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Sirius XM Holdings, Inc. (NASDAQ:SIRI)

Morgan Stanley Leveraged Finance Conference

June 12, 2014 10:30 AM ET

Executives

David Frear - EVP and CFO

Analysts

David Frear

Okay. Very well, I know it’s a packed house, so I hope you’re comfortable. All right, there will be forward-looking statements. Okay. So what are we? It’s music, talk, news, sports and entertainment content, weather and traffic, as well as now with the acquisition of Agero last year, safety, security and convenience features - it really is an entire package for the driver. We also make the content available across the Internet so anybody wants to extend the experience outside of the car they’re free to do that; we do run a business on a subscription fee basis which produces what we think our greatest strength is, a large predictable cash flow base business, that is - I say we do have a complete package of services into the vehicle with the satellite system we deliver effectively 10 megabits of data in the cars, we have chosen to use that data to provide audio entertainment, it could be used for anything but audio is what we think monetizes best.

The unique content we have is really what drives interest in the company, it is a package of stuff and I will talk more about it later that it’s really hard to replicate any place else. Having deep relationships with every automaker in North America is incredible strength for the company, we have built the production penetration rate up to 70% and I guess one of the benefits of having spent so much money, we invested $11 billion to 12 billion in building the business is that we saw a 6 billion of NOLs which will provide a nice shelter for cash flow over the course of the next several years.

Subscriber growth has been good, the since the depth of the recession we’ve added - will have added by the end of this year 8 million additional subscribers. It’s a little more than 40% growth since the depth of the recession. We’ve translated that into very consistent growth in revenues, sort of 10% growth over the last five years. The operating margins in the business are very strong, that we have been expanding EBITDA at roughly 25% rate and free cash flow has been expanding even faster at a sort of 43% rate over the last five years. Now a lot of times when people do these multiyear charts right, the key is, in the first year picking a number that’s really low so that you get really good growth rates, right, you know the math works out great.

But as you can see that we’re delivering these growth rates consistently so as you look at the first quarter of this year over the first quarter of last year you see the continuous improvement. Actually churn coming down was a nice benefit; it wasn’t something we actually expected. Subscriber growth remains steady at about 6% and then you see the double-digit revenue growth, the 28% EBITDA growth, 56% free cash flow growth and for the equityholders out there the buyback program has delivered 64% growth in free cash flow per share.

Auto sales has been what we’ve - it is sort of really the second phase, new car sales, the second phase of distribution for the company - in the first few years, I joined the company in 2003, we had a 120,000 subscribers of first phase of roll out, it was actually retail distribution. We sold at Best Buy, RadioShack, Silicon City, Wal-Mart and so forth. And we sold an aftermarket product that was self installed. And then began getting the OEMs ramped up as you can see from this chart in 2007, just before the financial crisis set in, the automotive industry was selling 16 million cars and we were in a third of them. And then as auto sales dropped in the recession, we were continuing to take our penetration rate up, so if you sort of do the math on this chart you see that through the recession we installed about the same number of new cars with a satellite radio in 2009 as we did in 2007, right, it is about 5.5 million in 2007, and it was still about 5.5 million in 2009 despite the fact that auto sales had dropped 40%.

And then as the recession, as the recovery from the recession came through we’d built up to 60% plus penetration production and so now that we’re fully recovered having come back to a year where everybody estimates we’ll do 16 million, there has been a real ramp-up in the installs, the installs have effectively doubled from the 2009 timeframe to this year at about 70% penetration of the automotive industry, will install about 11 million new vehicles.

Now we don’t really know where auto sales are going. So we just rely on what the experts in the industry say and what we’ve got on this chart is sort of what the industry experts say about auto sales in the United States. But they’re going to be in roughly the 16.5 million range, if that’s true and we expect to stay at about 7% to 8%, we’ll be installing 11 million new vehicles a year and there’s sort of an inevitability to this that you see on the next slide. That we have built, effectively what we’re doing satellite cable in the 80s, or cellular in the 90s, our equivalent of building out neighborhoods is building out cars. So we’re at zero when I got there 11 years ago, there are 60 million satellite enabled vehicles on the road today and at that 11 million pace, we’re going to double it in the next five years. And we’ll continue to build out the fleet. So we’ll go from the 60 million today to roughly 120 million in another five years time and five years after that the 120 million will go to roughly 150 million.

So we really are in this period of build out, we’ll be in the period of build out for an extended period of time. What’s going to happen in the next several years is we’re going to be migrating into another part of the automotive industry which is the previously owned vehicle sales. So if you look back the last five years for the most part we’ve been distributing to new car sales. Again go back 2003 to 2005 selling through retail stores, sort of the 2006 to 2014 really selling predominantly through new vehicle sales. But those vehicles are starting to turn over. So ultimately our market opportunity is going to reflect what the way that cars are distributed in the United States. 60 million cars sell every year, 60 million, only about 15 in the new car market and 45 in the used car market, you have sort of this 3:1 ratio. Over the very long-term our market opportunity is going to look the same. Ultimately will be more in 10 years from now, that our used car trial opportunities should be roughly triple what the new car opportunities are. But it’s like everything else in the automotive world it takes a long time to get there. Average first car ownership is about six years. The average second car ownership is about four years and then third car ownership another four years.

And so in the last few years, we’ve built up a distribution platform to capture transaction data in the used car sales that have satellite enabled vehicles and satellite enabled radios in them. There are over 12,000 dealers that are reporting to us now, these dealers much like the auto companies send us a flat file that’s got the customer name, address and vehicle number in it. With that information we run them through a direct marketing pipe. And those that direct marketing effort has produced pretty consistent results for a long period of time. And that the new car business we’ve seen 40% plus conversion rates, the used car business so far we’ve seen low 30% conversion rates.

And the big opportunity or challenge for us maybe in the next several years is that these dealers are only going to get to part of the market, the used car market is incredibly sort of fractionated. The dealers that we’re working with probably will cover about a third of used car sales. There is another third that goes on in private transactions and another third that goes on through independent dealers. And how we’re going to get after that transactional data is one of the operating challenges we’re working on but it represents an enormous opportunity for us because remember most people don’t take the service. If you have a low 40s conversion rate well that’s a 55% - 58% of the people said, no and no thanks, I don’t want it. So what do we want? We try and go back to that same owner we’re trying to remarket to him, but they didn’t take those service, I said no - they said no multiple times. So now what we really want is want is we want to sell their car and sell it as soon as you can because when they sell it we get an opportunity to market it to somebody else. And it’s a great long-term sort of opportunity for us.

The heart of demand for the product is the uniqueness of the programming. Content at the end of the day really matters and we have put together an array of content that really you can’t get any place else. So there is a lot of focus that goes in on music content. But there is really nothing unique about music. You can create a unique channel; you can put a unique host on that some programmers are better than others at picking songs, that’s great. But you can’t really sell it as a unique product. So, what we sell on the music side is commercial free music. We sell the lean back experience that it’s radio, you don’t have to be actively involved if you don’t want to be.

But then there needs to be something more and that something more has been all the sports, it’s been the news, it’s been Howard Stern, Opie & Anthony, Opera, Martha. Honestly it gets missed but having the news channels available, the major news networks, when you leave your house is great. Where else are you going to listen to CNBC when you leave the house and I know in this room we probably over index the likelihood to listen to CNBC. I watch every morning before I leave the house and it’s what I put on in the car when I go. And you can really only do that with us.

With 140 channels there are a lot of things we can do to make it a varied experience. Subscribers love live content. And so broadcasting sort of live events, it’s great. And then in the replay they still feel like they’re live and they’re really unique experiences; we did something with the Black Keys a couple of weeks ago.

But if you have an opportunity, if you’re subscribed to our app you just go in and pull it down from the on demand menu, it’s sort of an incredible thing; same thing with the Town Hall that we do, that Howard did and absolutely extraordinary Town Hall with Bill Joel a few weeks back. And that kind of thing is something that you’re just not going to find anywhere else in the radio.

Same thing with the town halls that we do that Howard did an absolutely extraordinary town hall the Bill Joel a few weeks back. And that kind of thing is something that you just not going to find anywhere else in the radio. We’ve -- last year we acquired the connected vehicle business from a company called as Agero and we’ve done this, it’s a great strategic fit for us. We have deep engineering relationships with the automakers. We get how to provide a trial service to a new car buyer and we get how to convert that into recurring subscription retain those people and things like that. And so the connected vehicle acquisition is really right up our ally of services we do.

Now I’ll tell you that the way the OEMs have decided to roll this out so far is the automakers are the face to the customer, they are all private labelled services. So each one has their own brand. And we’re providing the business-to-business backend for them. And it’s a great business. We expect the revenues to double in the next few years and we think there are additional expansion opportunities. We think that we’re as well positioned as anyone to win new business from OEMs that haven’t picked their partner yet. We think as the OEMs look to expand internationally that we could be a good partner for them on balance. We’re very excited about the connected vehicle opportunity.

And I’ll tell you that it’s not just a product diversification for us it also allows us to more smoothly integrate our app with our satellite broadcast product. And so as people talk about connected vehicle they generally see the competitive side to this which I’ll talk about just a second. But there is a product expansion side where our product becomes as opposed to just one way product to two way products in connected vehicles and we think that’s a great opportunity for us to enrich our subscriber experience.

Now streaming, it’s an incredibly busy space. It’s no longer a new space. So this is something that we worried a lot about five years ago and we still worry about it because we do operate in a very competitive universe but we worry a little bit less about it than we used to. It’s -- there are so for those in the Webcast I’m holding up my smartphone there are a 150 million of these already on the street in the United States that was not true five years ago. And so if streaming really represents a sort of a disruptive force in audio entertainment the effect of the disruption is already in our marketplace. The smartphones are incredibly easy to hook up in a car today. So you got Bluetooth, right, okay, does it all automatically, if you don’t, you just plug it into the headphone jack. And whether it’s an iTrip or USB port that you can easily connect up in vehicle and you can listen to any of these services today.

The one thing that really seems to be working in the streaming world is free, okay. Now we’ve never thought free was a great business plan. And business plans, so it matter to -- matter to us. But free definitely works, free music is huge to (inaudible), which is probably the best brand in the interactive space in the world, heads over 40 million active listeners worldwide. You know, we -- from some of the press articles it looks like they have maybe 12 million in the U.S. three years in the service. The iTunes radio was only last fall and launching it already over 20 million users. You know Clear Channel’s iHeart brand, has been great with 40 million registered users. Pandora which is probably the best brand in the internet radio space, 77 million listeners it is just an incredible number.

And it’s much larger than we are. Right, we have 25 million subscribers in the U.S. another couple of million in Canada you can think of that as 40 million listeners and so massive scale here. YouTube, which I don’t even know how to begin to put the numbers on this, YouTube is far in a way the biggest source of music listening globally. And when you’re looking at the United States, you have to consider the -- even though it’s not necessarily streaming, but the 800 pound gorilla, which is terrestrial radio. So over 200 million people that listen every week now that was through the day we launched and it’s still true today. So it’s a very crowded space. And we’ve been competing with it for a long time. So how is that going for us, no, no I think it’s going pretty well, okay. When you look at this chart, look at who’s actually paying to listen that the -- we totally dominate the performance metrics here, right at 25.8 million listeners, we have subscribers in the U.S. compared to 3.5 million paying subscribers for Pandora and estimated 3 million for Spotify, 1.7 million for Rhapsody.

Pandora and Rhapsody actually launched their businesses, I think before us and Spotify is now in the U.S. three years old. The 3 million paid subscribers that they have in the U.S. actually is about the same performance the satellite radio had 10 years ago in its first sort of 2.5 years. So when we kind of look at the products and honestly all these companies have been in, and they say how do you do it? How do you get to 25 million?

And the answer seems kind of obvious, right. The only difference really between us and all the other guys is that we’re more than just music, but if you go back to the 800 pound gorilla, right that terrestrial radio. What is terrestrial radio, it’s over 200 million listeners, what was their business plan. Music, talk, news, sports, weather, traffic, a lot of content, people like a lot of content that they love music it’s great lot of people listen to it. But I think what makes the content sort of compelling it is the breadth, the diversity that we can bring, the depth that we can bring in different genres and it’s doing something more than just in undifferentiated music product.

Now from a business model perspective, I mentioned just a few minutes ago, we monetize better than anybody else. So we’re monetizing at $149 per subscriber a year you can think of that is something like a $100 per listener per year, terrestrial radio we estimate monetizes, I mean a huge business, right. It’s $50 billion a year. But they are monetizing it about $12 to listener and again Pandora who has built massive scale in the internet radio space is monetizing about $8 a listener.

I know which business plan I like best. And it’s driven us to being the largest company in the radio space by revenue, measured by revenue in North America. And then as you look at other media companies that you guys may consider investing in that, I think it’s helpful to stack us up as to how do we perform relative to the pro-margin perspective. We have among the best margins in media that our guidance this year will -- goes to about a 34% EBITDA margin. We do believe that there is upside in that margin as we continue to grow and continue to show good cost controls.

We have the best free cash flow conversion ratio among all of the companies out there and some will say, wait a minute, you don’t have your taxes in there, okay. So, since we won’t pay taxes for another five years or so, you can take this 80% conversion ratio and you can knock it down to something it looks more like 58% it’s still the best then. There are another group of people, who’ll say wait a minute, what about your satellite expenditures, you just finished doing your launch and you’re not -- you’re kind of been in this period you’re not building. So okay, take another 3% off and say that when we order back in the build program that we might have 150 million a year, we’re spending on satellites. And you still end up with the mid 50s free cash flow conversion factor.

So we like the business model, we think it’s got great legs to it and produces great economic returns, over the course of the last few years. You’ve seen us pretty rapidly de-lever the balance sheet as the EBITDA has expanded, that with the $1.5 billion debt deal we did a few weeks back. Our leverages, I think just under the fourth times target that we have provided. It is a target. We don’t necessarily expect to operate at that, but by establishing the target we’re telling either we could go there, and we’re also telling you that we think it is a sort of a prudent amount of leverage. That when you look at the cash flow dynamics of the company, a lot of people ask us why four times? Couldn’t you be more levered?

And the answer is probably you could. Alright, so as you look at where we were in 2010-2011 timeframe between four and five times, and it could recognize a lot of the media companies that they also were able to operate at 4 to 5 times. If we thought that was a good place to go, I think we could safely go there. But now four looks like a good target. We don’t intend to drive the company do investment-grade. So that’s been sort of one of the guiding principles we have. I can’t begin to explain to you why Moody’s has us rated the way they do. We’ve met with them -- we’ve met with them a lot of levels, we’ve seen, the way they do it. And I don’t understand their conclusions at all. But what we expect to maintain is a strong BB rating.

And I don’t expect to change any of our targets in order to get Moody’s to bring us up. I think S&P has got a pretty good view of the company and its prospects and so again we’ll look to maintain a strong BB rating, as time goes on. We have been buying back stock. We’re about to, as of the call, our earnings call we were 2.3 billion of cumulative repurchases. The board has authorized up to 4 billion so far. We think the stock remains cheap in the market today. So that we think this is a good opportunity to buy. So if you look at the long-term, what is really going to drive business, far and away the most important thing is the enabled fleet. So getting the satellite radio in the vehicles, kind of stick around for a long time; once you put the radio in there, the car is on the road for generally about 12 years.

And so, our objective ultimately is to drive as many revenue generating months as we can out of that fleet. So 60 million today, 120 million in five years, and ultimately five years after that be headed to 150 million. I think you should expect subscriber growth running right along through that period of time. We do have a great business model. I think that the unique and compelling content is far and away the most important thing that we do, and we have to continue to drive at that. Maintaining good discipline around the costs; we have a very high variable margin business, so as long as management shows good discipline around costs, we should have nice steady growth in margins and free cash flow.

And so with that, let me open it for questions.

Question-and-Answer Session

Unidentified Analyst

I was just wondering how should I think about your operating leverage, let’s say you manage gross subscribers by 10%, how much of your costs are actually [levered] to your number of subscribers?

David Frear

So, for a long time, we have been talking about this thing that we call contribution margins, alright, and we’ve been talking about it as investors should assume 70% contribution margin. So what is that? It’s the revenue less the revenue share in royalties and the customer service and billing cost, and then a little tiny item called cost of equipment. And that’s how we get to contribute margin. The best guidance I can give you going forward is that, we actually believe we’re going to stay at about 70% contribution margin. And so another question is what’s happening below that? You know there are two -- subscriber acquisition costs are now really related to new car installations, right. So if you go back to that chart on auto sales, let’s assume that the analysts are right, auto sales are fully recovered. We’re at the sort of 60.5 million level, we’re going to stay at 70% penetration of that. That says we are going to install a little over 11 million vehicles a year. The unit cost of those installations is generally coming down just a little bit each year, and so your subscriber acquisition costs in the P&L, which I think are in the sort of mid-to-high 400s right now, should stay around that level even as the revenue grows.

So, right, you’ve got your 70% contribution margin, and then you are going to get this over absorption on subscriber acquisition costs, alright. Our sales and marketing costs are somewhat sensitive to; one, the size of the subscriber base. So when you have 20, 1 million self-pay subscribers as opposed to 15; you know you have got 33% more people to communicate with and you’re going to have costs and therefore retention and things like that. But the other part of some of the sales and marketing costs that will continue to grow is the conversion funnel. So, how do we acquire subscribers while the biggest funnel we have is new car trials, so this year and when we’re giving guidance we’ve talked about 11 million new car trails this year. And so, there are piece costs associated with doing that, right, and you’re going to send out an e-mail, you’re going to send out a welcome kit, you’re going to make a few outbound telemarketing calls. And so, you’ve got campaign costs associated with converting those guys.

Same thing on the used cars side, alright, so we also said when we’re giving guidance this year that we’ll have a little more than 4 million used car trials, and as those inevitability grow, right, as the satellite enabled vehicles turnover, you’re going to have some growth in sales and marketing costs, I think, that largely keep pace with subscriber and revenue growth. We’re constantly sort of retuning the campaigns there, but in general you should see some increases in sales and marketing costs associated with that. The rest of it is really more administrative-type growth, right. And so, I don’t see big expansions in employment at the Company itself, like we’re going to go from -- I think we have about 2,000 employees now, it is not like we’re going to 3,000, right. We don’t -- it’s -- we’re not in an employee-heavy business as we expand. So, generally the fixed costs should probably grow at sort of inflationary-type rates.

Unidentified Analyst

Years ago, your slide deck used to include trucks, boats, and I would assume the truck market is a significant market, because the truck drivers love the fact that the signal carries across state lines, is that not -- are those not meaningful markets anymore or are those included in your numbers at this point?

David Frear

It’s a great question. They’re definitely meaningful markets, but the size of the (inaudible) in comparison to consumer-owned vehicles, right, and so the aviation and marine business is something that’s probably a 75,000 to 80,000 subscriber business, right, but out of 21 million to 22 million self-paid subscribers, right, it’s a small number, so again to a group like this, probably not really -- we’re spending a lot much time on. That being said, we’ve got guys who’d focus on it, and because they monetize it sort of call it 45 bucks a month for pretty sophisticated products, and that actually drives a lot of contribution, right, so it’s a small business in comparison to the total, but it’s still a meaningful economic activity. Same thing true with the truck business. It went through, sort of the truck business has gone through a similar transition as the car business, where it started as aftermarket products, and we had a great distribution relationship with a company called Pana Pacific that was big in the truck business number years ago. We still have those distribution relationships, but increasingly truck manufacturers just include the radio in what they put in into the cab, and so it just becomes part of the overall business.

Unidentified Analyst

Is that in in your numbers…?

David Frear

It is in ours.

Unidentified Analyst

Largely in truck, so you’ve talked about 16 million people, you’re talking about…

David Frear

Yes, when you think about these, so the 16 million vehicles is actually a consumer number, right. If you were to include medium and heavy duty trucks, I am trying to remember exact what to add, but maybe you add a million to the 16 penetration rate we have is much lower than 70% in those vehicles since we’re marking different decisions, but it’s still a good robust market for us.

Unidentified Analyst

Talk about your relationship with Howard Stern?

David Frear

Sure, I think he is -- well what he said a few years ago was that he is the least unhappy he’s ever been in broadcasting. I thought that was great. I guess, the best example I can give is listen to the Town Hall he did with Billy Joel, I mean it was an incredible performance. And even as the morning shows talked about the next day and Charlie Rose said that, wow, he’s just a great interviewer, and he is. He’s just an unbelievable talent. Howard gets really -- his creative outlet on our platform is extraordinary. He can’t do the kind of show he does on our air on [Tresor] radio, right. And so, I believe he’s really happy that I know we’re thrilled with what he’s done, how long is he going to work that’s what everybody want to know, right.

And I can tell that only Howard knows the answer to that question that when you have a talent that good, that you want to keep him and you want to keep him happy for as long as he wants to do what he does so well. And we’d be thrilled to have him work for another 10 years if he wants to work for another 10 years, and I think he mentioned on the show yesterday or the day before that maybe he’s thinking about -- he’d like to push the start of his show back a little bit, right. He starts 6 in the morning, and then the guy talks for four hours, it is an incredibly difficult thing to do and almost there are so few people that can do that’s unbelievable. So look, Howard’s contract comes up at the end of ’15, we’ll talk to him of what he wants to do next in his life and hopefully one of those things will be, do you want to continue working on.

Unidentified Analyst

[Indiscernible] the fact that he’s on TV…

David Frear

You mean with this on demand thing that he’s got through?

Unidentified Analyst

With the America’s Got Talent…

David Frear

No I think that, if people at webcast can’t hear. The question was is there a threat because he’s on America’s Got Talent? I think it’s exactly opposite. I think it’s sort of great cross promotion that Howard was an incredible talent long before he hit our air. And the global press around him coming to satellite radio was astonishing. We knew it would drive a lot of media, we had no idea it would be front page news throughout Europe, and we don’t even provide service there, so why did it matter? But it was front page news in London and Munich, Berlin, Paris as well as every place in United States. And so, that as Howard has branched out to and he’s the king of all media, let’s be honest here, I mean this guy is incredible, there is nothing he doesn’t do well, and he’s done a great job on America’s Got Talent. I think that’s very cross promotional for us. I think as Howard continues to build the Howard brand, it’s a great thing for Sirius XM.

Okay, anything else, one more? Alright, thanks everybody I appreciate your time.

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