"Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.…"
Winston Churchill, November 11, 1947
Our elected leaders are certainly validating Churchill's comment as they refuse to reach a compromise, and instead of working against a December 31st deadline, have chosen to take a vacation. And while the economy faces a Fiscal Cliff that includes income and Social Security tax increases, cuts in Medicare payments to healthcare providers, cut-off of extended unemployment benefits, sequestration, etc., Sirius XM Radio is facing a cliff of another sort. Rather than the economic cliff that our government seems hell-bent on pushing us over, Sirius XM Radio (NASDAQ:SIRI) faces a steep cliff of subscriber growth that is becoming increasingly difficult to scale.
Sirius XM is about to record its best subscriber growth in more than five years. It has been growth driven by OEM relationships and new vehicle sales where potential self-pay subscribers received a free trial to expose them to the commercial free music and unique content of Sirius XM. At the end of the trial period, enough potential customers have seen sufficient value and chose to pay (the conversion rate) for the service. As new car sales, and the percentage of vehicles that came equipped with satellite radio (the penetration rate) increased, Sirius XM subscribers continued to grow.
The growth has also been aided by used car initiatives. Sirius XM began attacking the installed base of used vehicles several years ago. First with its Certified Pre-Owned (CPO) vehicle program and more recently with its "any OEM-installed" three month free trial offer. This year the used vehicle program was a key factor in driving net adds that the company has forecast will reach 1.8 million. Some expect the number of net adds to exceed 1.9 million or even 2.0 million. What should investors expect for 2013 net adds?
According to the company's 10Q, Sirius XM finished the third quarter with "23,365,383 subscribers of which 19,041,519 were self-pay subscribers and 4,323,864 were paid promotional subscribers." And, from the Q3 conference call, we also know the following:
We entered the year with nearly 5.5 million trials in the conversion funnel. Growth in new and used car sales has led to consistent growth in the inventory of trial subscriptions, which now exceeds 6.2 million.
So, with 4.3 million paid promotional subscribers and 6.2 million total trials, we know that there are 1.9 million unpaid trials. These unpaid trials are a combination of the used car program 3 month trials and other unpaid trials through certain OEMs. It is a pipeline for new subscribers that remains strong. In addition, recent forecasts indicate strong 2012 and 2013 light vehicle sales.
Based on strong sales in November and early December, LMC Automotive is edging up its 2012 forecast for total light-vehicle sales in the United States to 14.5 million units from 14.4 million units and maintaining the forecast for retail sales at 11.7 million units. The forecast for 2013 remains 15 million units for total light-vehicles and 12.2 million for retail sales, but represents a slower growth rate of four percent from 2012.
"The U.S. light-vehicle sales market continues to be a bright spot in the tremulous global environment," said Jeff Schuster , senior vice president of forecasting at LMC Automotive. "The only major roadblock ahead for the U.S. market is the fiscal cliff. Assuming that hurdle is cleared, 2013 is one step closer to a stable and sustainable growth rate for autos, with volume above the 15 million unit mark."
Regardless of whether the fiscal cliff is averted, Sirius XM has its own steep cliff to overcome. The company regularly loses subscribers from its self pay population. From the company's 10-K reports we know that the self-pay monthly churn for the past five years has ranged from 1.8% to 2.0% and averaged 1.9%. Assuming this 1.9% churn rate continues in 2013, that churn will result in the loss of more than 4.3 million subscribers from the Q3 base of 19,041,519 self-pay subscribers - subscribers that need to be replaced just to stay even. In addition, this number should be considered conservative. The actual number of self-pay subscribers at the start of 2013 should be higher than it was at the end of Q3 2012, and the number of self-pay subscribers should continue to grow throughout 2013. If that average number of self-pay subscribers in 2013 is just 19.6 million, the 4.3 million loss grows to 4.5 million. Where will the replacements come from?
Most will come from new car sales. Using a 68% penetration rate (a figure that Sirius XM CFO David Frear used at the UBS Global Media and Communications Conference earlier this month) and 15 million new light vehicle sales forecast for 2013, there will be 10.2 million paid and unpaid trials coming from new OEM sales. Of those, 45% - or 4.59 million - are expected to eventually convert to self-pay subscribers at the end of the trial period, and will eventually be added to the subscriber total.
The Increasing Importance of Used Cars
The next most important category for new subscriber additions will come from the used car programs. At the UBS conference, Frear noted that the used car program would generate the equivalent of one million gross additions. On previous conference calls, the company indicated the conversion rates on used cars were lower than those of new cars. During the Q3 2011 call, James Meyer said:
Regarding used car conversion, as Mel mentioned, we're pleased with the conversion so far that we've seen on certified preowned vehicles. It's not as high as new cars. It's, in fact, it tracks in the mid- to high 30s right now. I think it's too early to say what the long-term trend of conversion is going to be in used cars, because like many -- if you remember, in a new car conversion, it takes a while to figure the cadence, the proper cadence, and the proper offer strategy and a proper follow-up to optimize that number. And used cars, that we're still relatively new at it. I don't believe at all it'll ever be as good as new cars, but I do believe that it will be very, very strong and a good contributor for our growth for many years.
There has been little information added on this important metric, and the Sirius XM executives have chosen to skirt the issue. At other times when discussing new vehicle conversion rates, the company has stated that the conversion rate tends to correlate to income levels, with more expensive vehicles showing higher rates. A year ago, Frear said this about conversion rates:
The range really varies. And it tends to move consistent with the price of the car which is -- tends to be consistent with the incomes, all right? And so very high-end cars are going to convert at better rates than low-end cars. So for instance, if we have some models that convert north of 70%. We have other models that convert below 30%. It's -- I think that on the low end of the conversion, that it's not all explained by income differential. That we find that with some of the lower converting cars, that there are actually executional issues with those auto makers, all right?
If the CPO program exhibited conversion rates "in the mid- to high 30s," and the CPO cars tend to be premium cars, and conversion rates have a correlation to car price and income levels, it is highly unlikely that the used cars will convert at a higher level than CPO. This, in turn, indicates that used cars will convert at significantly lower rates than new cars. As stated above, this year the used car program is expected to generate one million "gross adds" and should eventually add less than 400,000 self-paid subscribers from the 2012 activity.
Fortunately, there will be an increasing number of used cars entering the free trial program. This is due not only to the increasing number used cars with OEM installed satellite radios being sold in the used car market, but also to the increasing number of dealers participating in the used car free trial program.
At the UBS conference, Frear presented a slide showing the growth in dealers participating in the program, increasing from 103 in Q1 of 2011 to 7,075 in Q3 2012.
# of Dealers
He also noted that there are about 16,000 dealers, but that the company would not be approaching that number in its free trial program. It is more likely that the company will sign up another 3,000-4,000 dealers.
The current, and growing, number of self-pay subscribers generates significant lost subscribers (churn ) that need to be replaced. Without the significant growth in the used car free trial program and increased levels of retention discount offers, subscriber growth in 2012 would likely come in at or below the 1.7 million net adds generated in 2011.
New subscribers that will be generated from increasing light vehicle sales in 2013 will barely be sufficient to overcome the subscriber losses due to the self-pay monthly churn. Sirius XM should continue to benefit from increasing net adds generated by the used car program, but it will be hard pressed to overcome the anticipated losses due to churn and duplicate 2012 net adds that could approach, or even exceed, 2 million units.
Better execution, increased retention discounting, and increased dealer participation in the used car program could all help grow the subscriber population, but Sirius XM has a very steep cliff to climb. I expect that when net adds are issued as part of 2013 guidance, the figure will be significantly below 2012 actual performance.
Additional disclosure: I have $3 January 2013 covered calls against most of my SIRI position. I also have a variety of other covered call positions. I may initiate (or close) a buy stock/sell option position in SIRI discussed in a recent article 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.