By now most Sirius XM Radio (NASDAQ:SIRI) investors know that the company has been aggressively pursuing a strategy to grow subscribers by attacking the used car market. A program that initially began with specific OEMs and Certified Pre-Owned, or CPO, vehicles has morphed into a program that covers any used car with an OEM installed Sirius or XM satellite radio sold by a participating dealer. And, the number of dealers participating in the program that offers a 90 day free trial has risen dramatically in the past few years.
The growth in dealers is shown below (from a slide that Sirius XM CFO David Frear presented at a UBS conference in December):
# of Dealers
As of the February 5th conference call, that number of participating dealers had grown to more than 8,000. We know this because Sirius XM CEO Jim Meyer stated:
Our used car trial program has now been implemented at over 8000 dealer locations across the country, including all of those run by many large retailers such as CarMax, AutoNation and Penske.
It is also known that the used car program is contributing a substantial number of new subscribers. Meyer also stated:
As we mentioned last year, we expected to do approximately 1 million gross adds in the used car channel in 2012. We surpassed this number and in 2013 we are targeting used car gross additions in the range of 1.5 million.
Clearly, those figures indicate the program is a success in terms of adding potential subscribers to the unpaid trial pool. At year end 2011, there were 5.5 million total trials, of which 4.0 million were Paid Promotional Subscribers. At the end of 2012, there were 6.1 million total trials, of which 4.3 million were Paid Promotional Subscribers. During the past year, the free trials, a combination of used car and OEM unpaid trials, grew from 1.5 million to 1.7 million.
Conservative Growth Estimate
Looking more closely at the numbers, it would appear that the estimate of the used car contribution to the subscriber trial population for 2013 is extremely conservative. First, the number of dealers participating in the used car program more than doubled from 3,734 at year end 2011 to more than 8,000 today, and it is reasonable to assume that participating dealers will continue to grow during 2013, although the rate of growth should be somewhat slower. Second, the number of registered vehicles with OEM installed satellite radios has been increasing, and there should be more of these enabled vehicles sold by the participating dealers as the vehicles enter (or re-enter) the used vehicle market. The two factors - more than double the number of dealers and a larger pool of satellite enabled vehicles for sale - would lead one to conclude that the 90-day free trials offered on used vehicles in 2013 should more than double the number achieved in 2012. However, the number of Gross Additions from the used car program is only increasing by about 50%, from more than 1 million to the "range of 1.5 million."
Incremental Revenue of Used Car Opportunity
Unfortunately, Sirius XM management has chosen not to share too many details about the success or profitability of the used car program. Here is a statement by Frear on the recent conference call:
...it's still sort of early days on individual metrics, and I know it sounds like we've got a lot of transactions, and we do. But we do like to see these things sort of trend over time. Overall profitability on used cars is going to be certainly as good as the new car profitability, the single biggest reason being that we don't have to reinvest in the radio. So reacquiring revenue generating subscriptions on previously installed radios is an immensely profitable business for us. I think it will be a little while before we're able to tease out sort of sustained differences in churn profile.
At first glance, Frear's comment seems somewhat contradictory. He said, "Overall profitability on used cars is going to be certainly as good as the new car profitability." Why not say better than new cars? And, later on states, "...reacquiring revenue generating subscriptions on previously installed radios is an immensely profitable business for us." So, is this an immensely profitable business or one that is "as good as" the new car business? Probably both.
Based on management statements, during 2012-2013 the used vehicle program should contribute a net of roughly 750,000 self-pay subscribers. This figure is arrived at by using several data points. The first is the conversion rate. In late 2011, former CEO Mel Karmazin said:
And the conversion rate from these certified preowned trials is solid, below the level of our new car conversion rate but still very, very acceptable.
and Meyer added:
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.
The CPO program cars tend to be higher priced and newer used cars. And, from the recent conference call, we also know that where new cars are concerned, lower priced models tend to convert at lower percentages. On the last call, Meyer stated:
...we have issues of mix that we wrestle with every quarter. The primary reason is, obviously, the lower price models convert at a lower rate than the higher price models. And so we wrestle with that.
Putting these pieces of information together, it seems reasonable to use a 35% conversion rate for the used vehicles. Once converted, it will be assumed that the self-pay subscribers that initially entered from the used car pool will churn, or cancel, at the same rate as those that became subscribers as the result of a new car trial.
Using the 2.5 million Gross Additions for 2012-2013 and a 35% conversion rate, these will eventually become 875,000 Self-pay Net Additions. And, in a year, it can be expected that about 20% of those would be lost to a 1.9% self-pay monthly churn. By the end of 2013, the used vehicle program could generate $200-$250 million in revenue.
Used Car Program Costs
When Frear discussed the used car business as being "immensely profitable" he noted, "the single biggest reason being that we don't have to reinvest in the radio." This cost, the Subscriber Acquisition Cost ("SAC") was $54 for both the full year and fourth quarter of 2012 for each new vehicle Gross Subscriber Addition.
However, the program is not without other costs. There will still be marketing and sales costs, in addition to the music royalty and Revenue Share. When questioned about the Revenue Share for the used car program at the Citi Global Internet, Media and Telecommunications Conference on January 9th, Frear said it depended on the OEM agreement, but that if there was Revenue Share in the OEM agreement, there would still be the Revenue Share expense:
... whenever an enabled vehicle is revenue active, that whether it's original owner or subsequent owner, that generally there's a Revenue Share being paid.
Also, there are Customer Service and Billing, or CS&B, expenses. During the Q3 conference call, Frear was discussing the increase in the CS&B expense:
When you think about the business we're running that we are sort of a fairly aggressive and large-scale direct marketer, right? We get all these names from auto dealers and from auto companies about who's bought new and used cars, and then we market to them with a variety of campaigns that are all oriented towards driving people to contact us, whether they come onto our online account center and serve themselves across the web or whether they call into the call center or are part of our outbound telemarketing campaigns that we have, as you should expect the customer service and billing costs to continue to rise as we continue to sort of grow the funnel of opportunities that we're after and grow the customer base that we are serving.
With the increase in activity in the used car segment, customer service and billing expenses will continue to rise. Carefully looking at the recent 10K, we find that CS&B rose 14% in 2012 compared to 2011. However, it is not just that the CS&B is growing slightly faster than revenue (which grew 13% for the period), but that the customer metric that Sirius XM tracks also showed an increase. The measure - customer service and billing expenses, per average subscriber - increased from $1.03 in 2011 to $1.07 in 2012 per subscriber per month. Even more startling, is that this metric jumped to $1.16 during the last quarter of 2012. The increase in CS&B was "primarily due to longer average handle time per call and higher technology costs."
Sirius XM management appears to have been very conservative in its 2013 estimate of the growth in gross additions provided the used car program. This should provide fuel for the company to beat its subscriber guidance for 2013. However, it is also a program that comes with incremental costs.
Running a large direct marketing campaign is not inexpensive. Tracking and contacting the more than "1 million gross adds" from the used car program in 2012 required resources and cost money. It may also be part of the reason for the increase in the length of time spent on calls as these potential subscribers may be a more difficult sell. The growth of CS&B expenses is certainly worthy of continued monitoring.
The used car program is clearly providing a significant portion of the growth in subscribers and revenue during the 2012-2013 time period and we have been told that the profitability of the program is "as good as" the new car program. We have also been told that it is "immensely profitable."
Looking at the used car business as an incremental business may justify the use of the term "immensely profitable." However, if it is looked at as a fully loaded business unit carrying its fair share of all the company's operating expenses, it is likely that it is really only "as good as the new car profitability."
Additional disclosure: I also have $3.50 January 2014 covered calls against a portion of my position, and may open new positions at any time.