Sirius XM: The Ultimate Subscription Model

Nov.29.13 | About: Sirius XM (SIRI)

In a recent article I discussed how Liberty Media (NASDAQ:LMCA), the parent company of Sirius XM Radio (NASDAQ:SIRI), was rumored to be pursuing Time Warner Cable (NYSE:TWC) through Charter Communications (NASDAQ:CHTR), a company where Liberty recently acquired a 27% equity interest. That article briefly discussed how Liberty might raise capital using its Sirius XM asset. As often happens with Sirius XM articles on Seeking Alpha, the comments were far more interesting and explored much more than the topic addressed in that article. One Seeking Alpha member decided to bring up past comments of mine regarding the conversion rate from trials to self paying subscribers.

For those unfamiliar with the Sirius XM subscription model, the company has agreements with OEMs to place satellite radios in nearly 70% (the company's penetration rate) of new vehicles sold in the US. Sirius XM subsidizes the cost of the hardware and the purchasers (or lessees) of those vehicles receive a free trial to experience the benefits of the satellite radio service for a period that typically lasts for three to twelve months. At the end of the trial period, the objective is to "convert" the owner to a paying subscriber - or what the company terms a "self-pay subscriber." Sirius is successful about 44% of the time in these efforts with new car buyers. The comment was:

Due to wonderful insight provided by same author, I've become aware of the following fact regarding Sirius/XM.... "Only 44% of new car buyers elect to pay for the service after their free trials end.".... Only a 44% take rate, how can the company possibly survive?

I appreciate sarcasm as much as the next person. How do I know this was sarcasm? Easy. The same individual had previously written the following:

Only 44%?... How do you say that with a straight face? Most companies would drool to have that type of conversion rate to their respective product or service.

So, how do I "say that with a straight face?" Would other companies really "drool to have that type of conversion rate?"

Some of those with a very bullish outlook on the stock do not react too favorably to the choice of certain words, especially those that minimize the company's accomplishments. In this case, the term only was the obvious cause for the reaction.

Quite frankly, I have no idea if other companies would benefit from a 44% conversion rate, but the more important question is what the 44% rate means to Sirius XM. The company's business model is currently adding self-pay subscribers because it is managing to keep its conversion rate in the mid-40% range. This rate has been fairly consistent for quite some time.

Year

2008

2009

2010

2011

2012

YTD Q3 2013

Conversion Percentage

47.5%

45.4%

46.2%

45%

45%

44%

Click to enlarge

Data Source: Company 10Ks and 10Q.

Note that the rate has trended down slightly. One explanation might be tied to the company's penetration rate. This has risen substantially since 2008 when it was 44%. At the time, Jim Meyer, then President and current Sirius XM CEO, stated:

It is important to note, however, that during the fourth quarter we did improve overall penetration rates of new car production to approximately 52%. We are pleased with this improvement and expect further improvements later this year when Toyota increases its penetration rate. I believe this positions us well when the auto industry recovers. ...

...Overall, conversion rates for trial subscribers did show year over year reductions but primarily due to higher penetration rates and lower price models as well as lower price trim levels.

The penetration rate is negotiated with the OEMs. The objective is to place the satellite radios in cars with a reasonable chance for a successful conversion. As the partners move toward lower priced models through increasing penetration, the conversion rate has declined. A few years ago Sirius XM management discussed conversion rates:

David Frear, Chief Financial Officer: I think, generally we feel as managers like we can do a better job in conversion but we feel like we can do a better job on everything we do every day. And so we'd like to improve it. We spend a lot of time with our automotive partners making sure that we are getting the customer name and address data coming across to us quickly and accurately, striking while you still have that new car smell in the car is something that we know makes a difference in conversion rate and smarter in the kinds of messages and the cadence of the messaging that produces higher conversion rates. We do a lot of tests, a lot of different programs, and try to measure statistically what creates a difference in the rate. And then the last piece is that we have an opportunity in reactivating radios as well, which is not necessarily part of the conversion rate we report. But an important part of the business where we are spending a lot of effort in, finding out where the best information is on, who those new used car buyers are and what we can do to reactivate more radios that are out there on the road.

Meyer: I think, just to amplify what David said. We've been at this a long time. We still continue to learn new things every month. I think over the course of the plan our assumption is that conversion remains in the mid-to-high 40%. And we don't see any magic bullet that magically takes it into the mid-50%. That's not to say it's not out there and that's not to say we're not committed to continue to work on it and we will continue to work on it.

Mel Karmazin (Former Sirius XM CEO): We don't have any plan of significantly increasing our expenditures in order for us to get the conversion rate up. We believe that by just best practices and doing things longer and smarter, the conversion rate will go up but won't require any additional material expenditures.

It appears as though the increasing penetration into lower priced models has outweighed any benefit from improving the "cadence" or "doing things longer and smarter." There is also little evidence to suggest that a magic bullet has been found. So, what does a 44% conversion rate do for the company?

Currently, Edmunds is predicting new car sales for 2013 to come in at "around 15.5 million." If 70% of those cars come with free trials, and 44% eventually convert to self-pay subscribers, those 15.5 million sales would result in:

15.5 million * 70% * 44% = 4.774 million new self-pay subscribers.

The addition of nearly 4.8 million subscribers paying their own way sounds impressive, and in many respects, it is. However, equally impressive is the number of self-pay subscribers Sirius XM loses on a monthly basis. The company calls this self-pay monthly churn, and the number through the third quarter has been 1.8%, the lowest since it was also 1.8% in 2008.

Again, Sirius XM supporters look at that 1.8% and see a relatively small figure in absolute, or perhaps even relative terms when compared to other subscription models. But, with 19,570,274 self-pay subscribers at the start of the year and 20,670,333 currently, the company will lose more than 4.3 million self-pay subscribers during 2013 through self-pay monthly churn.

So, the 44% conversion rate, along with the 70% penetration rate and the 1.8% churn rate, eventually combine for a 0.5 million increase to the self-pay subscriber population. However, because of a lag from the start of a trial to the eventual conversion, some of those 0.5 million won't be appearing in the reported figures until 2014, and some of the current net adds in 2013 are the result of trials that began in 2012.

Investors who have carefully followed the company also know that the company is anticipating 1.5 million additions to the self-pay population in 2013 from the used car free trial program and other used car activations. And, they are aware that the company is currently guiding to 1.5 million self-pay net additions for all of 2013. So, how does one reconcile the disconnect between the 1.5 million guidance for used cars, the 1.5 million total guidance for 2013, and the 0.5 million expected from the new car trials?

The disconnect in the calculated figures can be attributed to a combination of factors. As previously noted, there is a lag effect from trials that began in the prior year or roll into the subsequent year. There are also going to be differences caused by rounding. Changes in the fourth decimal place of churn or the third decimal place of penetration or conversion rates when applied to 15 million vehicle sales or a 20 million self-pay subscriber population can have a significant impact.

Summary

The subscription model that Sirius XM has in place is currently working and the self-pay subscriber base continues to grow. Now, consider these two figures. Total 2013 self-pay net add guidance is 1.5 million. 2013 net add guidance for used car activations is 1.5 million. Ask yourself this: Without the 44% new vehicle conversion rate that "other companies would drool to have" or the 70% penetration rate or the small 1.8% self-pay monthly churn rate, how would Sirius XM be able to grow its subscriber base by 1.5 million?

While a 44% conversion rate may be desirable for other companies offering free trials, 44% is close to being the minimum requirement that Sirius XM needs to be able to grow.

Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.