Since coming out of the recent recession, several years of rising auto sales have helped fuel the growth of subscribers at Sirius XM Holdings (SIRI). This growth was due to the way that Sirius gains the majority of its new subscribers. The company has had deals in place with almost all the OEMs that sell cars in the US for a number of years. The company subsidizes the placement of satellite radios in new vehicles and the two parties offer a free trial to the buyer or lessee of those vehicles.
During the free trial, that typically lasts from three to twelve months, the Sirius XM direct marketing machine rolls into action and attempts to convince the recipients of the trial to pay for the service once the trial ends. So, as OEM sales increased, the company has had a greater pool of potential customers.
But it wasn't only the rising auto sales that drove the increases to that growing pool of potential customers. At the same time that sales were rising, Sirius XM and the OEMs agreed to offer trials and place satellite radios into a greater percentage of production, referred to by Sirius XM as its penetration rate.
New Car Sales (millions)
A portion of the buyers that had received a free trial were expected to eventually convert to what Sirius XM terms self-pay subscribers. These conversions have held relatively steady over the past six years, although it appears that the rate of conversion is trending slightly lower. The company expects the rates to remain between 44% and 46%. During the 2012 year end conference call, Sirius XM CFO David Frear discussed conversion rates:
Asian automakers continued to gain share versus the prior year period and market share continued to shift towards small to mid-size cars, both of which tend to put downward pressure on conversion rates.
The new vehicle conversion rate was 44% for the quarter and remained at 45% for the year, both within our 44% to 46% expectations.
YTD Q3 2013
Data Source: Company 10Ks and 10Q.
The conversion rate is obviously very important to Sirius XM. It is the clearest indication of a willingness to pay for the service by end users, and it is a key factor in measuring the profitability of the current business model. Since Sirius XM subsidizes the placement of radios in new vehicles, the fraction of those that choose to convert must generate enough revenue to cover not only the cost of those that choose to pay, but also the cost of all the placements that won't be converted.
One of the built-in drawbacks to the business model is that when these self-pay subscribers eventually purchase or lease another car, they get a new free trial. Essentially, the company is subsidizing the installation of a new radio, and offering another free trial, to a customer that has already been sold on the concept of paying for radio. As the economy improves, or as the company builds up a larger base of self-pay subscribers, this turnover occurs more frequently. On the recent conference call, CEO Jim Meyer discussed how this can affect the company's subscriber growth:
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 this trend of faster turnover is good for the business long-term as it leads to increased opportunities for used car subscriptions, but we are now estimating self-pay net adds of approximately 1.5 million for 2013.
That 1.5 million figure represents a miss of 0.1 million from the full year guidance for self-pay net adds. The miss is significant for at least two reasons. First, the company has a long history of issuing conservative guidance and then gradually increasing that guidance throughout the year and eventually delivering results that excceded guidance. Even this year, the company increased guidance for each of its other metrics
- Total subscriber additions was increased twice from 1.3 million to 1.6 million.
- Revenue from "over $3.7 billion" to "approximately $3.77 billion"
- Adjusted EBITDA from "over $1.1 billion" to "approximately $1.14 billion"
- Free cash flow from "approaching $900 million" to "approximately $915 million"
Second, at the start of the year, Jim Meyer told investors and analysts that the focus would be on the growth of self-pay subscribers.
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. Internally, we are constantly asking ourselves how our decisions will improve the subscriber experience.
We will keep our subscribers front of mind when we make business decisions and we will keep our focuses tight as ever on operational excellence. If we do a good job satisfying our subscribers, I truly believe that the ultimate result should be very rewarding to our shareholders as well.
Frear later added:
Our 2013 guidance issued a few weeks ago continues our record of cost effective growth.
We expect to see another strong year with 1.6 million net self-pay subscriber additions as total subscribers will grow to 25.3 million.
One of the reasons that the emphasis was placed on self-pay subscriber net additions was due to an anticipated shift from paid promotional trials to unpaid trials in the fourth quarter. While this would place downward pressure on total subscriber growth, it would have no impact on self-pay subscribers. Frear also discussed this in response to an analyst's question:
Many analysts, I think Vijay included, have written on the subscriber recognition affected. Effectively, in the contract that we have a paid trial moving to an unpaid trial, so the year on year comparisons and total subscriber additions fourth quarter to fourth quarter will be down. But it really doesn't affect self-pay. The business is effectively how many self-pay subscribers do we have and how many conversion opportunities do we have in the trial funnel, and the change in geography for the OEM between paid and unpaid trial doesn't change any of those dynamics.
Clearly, the company is focusing on self-pay net adds. This makes perfect sense. These are the customers that have demonstrated a willingness to pay for the service, and missed guidance in that area is especially troubling. Meyer's comment, when he discussed the guidance reduction and stated, "this trend of faster turnover is good for the business long-term" should be taken with a grain of salt.
This trend is bad for business short term, and it is bad for business long term. Not only will Sirius XM be paying an OEM another subsidy to install a new radio, but the company will lose a paying subscriber, even if it is only a temporary loss. The company already had a paying subscriber and it expected the customer to remain a paying subscriber for a longer period of time. That subscriber is now going to get another free trial which means less revenue for Sirius XM. Even worse, the large OEM that is moving from paid promotional trials to unpaid trials during the current quarter makes it more likely that the company won't get any revenue from the next trial that goes with the average new car purchase.
The longer term benefit that Meyer discussed is linked to his recent comment, "We're now getting two bites at the apple". This refers to the satellite enabled vehicle that the particular new car buyer will be trading in or selling, where Sirius XM may have a second opportunity to sell the buyer of that particular used vehicle a subscription. That particular used vehicle will not have the expense of another hardware subsidy.
While there will be no incremental subsidy, the conversion of the used car buyer will have a marketing expense that should be higher than average. We can infer this because the conversion rates for the used car trials is significantly below the 44% for new car buyers. This was recently disclosed by Meyer:
In those instances where we are able to offer used car buyers a formal trial period, we are seeing excellent results. used car conversion rates today are in the low 30s...
To achieve that low 30% rate should require an effort at least as great as trying to get a new car buyer to convert, and probably much more of an effort. After all, there are already former self-pay subscribers that are included in the 44% of new car buyers that convert. That alone should be an indication that, on average, they will be an easier conversion to self-pay subscriber.
Regardless of whether or not converting a used car buyer to self-pay subscriber is more profitable than the loss of an existing self pay subscriber to a new car free trial, the larger concern for investors should be the missed guidance on self pay net adds. This has occurred despite continued expansion of the used car trial program (participating dealers increased from 8000 at year end 2012 to 10,500 at the end of Q3) and increases in both new car sales and the percentage of new cars that come equipped with satellite radios.
Within the next two months Sirius XM will be providing more detailed guidance for 2014 beyond the previously issued "Revenue of over $4.0 billion, and Adjusted EBITDA of approximately $1.38 billion." Investors should pay careful attention to free cash flow, subscriber net adds and where the company tells us to focus.
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.