Sirius XM Since the Merger, Part II: Back From the Brink

 |  Includes: LMCA, SIRI
by: Satellite Radio Playground

by Dennis “Cos” Costa

This is the second installment of a three part series on Sirius XM Radio (NASDAQ:SIRI). The first installment, Part 1 – A Look Back, discussed the period between the FCC merger approval at the end of July 2008 to the period when the company’s debt maturities and the banking crisis made it necessary for the company to strike a deal with John Malone’s Liberty Media (NASDAQ: LCAPA). Part 2 – The Recovery will focus on the remainder of 2009 from March through December. Part 3 – A Look Forward will discuss the company’s debt, capital expenditures, and free cash flow. We will then take a look at the company’s future and possibilities for success, as the economy and the company’s partners move forward on firmer financial footings.

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The doubt expressed by analysts and investors has always been whether the enormous upfront capital expense, generating most of the company’s debt, would allow the company to develop a sustainable business model which could produce a profit. The costs of putting satellites in the sky, installing the necessary transponders and ground station infrastructure in place, developing contracts with auto makers to install receivers in their dashboards, and securing premium and unique content to attract consumers, had created over $3B in debt by the end of June 2009, as reported in their second quarter filings for that same year.

These relatively large debt liabilities, which carried higher interest rates since the merger, were exacerbated by pre-merger costs associated with the competition for content, auto manufacturing partnerships, and consumer subscriptions — which were required by the two companies to generate revenue. Some speculated that payment for talent, such as Howard Stern, Oprah Winfrey, and Major League Sports, was driving the business model towards unsustainable levels of expense.

Others believed that it was the signing of the self proclaimed King Of All Media, Howard Stern, in January 2006 at a cost of $100M per year through December 2010, which turned the tide for Sirius in its competition with XM for subscribers, giving Sirius the upper hand in this merger-of-equals. Many, including this author, believe that Stern, in the four plus years he has been broadcasting his unique brand of entertainment on Sirius, has paid his way by bringing in subscriber revenue well over the cost of his contract. This assessment comes without assigning a dollar value for the attention to the technology and product brand, which Stern’s fame and name recognition drew to the satellite radio industry — by simply the signing of his name to a contract. Enjoy his brand of entertainment or not, Stern is a magnet for media attention and will continue to be while this debate goes on, as his contract with Sirius XM comes up for negotiation this year.

Whether it was the higher carrying cost of the debt, or the competition for content driving up this expense category, it all carried over into the merger and created an unsustainable cash flow situation, bringing Liberty Media into the picture as beneficial owners on March 1, 2009.

With the merger done, and Liberty’s Chairman John Malone, CEO Greg Maffei, and Senior Vice President & Treasurer David Flowers now sitting on Sirius XM’s Board of Directors as Preferred Directors, the stage is set for a discussion of the company’s recovery from a near bankruptcy filing - a bankruptcy that may have wiped out the common shareholder from receiving any rewards for their early investment in the company.

The Recovery

Just over a year ago, while navigating through the worst economic downturn in decades, being forced to give up 40% ownership rights to Liberty Media, and as the country watched all three U.S. auto makers seek relief from the Government, we read this in the company’s May 7th, 2009 press release highlighting the Q1 results:

“Satellite radio is now a cash flow growth story. First quarter 2009 adjusted income from operations of $108.8 million is our second consecutive quarter of positive adjusted income from operations and represents an improvement of $179 million over last year’s first quarter pro forma loss from operations of ($70.2) million.”

-Mel Karmazin, CEO Sirius XM Radio

After failing to generate the necessary cash from operations to meet its debt maturity obligations, and with banks lacking the resolve or ability to lend money, with this report the company showed that time was what was needed to fully develop the business model of self sustaining income. In this first quarter of 2009, the company reported a loss of 404K subscribers, of which almost 370K came from the retail sector, and still managed to grow pro-forma revenue by 5%, and decrease cash operating costs by 23%, creating positive income from operations. As a forecast of what was to come, CEO Mel Karmazin in the same release increased his guidance for the year for adjusted income from operations to $350M from $300M. In addition, the company reported that revenue increased from the sale of a new merger-related premium service, offered as “Best Of” programming. This was another first time benefit attributed to the company’s merger, which increased revenue rather than simply reducing costs.

This report of positive income ran contrary to what most observers would have expected, given that auto sales were down significantly and Satellite Radio’s retail and OEM subscriber growth was in decline. This was the first credible sign to investors and analysts that the business model, relying almost completely on subscription revenue, could indeed create cash from its operations in the worst of times. It was also the first sequential growth in adjusted income from operations, from the fourth quarter of 2008 of $31.8M to this first quarter of 2009 of $108.8M. It is this performance that gave investors confidence, and initiated the-beginning-of-the-end of sequential quarterly cash-burn from operations for the company. We can also assume that Liberty was able to get a glimpse at this performance during their due diligence process, giving them reason to move forward with their investment in Sirius XM.

In retrospect, these reported first quarter results were what represented the turning point for the company. While existing investors were still reeling from the stock’s price reaching bankruptcy levels of $.06 per share in mid February 2009, astute investors were reading these results and the Liberty Investment Agreements for what they were. This was the beginning of a turnaround story which would net up to 2000% for those investors who put their money in at these levels. A year later, it was still a very good return of ~500% for those who waited until the stock price got to .30 cents a share before entering a position.

As the company navigated its business through the second quarter of 2009, and General Motors and Chrysler went through structured bankruptcies on a bailout from the U.S. Government, at the annual shareholders meeting the Board of Directors sought and received authorization to execute a reverse stock split. The NASDAQ had suspended their market bid compliance rule during this difficult economic time, in which many of its listed companies found their stock price below a $1.00 per share. With anticipation of the rule being reinstated as the economy improved, Sirius XM wanted authorization for the Board to execute a reverse split to avoid delisting from the NASDAQ Global Select Market if needed. This issue preoccupied some analysts and investors, and became quite a distraction from the real story of the company’s recovery for months. This proved out in April 2010, when just before a hearing on the issue, the company regained compliance without issue or execution of the reverse stock split.

Returning our discussion back to May 29, 2009, the company’s stock price was still trading below a $1.00, and the Russell reconstitution rules disqualified Sirius XM from being included for continued entry in the index. This year the company may be included again if the stock price remains above the $1.00 mark on the last trading day of May 2010. This qualification will be closely watched as the end of May approaches. For investors, the second quarter of 2009 was a confusing period filled with SEC filings of debt restructuring events, beneficial ownership filings, market exchange related issues, and continued uncertainty for the economy and Sirius XM’s auto manufacturing partners.

Despite all this uncertainty, Sirius XM with solid executive management implemented an unregulated price increase of $2 for multiple family subscriptions to $8.95 per month to start the second quarter. The company also implemented an Internet subscriber fee for its Internet radio programming of $2.99 per month in anticipation of the Apple (NASDAQ:AAPL) iPhone streaming application, which was released in June 2009. In the first weeks of the third quarter, in emails and subscriber agreement offerings, the company announced that they would be implementing a Music Royalty Fee to all new and renewing subscribers beginning on August 1, 2009. This fee would be $1.99 per month for primary accounts and $0.99 for each multiple subscription. All of these revenue generating initiatives are measured against customer churn, and prove to be vital to the company’s attainment of free cash flow, which can pay for and sustain the company’s growth and upcoming debt payments.

In taking advantage of a more liquid credit market, the company announced on June 25, 2009, just three months after acquiring Liberty’s loan agreements, that it had increased its 11.25% Senior Note Offering due 2013 from $350M to $525M — due to strong investor demand. With these funds, the company paid in full all money agreements that XM had with Liberty Media, and reduces its interest rate by 3.25%. Additional monies received in the offering went to pay other debt, more specifically $179M of 10% Convertible Senior Notes due in December 2009, leaving a balance of ~$49M. A little over 6 weeks later in mid August 2009, the company announced that they paid back the Sirius 15% loan agreement with Liberty Media, with a $257M 9.75% Senior Secured note due 2015, again reducing the interest rate by 5.25%. In just six months from receiving the bailout from Liberty Media, all loans and credit agreements were refinanced, and the new agreements had lower rates and extended maturity dates. We could talk about timing here, the melt down in the economy and an FCC approval process that took too long, but none of that discussion would accomplish what the company’s management did in such a short period of time — in a very difficult operating environment.

To reinforce just how well Sirius XM’s business model performed in such a serious downturn of the U.S. economy, and specifically with the auto industry and consumer spending, the company reported its second quarter results on August 6, 2009, and in a press release we received this:

“Just one year ago, combined operations produced negative adjusted income from operations of $61 million. This year our revenue increase in the second quarter, paired with a $187 million expense reductions, drove an improvement of approximately $193 million in adjusted income from operations to $132 million in second quarter 2009. Growing our revenue in the face of broad declines in the advertising and automotive markets is a remarkable accomplishment, and we are well positioned for a rebound in auto sales.”

- Mel Karmazin, CEO Sirius XM Radio

With the second quarter report in the books, the Liberty loan agreements now repaid, new revenue streams rolled out in fees and services, the company had now verified how important its business model, which relied on subscription revenue, was. The second quarter also confirmed customer commitment to the Satellite Radio content and service as a must-have, with subscriber churn being managed at 2.0%. A surprising outcome in this report was that, with two auto manufacturers shutting down production and rinsing-through bankruptcy, the company managed to gain 123K subscribers from the OEM channel. This was now the third consecutive quarter of positive income from operations being achieved. Over the next two quarters, with a slowly recovering auto industry being jump-started by the Government’s Cash-For-Clunkers program, Sirius XM was on the way to recovery.

In the third and fourth quarters, the company used the additional cash generated from the rate increases on the company’s multi-subscription and Internet packages, “Best Of” programming and the U.S. Music Royalty Fee, to pay down all debt due for the remainder of the year and started paying debt due in future periods without using common shares — not diluting investors any further. These additional revenues, combined with reduced expenses brought on by the merger synergies, clearly defined the merger benefit, the importance of timing, and the absolute need for cash on hand to properly sustain future success.

Subscribers also proved to be more stable than otherwise characterized, showing pricing elasticity by accepting reasonable increases in content costs and fees, ultimately represented by a manageable full-year churn. The last half of 2009 had the company’s subscriber base return to growth, with net subscriber additions of 102K and 257K in the third and forth quarters respectively. Although retail subscribers were still in a downtrend, the company’s efforts in the certified pre-owned markets were proving to be effective, and in a fertile area for future growth.

In less than one year, the company was moving from using its common stock to pay down debt to using cash being generated from operations to meet liabilities. In these two quarters the company paid cash for ~$2M of 8-3/4% convertible notes, $48.5M of 10% convertible notes, $33.3M of 10% discount convertible notes, and $58.8M of 10% PIK Notes due in 2011. Sirius XM finished 2009 with just over $380M in cash and equivalents after paying off these debt obligations totaling ~$142.3M.

In the fourth quarter of 2009, in the most tumultuous environment to date that Sirius XM Radio has had to operate in, the company managed to post a 4% increase in year-over-year pro-forma revenue of $2.53B, attained the first full-year of free cash flow, topping $185M dollars, beat all of their projections, posting $463M in income from operations, and attained a break-even net income on a GAAP basis of $14M.

The recovery was now firmly in place with a brighter future ahead in 2010.

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As we move into the final installment of this three part series, Part 3 – A Look Forward, a discussion of Sirius XM Radio’s “other expenses”, which increased by 53% in 2009 over 2008 to $202M, and were attributed mainly to the increase in loss on the extinquishment of debt and credit facilities of 170M and interest expense of $89M, will be evaluated. The impact on income without these costs in 2010 will be discussed, and the continued use of the company’s cash to pay down debt and payable liabilities will ensue. A glimpse of that intent is evidenced by this recent 2010 first quarter statement:

“Our strong cash position, strong year-to-date subscriber growth and the improving outlook for the economy have put us in position to retire $175 million of high cost obligations a year ahead of schedule. The early retirement of the PIK Notes and deferred payments will reduce interest expense and increase our free cash flow.”

- David Frear, Sirius XM’s Chief Financial Officer

Join me for Part 3 – A Look Forward after the Memorial Day Weekend.

Disclosure: Long Sirius