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Sirius XM Radio (SIRI) was downgraded by both Evercore Partners (from Overweight to Equal Weight) and Goldman Sachs (from Buy to Neutral) following the company's release of earnings and issuance of partial guidance for 2014. Are these downgrades warranted? Although there are many Sirius XM bulls that didn't think so, a closer look at some of the data and comments about the company reveal that there was some justification.

First, consider the ratings. These are not outright sell recommendations. They essentially tell investors to hold onto their shares and to expect the company's stock to perform in line with the overall market and/or sector, and perhaps a little bit better. In fact, Goldman didn't even lower its 12-month price target of $4.25. Firms and analysts should change their ratings - up or down - for one of two reasons. Either the price has moved too far and the divergence from the analyst's valuation has become too great, or there has been a fundamental change in the company's business. In the case of Sirius XM, it seems to be a bit of both.

Heading into earnings, the price had moved up significantly, climbing from $2.87 to as high as $4.18, or more than 45%, in the past year. There were many significant events during that time:

  • A special $0.05 dividend was declared
  • Liberty Media (LMCA) went to majority ownership and took control of the Board
  • Longtime CEO Mel Karmazin was forced out and replaced by Jim Meyer
  • The company announced a pair of $2 billion share buybacks
  • A new free trial program offered through car maintenance providers was introduced
  • Most of the company's higher interest debt had been, or is in the process of being, refinanced
  • The company announced its intention to purchase the Connected Vehicle Unit from Agero for $530 million
  • A new low cost Hispanic-targeted subscription package had been introduced
  • Liberty agreed to begin selling back $500 million worth of its shares

Clearly, the company had not been standing still, and many of the moves should have a positive benefit for the company's subscriber numbers, revenue, earnings and free cash flow. Add to this a positive backdrop of increasing auto sales to the highest level since before the recession, increasing penetration of satellite radios in the dashboard to all time highs, and a growing number of participating dealers in the company's used car trial program, and the expectations were high. That's where the results and guidance proved to be disappointing.

The Debt

The refinancing of the debt resulted in much lower coupon rates, and that should be good long term, shouldn't it? We already know that calling the older debt early resulted in a significant charge in Q3 and another announced redemption will cause a substantial charge in Q4. As a result, there won't be a noticeable benefit in Q4 either. Investors should also know that if I could calculate and predict these charges in Q3 and Q4, the analysts should know all about them as well.

On July 31st I wrote:

At some point in the second half of 2013, Sirius XM will incur a charge for the early termination of debt of more than $100 million.

And on September 30th, Seeking Alpha published an article with the following headline, Sirius XM Likely To Incur Incremental Debt Charge Of Nearly $70 Million In Q4. That article addressed another bond redemption and refinance. These articles and the calculations, although tedious, were not rocket science. They were based on well known public information. The exact timing had been in doubt at the time of publication because the notification process to bond holders had not begun, nor was it known how much notice Sirius XM would give. (The notes required 30-60 days notice.) That timing was known before earnings were announced, and should have been no surprise. These one-time charges are referred to as "Loss on Extinguishment of Debt and Credit Facilities, Net" on the income statement.

One would think all of this good news on lower interest rates on the Sirius XM debt should lead to lower interest expense in 2014. Or, at least that's what I initially thought. From the recent 10Q:

For the three months ended September 30, 2013 and 2012, interest expense was $54,629 and $70,035, respectively, a decrease of 22%, or $15,406. For the nine months ended September 30, 2013 and 2012, interest expense was $150,531 and $219,777, respectively, a decrease of 32%, or $69,246. These decreases were primarily due to lower interest rates.

We expect interest expense to increase in future periods as we issue new debt and as total debt outstanding increases.

While interest expense was down sharply for the quarter and year-to-date, Sirius XM is expecting that it will rise as it adds debt to fund the share repurchase programs, the $500 million Liberty share sale and the Agero acquisition.

Subscribers

This is the area that should have raised the most concern for analysts and the market. On Meyer's first earnings call he was discussing how things would remain the same after Karmazin's departure.

The first question I usually get from investors is what should we expect from you and what's going to change at SIRIUS XM under your leadership?

Well, I can tell you that you will see a lot more of the same with a focus on self-pay subscriber growth and a very tight focus on costs.

Notice the first item is subscriber growth, and specifically self-pay subscriber growth. For the past several years Sirius XM has issued conservative subscriber guidance, periodically increased the guidance throughout the year, and consistently exceeded it. While guidance for total subscriber net adds has been increased twice from the original 1.4 million to 1.6 million, the reduction of self-pay net adds last week to 1.5 million had to be a surprise.

Almost everything was pointing to stronger than expected self-pay subscriber growth. On the call, Meyer said:

In the meantime, new car sales were up, trial starts are up and we continue to be bullish about continued growth in the business. U.S. light vehicle sales remained strong, and consistent with our thinking, came in at SAAR of 15.7 million in the third quarter.

Consensus estimates still peg the full year at between 15.5 and 15.6 million units. Our new car penetration rate in the third quarter was a hair under 70%, up about two points from last year's third quarter and the highest quarterly penetration rate in the company's history. Year-to-date, our penetration rate is about 69% of new car sales.

New vehicle sales continue running well ahead of the 15.1 million SAAR that the company used to develop guidance. New vehicle penetration increased and is somewhat ahead of the anticipated two thirds rate, while churn, at 1.8%, is at the low end of the expected range of 1.8%-2.0% and below the 1.9% rate of 2012. And even on the used car front, which last year contributed over 1 million gross subscriber additions, there were no apparent weaknesses. Meyer stated:

We are still on track to deliver more than 1.5 million self-pay gross additions from pre-owned vehicles this year.

and, CFO David Frear later added:

It is probably best to just stay focused on the fact that we are seeing roughly 50% growth year-over-year in additions from the used car volume.

There were two areas of weakness. The new vehicle conversion rate is running at 44%, below the 45% rate for 2012, but within the company's anticipated 44%-46% range. The other area was a new one for followers of the company:

We have seen that our existing new car subscribers are turning over their vehicles sooner than what would have been predicted based on historical industry trends. As a result, our subscribers are migrating from one radio to another in a newer car. This trend picked up in the third quarter and is ahead of our expectations and... ...we are now estimating self-pay net adds of approximately 1.5 million for 2013.

I can understand the issue of lost or reduced subscriber numbers (and lower revenue) during a transition period when self-pay subscribers "cancel" because they get a free trial with their new car. What is puzzling is that these cancellations should show up in the self-pay monthly churn, but with churn at the low end of the historic range, that does not appear to be the case. In addition, there should be a decrease in revenue as self-pay subscribers move to unpaid trials or paid promotional trials that are subject to lower monthly fees. However, instead of lowering revenue guidance for 2013, it was increased.

Revenue

Subscriber revenue for Sirius XM is comprised of the fees from self-pay subscribers and paid promotional fees from certain OEMs. It is also fairly predictable and makes up most of the company's revenue. Not only are the fees pre-paid, but many self-pay subscribers choose longer term contracts to save money. This can be seen in the balance sheet where deferred revenue totaled $1.7 billion at the end of the third quarter (down $24.6 million from Q2). Total revenue has other components, including hardware, the Music Royalty Fee and advertising. According to Reuters:

Quarterly revenue increased 11 percent to $961.5 million from a year ago, and missed estimates by less than $10 million.

It should also be noted that the 10Qs show that the 11% revenue growth in the third quarter was down from 12% in the first half of the year. Perhaps even more telling was the decline in the growth of subscriber revenue in the third quarter to 10.1% from 11.7% in the first half of the year. It is likely that the decline in the rate of growth was due to the earlier than expected trade-ins by self-pay subscribers referred to by Meyer.

There is also a component labeled Other Revenue, comprised mostly of the Music Royalty Fee. Sirius XM tacks on the Music Royalty Fee to recover the cost of its music royalty cost. Other Revenue represents approximately 9% of total revenue, is up 18% year to date and up more than 20% in the two most recent quarters.

Revenue will continue to grow as Sirius XM adds subscribers and increases rates, but it also may be growing at a slower rate. It will also be negatively impacted in the fourth quarter and 2014 as one major OEM transitions from paid promotional subscribers to unpaid trials. It will also be affected the recently announced Hispanic package for $5.99/month.

Content Cost

Sirius XM has recently extended several key content agreements. At the recent Deutsche Bank Leveraged Finance Conference, Frear stated:

...we still expect programming cost to come down slightly from where they are now, but we really have now sort of gotten through, I think all of the - all of the big deals. and so I wouldn't expect any material declines in programming cost from here in the absence of a major piece of content leaving the platform.

But what about adding content? Subsequent to that conference Sirius XM announced the signing of Hispanic radio personality Piolin, whose show began on October 18th. The second quarter 10Q stated the following:

Excluding the impact from purchase accounting adjustments, based on our current programming offerings, we expect our programming and content expenses to decrease as agreements expire and are renewed or replaced on cost effective terms, offset by increases as we offer additional programming.

The current 10Q has discloses somewhat different expectations:

Excluding the impact from purchase accounting adjustments, based on our current programming offerings, we expect our programming and content expenses to fluctuate as we offer additional programming, and renew or replace expiring agreements.

While the change in the wording is slight, the expectation of a decrease has been replaced by the term "fluctuate." This is also consistent with statements by Frear and Meyer on the conference call:

Frear:We only have one pre-merger contracts left, which is the NHL agreements, those and up until after the Stanley Cup in 2015. I think that the process of continuously declining programming cost was certainly going into abate in the next couple of years. Then like every other business that we are subject to inflationary increases from time-to-time, I don't think you will see us have the kind of pressure in content cost that you have seen on the video side.

and,

Meyer:When we look at our conversion data, when we look at our self-pay data, we are clearly under indexed and that can only be from first from one conclusion which is we didn't have the content necessary to successfully compete in this important segment, so we very carefully and someone asked a question earlier about are you going to invest. We are investing pretty heavily in the Hispanic community and the Hispanic tier in content.

Not only will Sirius XM adding content to target the Hispanic population and be subject to inflationary pressures, but it also intends to go after other demographics with different packages and price points where it believes it is underrepresented:

Meyer:I also want to point out that I don't think Hispanic is the only place that this concept can work. So, I think you are going to see us look at other niche, that are single-digit, low double-digit parts of the demographics out there where we can offer unique programming and mass markets to that unique segment.

In other words, it seems as though the steady decline in content costs is over.

Summary

I would suggest that the price of Sirius XM carries an expectation of significant growth rates in the future and that the analysts are correct to be concerned. There are changes in subscriber car buying patterns and Sirius XM reduced self-pay subscriber net add guidance. The analysts should also be concerned about small revenue misses, declining growth rates and 2014 revenue guidance.

At the same time that there are issues with slowing self-pay subscriber and revenue growth, there will be rising costs. The debt cost increases were probably considered, but the expanded content costs represent a change in direction. And while the expanded content and targeted pricing options could represent future growth, it is a significant unknown with little immediate return. As Meyer stated:

I want to caution you, and I made my comment very deliberately so you can hold me accountable to it, this is a march, not a sprint. Okay?

Many Sirius XM investors have become used to the price of the stock sprinting ahead since Sirius XM's brush with bankruptcy in early 2009. Meyer's comment about this being a march may also be applicable to the share price going forward.

Today is Halloween and many small children will be frightened by ghouls and skeletons wandering the streets and shouting "trick or treat!" Investors should not be frightened by the recent price action of Sirius XM, but, like some of the analysts, it may be wise if they adjusted their expectations.

Source: Sirius XM: Do The Analysts Have It Correct?

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.