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The number of subscribers at Sirius Satellite Radio Inc. (NASDAQ:SIRI) and XM Satellite Radio Holdings Inc. (XMSR) is growing briskly, but cancellations are also rising. Although subscriber attrition, the churn rate, for both firms is low, a case can be made that customer satisfaction is still an open question, and part of that question may relate to the phrase "commercial-free". The devil, it appears, is in the details, with both firms already earning advertising revenues and aiming for more.

Official churn rates for both companies are well below 5 percent but detailing satisfaction is a trickier task. One method is to illustrate the relationship between deactivations and new sign-ups as in Table A for XM and comparable figures we presented on Aug. 2 for Sirius.

These percentages are much higher than the churn rates since the latter - deactivations divided by average subscribers in the period - are depressed by a rapidly growing denominator that can be assumed to include many newbies who haven't yet had time to really determine whether or not they like the service.

It's possible that upcoming new programming and hardware will improve satisfaction at either station or both. But while awaiting customer verdicts on these issues, another question has been raised that could be a harbinger of things to come for customers.

In an e-mail sent to XM, miffed subscriber Patrick Galphin wondered why he was paying for commercial-free music but hearing more and more commercials. XM's response to the e-mail, which was also sent to related links on the subscriber's favorite stations and to this writer, blamed the commercials on a partner company, adding that there would be "no reduction in the total number of commercial-free music channels." Perhaps not, but there will be more ads.

A graphic on the home page of the XM Web site says "Most Commercial Free Music Channels, plus News, Talk, Comedy and Traffic & Weather." The Sirius home page contains an image that states "SIRIUS 100% COMMERCIAL-FREE MUSIC." Notice, though, that neither service is promising that users won't ever hear commercials. Both leave the door open to commercials on non-music stations. The XM text suggests that however many commercial music stations it may have, its non-commercial roster of music stations is greater than the total number of music stations offered by Sirius.

In response to Galphin's e-mail, Jon Zellner, senior vice president/music programming for XM, Michelle Cartier, program director for XM's Top 20 on 20 station, Rick Stacy, program director for XM's 80s on 8 station, and PJ, an on-air personality on the XM's Flight 26 station replied with nearly identical e-mails stating that "[b]ecause of their early investment in XM, radio broadcasting company Clear Channel Communications provides programming for four music channels (Nashville, Kiss, Mix, and Sunny). An arbitration panel recently ruled that Clear Channel has the right to include commercials on the music programming they provide XM. As a result, these channels have now started carrying a limited amount of commercials."

The XM e-mails also referred to "our commitment to commercial-free music" and reiterated that "XM has added new commercial-free, XM-created alternatives for each of the Clear Channel provided music channels. Subscribers will see no reduction in the total number of commercial-free music channels."

Music aside, this doesn't seem like the last word on XM's airing of commercials, which contributed 4.4 percent of revenue in the second quarter.

In a June 6 presentation for investors XM offered the following:

  • A slide trumpeting the company's efforts to develop content that will appeal to women, stating that "[A]dvertisers desire highly targeted sales opportunities."
  • A slide entitled "Appealing to subscribers...and Advertisers" containing a bullet point stating that "XM's unique presentation of content provides advertisers the ability to align their brand and 'own the event.'"
  • A "Content Strategy" slide containing a bullet point stating the company's desire to "Develop Content that is appealing to Advertisers" with a sub-point stating "10% of Revenue by 2010 with unique opportunities."
  • XM is not alone in its desire to boost ad revenue.

    At Sirius, advertising contributed 5.4 percent of revenue in the second quarter. On its Aug. 1 analyst conference call, management said, with respect to advertising sales, that "the department continues to carefully ramp up its staffing as we progress toward our long-term goal of having ad sales approach 10 percent of our overall revenue."

    It appears that commercials are very much on the satellite radio agenda. And presently, it looks like non-music programming is the main focus for these endeavors.

    But with deactivations as a percent of signups looming large for XM and growing for Sirius, several questions come to the fore:

    1. Considering how content and marketing costs are so much higher than subscription revenue, how willing will the companies be to reign in ad sales growth when their 10 percent thresholds are reached?
    2. Assuming major advertisers come to cherish satellite broadcasting, might they seek further inroads into music programming and if so, how staunchly might XM and Sirius resist?
    3. How likely are subscribers to recognize and accept the boundaries that delineate which offerings are covered by the "commercial free" label and which ones are not?

    It will take some time, perhaps a few years, to fully answer those questions. For now, the best investors can do is continue to monitor the trend in deactivations.

    At the time of publication, Marc H. Gerstein did not own shares of SIRI or XMSR. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

    Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

    Source: Why Are There Commercials on Commercial-Free XM and Sirius?