCA) has asked the Federal Communications Commission (FCC) for permission to buy a majority interest in Sirius XM. All paperwork was submitted by November 20th, and the FCC should render a decision within the next six months. With little opposition, it appears to be more a matter of when, rather than if the approval will come. However, another government decision that could have a more significant impact on the price of Sirius XM shares is a decision to be issued by the Copyright Royalty Board (Pending:CRB) in less than two weeks.

The current agreement under which Sirius XM pays artists royalties for sound recordings, the company pays 8% of most subscription revenues. This agreement expires at the end of the year, and I expect to see a sharp increase in the royalty rate. It is known that Sirius XM had proposed rates of 5%-7% and that SoundExchange had proposed rates beginning at 13% of revenue and escalating to 20% over the term of the new agreement. It should also be noted that Sirius XM is in litigation with SoundExchange over the royalty issue.

Sirius XM CFO David Frear presented at the UBS Media and Communications Conference on December 3rd, and I was expecting to hear questions about the CRB proceedings and hoping to gain some insight. I did not have to wait long, since the first question posed to Frear by an audience member was about the negotiations with the recording industry. However, the answer was not particularly enlightening.

Maybe Frear has a wry sense of humor, but instead of providing insight, Frear sounded more like a trash talking pro athlete than a key executive at a Nasdaq 100 company. What follows is the response to the question about the negotiations.

In terms of negotiations, we continue to be interested in reaching a settlement with the music industry. I do not believe we'll be successful in doing so. There is a long history of negotiating with SoundExchange and with the negotiations being largely nonsensical. I hold out no hope that we'll actually be able to reach a settlement.

I do expect the judges will render their decision on rates in just over a week. It's by statute due December 14th. I can't handicap the outcome. We've got three judges who have heard all the evidence. I will tell you that in a completely unbiased point of view that we did a spectacular job of presenting a case to the judges. I think the music industry did a truly horrific job of putting on their case. They retreaded a bunch of arguments from the prior proceedings seven years ago as if nothing had changed in the world. We have given the judges new evidence, new facts to help better benchmark the rates. I think on the merits that our case is significantly better than the case put on by the music industry.

It should be pointed out that the prior case before the CRB resulted in the rate increasing from 2.35% to 6% for 2007 and 2008, and then increasing by 0.5% per year to its current rate of 8%. When setting that rate, the CRB wrote:

Based on the record of evidence in this proceeding we have determined that the 13% rate identified hereinabove marks the upper boundary for a zone of reasonableness for potential marketplace benchmarks. We have also determined that potential marketplace benchmarks cannot be less than or equal to the SDARS' musical works rates (i.e., 2.35% of gross revenues).

... Therefore, based strictly on marketplace evidence, a rate close to the upper boundary is more strongly supported than one close to the lower boundary.

However, recognizing the weak financial condition of Sirius and XM at the time, the CRB decided that due to the state of the economy and the necessity to launch satellites that a 13% rate would be disruptive to the industry and the 6%-8% rates would be appropriate.

The financial condition of the merged Sirius XM is much improved, and with the exception of the launch of one already built satellite, there will be no need to build and launch additional satellites for five years. Those factors would seem to argue for a higher royalty rate.

When a follow up question was asked about recovering the a potential increased in the cost, Frear said "raising prices is something we take very seriously" and did note that he thought "we'll continue to be able to achieve our contribution margins in the future."


What is not clear is the level of royalty rates the market is anticipating. If Frear is correct in his assessment, and the benchmarks used by Sirius XM are found to be reasonable, it is likely that there will be a favorable move in the price of the shares. I find this unlikely.

When the current SDARS royalty rates were set, the CRB judges determined that the potential for disruption would diminish over time. Considering the growth in revenue, subscribers and free cash flow over the period, their determination has turned out to be correct, and would suggest that a further increase in rates should be forthcoming when their decision is released. It also seems unlikely that "the music industry did a truly horrific job of putting on their case," so I suspect we will see a significant increase. And, since the market prices shares based on future projections, I also suspect that a royalty rate increase has been partially priced into the shares.

Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have $3 January 2013 covered calls against most of my SIRI position, as well as some $2 and $2.50 January 2013 and $2.50 December covered calls. I may initiate (or close) a buy stock/sell option position in SIRI at any time. Also, in addition to long-term holdings, I have recently begun day trading 10,000 share blocks of SIRI and may continue to do so. I have no position in LMCA.

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