Most Sirius XM Radio (NASDAQ:SIRI) investors are well aware of the company's business model. Subsidize the OEM's cost of installing a satellite radio in a new car, offer the buyer or lessee of the new vehicle a free trial, and try to convert that buyer to a paying subscriber as the trial draws to a close. Most of Sirius XM's subscriber growth over the past several years has come from this program, and the company has benefited from increasing car sales, increasing the percentage of new cars equipped with a satellite radio, and a slowly improving economy.
More recently, the company has been focusing its efforts on the used car market. Its strategy has been to work with dealers and offer used car buyers a three month free trial. There are several reasons to go after this market.
First, with nearly 70% of new vehicles now rolling off the production line with an OEM installed satellite radio (it reached 68% in Q4 and 67% for all of 2012), Sirius XM believes it has reached an optimal penetration level. In other words, increasing the level of penetration above 70% reduces the likelihood of a free trial being converted to a paying subscriber, and the company would be unlikely to recover the incremental cost of providing subsidies. On the year-end earnings conference call, the following exchange took place between Sirius XM CEO Jim Meyer and an analyst:
Meyer: ...I personally believe, still, that high-60%, 70% is the right sweet spot for us for penetration, and I do believe that's kind of where you'll see our penetration stay over the next five years.
Benjamin Swinburne - Morgan Stanley: And you wouldn't expect any change to conversion ratio as a result of that inching up over time as you get into maybe lower price point cars and stuff?
Meyer: It's a challenge, I'll be honest with you. I mean, 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. I think we're still comfortable with our range that we've given for conversion, and I think we'll see how 2013 goes.
This means that growth will come from increasing US new vehicle sales, but the extra growth that came from increasing the penetration rate will end.
|New Vehicle Penetration Rate|
Second, according to Meyer, the growth in new vehicle penetration over the years has resulted in:
...approximately 50 million satellite-equipped vehicles in operation in the United States, roughly a 20% penetration rate of all registered vehicles on the road and up from about 40 million vehicles at the end of 2011.
Those inactive satellite-equipped vehicles that are not Sirius XM subscribers - about 26 million - represent a significant marketing opportunity. And third, since the radio has already been installed and expensed, there is no additional "Subscriber acquisition cost." Subscriber acquisition cost is defined by Sirius XM as:
...hardware subsidies paid to radio manufacturers, distributors and automakers, including subsidies paid to automakers who include a satellite radio and subscription to our service in the sale or lease price of a new vehicle; subsidies paid for chip sets and certain other components used in manufacturing radios; device royalties for certain radios and chip sets; commissions paid to automakers as incentives to purchase, install and activate satellite radios; product warranty obligations; freight; and provisions for inventory allowances attributable to inventory consumed in our OEM and retail distribution channels.
It is equally important to understand that this cost does not include:
...advertising, marketing, loyalty payments to distributors and dealers of satellite radios or revenue share payments to automakers and retailers of satellite radios.
In 2012, subscriber acquisition costs were $474.7 million, an increase of 9% over 2011, and reached $126.7 million in the fourth quarter. That's an annual run rate in excess of $0.5 billion. It is also the company's single largest expense. (The "Revenue share and royalty" line item is larger, but it is a combination of two separate expenses, each of which is smaller than subscriber acquisition costs.) Will it decline? While possible, it seems unlikely.
There is another cost published by Sirius XM called "SAC, per gross subscriber addition." This is defined by the company as the adjusted "Subscriber acquisition cost" line item divided by the number of new vehicle gross subscriber additions. SAC has continued to decline over the years, although the improvement has slowed markedly this past year:
|SAC, per gross subscriber addition|
The slowing improvement in SAC coupled with an expected growth in new vehicle sales suggest that the total subscriber acquisition cost line item will continue to rise.
However, savings in acquiring subscribers for Sirius XM will come from its efforts in the used car program. Once the radio is installed, Sirius XM will have additional opportunities to market the service to buyers of used cars. There would be no additional "Subscriber acquisition costs." Recently, CFO David Frear stated:
But the big difference is that we subsidize the installation of the equipment once in the life of the car, right? And that's when it's originally produced coming out of the factory, there is no subsidy that goes along with the radio after that, so every time you are able to capture they recapture a subscription and a vehicle where we have already put a radio in. You're just monetizing that investment better [each time] [ph].
That does not mean that there will be no additional costs to acquire subscribers originating from the used car market. There will continue to be "marketing, loyalty payments to distributors and dealers of satellite radios or revenue share payments to automakers and retailers of satellite radios" as well as additional "Customer service and billing" expenses.
The used car market subscribers still must be signed up by Sirius XM at the end of the trial period. These direct marketing efforts originate in the customer service department. Recently, the customer service and billing expense has risen more sharply, and part of the explanation was an increase in the length of time spent on each call.
It is not surprising that the length of time spent on each call has increased. The used car conversion rate was expected to be significantly below that of the new car conversion rate of about 45%. These potential subscribers are likely to be a more difficult sale, and even with an increase in the time spent on a call, the call will likely end in failure more than 60% of the time.
Sirius XM expects the number of self-pay subscribers to grow by 1.6 million net additions in 2013. A previous article discussed how the used car marketing efforts by Sirius XM have become increasingly important to the growth of these self-pay subscribers. I believe the used car marketing efforts will contribute more than one quarter of the 2013 net additions.
As Frear noted, with SAC subsidies being a one-time cost, the used car program has the benefit of "monetizing that investment better." This should not be confused with the idea that the subscriber acquisition cost line item will decline (it is tied to growing new vehicle sales), or more importantly, that the total cost of acquiring - and maintaining - subscribers will decline.
Meyer's recent comments about the correlation between lower priced cars and lower conversion rates, as well as his previous comments about used car conversion rates, would indicate that used car buyers are a more difficult sale for Sirius XM. It would also seem reasonable to conclude that the increased time on a customer service call is attributable to the company's increasing efforts with lower-priced used cars.
I have no doubt that the used car program will become increasingly important to the profitability of Sirius XM and will allow the company to better monetize the subsidies provided to the OEMs. I also have no doubt that the overall cost of acquiring and maintaining subscribers will continue to rise.
Additional disclosure: In addition to my long positions, I have January 2014 $3.50 covered calls written against many of my long positions in Sirius XM. I also trade blocks of Sirius XM on a regular basis.