More than three years ago I wrote an article that looked at the basic metrics of the Sirius XM Holdings (NASDAQ:SIRI) subscription model. It was an exercise to determine where the subscriber growth was heading. That article suggested that the subscription model that was dependent on new car sales could be reaching subscriber equilibrium - new subscribers would only be sufficient to replace subscriber losses, and the growth in subscribers would cease - much sooner than I had originally thought would occur. It was based on a fairly simple formula using the then-current rates for churn (2.0%), conversion rate (45%), a new car penetration rate that was somewhat higher than the actual rate (65%) and new vehicle sales increasing to more normal levels.
Using those metrics and annual sales of new cars hitting 16 million resulted in the following formula:
(16 million new car sales per year x 65% penetration x 45% conversion) = (Average Number of Self-pay Subscribers x 2% churn x 12 months), or,
Self-pay subscribers = (16 million x .65 x .45 ) / (.02 x 12 ) = 19.5 million
That article also noted:
Sirius reached 16.8 million self-pay subscribers at the end of [Q1 2011]. Are we now less than 3 million self-pay subscribers away from equilibrium? Well, adjusting vehicle sales, penetration, conversions and churn will all give different values for equilibrium. ... ...And there should be additional subscribers outside the OEM channel, including used car re-activations, Internet subscribers and smartphone usage or there could be improvements due to 2.0 or there could be negative effects of a price increase.
Note that the 19.5 million self-pay subscribers was from the new car sales and ignored used car re-activations, Internet subscribers and smartphone usage. As we head towards the second quarter report, self-pay subscribers should be comfortably above 21.5 million. Clearly, several factors have helped Sirius get above the 19.5 million self-pay subscribers.
All of the previous metrics have changed. The penetration rate of satellite radios in OEM vehicles has increased beyond management's original plans. When I first started writing about Sirius, management discussed penetration stopping in the low 60-percent range. Former CEO Mel Karmazin had this to say on subscriber forecasts at the year end 2010 conference call:
And our penetration level has been picking up a little bit actually, so we're in the low 60% and we don't see that changing. Higher car sales, higher penetration, good conversion would get us to a different subscriber number but we don't have the confidence today to give you that number.
OEM penetration has since climbed to 70%, although there has been a cost to that increased penetration. The new vehicle conversion rate for 2010 was 46.2% and had declined to 45% in 2011. It has since fallen to 42% in the two most recent quarters. Whether this has been solely caused by the increased penetration into vehicles less likely to convert, or if it is a combination of model mix, price increases and increasing competition remains to be seen. On the plus side, churn came in at 1.8% in 2013, the lowest level since it was also 1.8% in 2008. In Q1 it came in at 1.9% and it may yet have another year at 1.8%.
How have these changes affected the numbers? At 16 million new vehicle sales, the increased penetration from 65% to 70% adds 800,000 trials for 2014, but with a 44% conversion rate (the 2013 figure), the total from new OEM sales would add 4,928,000 self-pay subscribers (a modest increase of 248,000 over the prior calculation). These would be offset by approximately 4,824,000 cancellations from a 1.8% self-pay monthly churn rate (assuming a beginning population of 21,081,817 for 2014 and an ending number 1.25 million higher based on guidance).
Regardless, the higher penetration and the more favorable churn rate more than offset the decline in the conversion rate.
Self-pay subscribers = (16 million x .7 x .44 ) / (.018 x 12 ) = 22.8 million
or using the same figures but with a 42% conversion rate
Self-pay subscribers = (16 million x .7 x .42 ) / (.018 x 12 ) = 21.8 million
The new car business is still generating more than three fourths of new self-pay subscribers for Sirius. It is also clear that without the self-pay subscriber growth from the used car business reactivations, the subscriber growth at Sirius would have stopped. Unfortunately for investors, what is much less clear is that we do not have a solid handle on how the used car portion of the business will behave.
The metrics for the new business from the OEM funnel has been fairly consistent for a number of years. New vehicle sales multiplied by satellite radio penetration rates gives the number of free trials. At some point, the free trials will either convert to self-pay subscribers at the rate of 42%-44%, or they will cancel. And, the self-pay subscribers will cancel at the rate of 1.8%-2.0% each month.
Analyzing the used car portion of the business is more difficult. All we know is that all reactivations from idle satellite radios results in a "used car conversion rates today ... in the low 30s" according a statement by Sirius CEO Jim Meyer. Will that conversion rate hold up? I suspect that it won't.
The used car trials today are largely from new cars that were sold several years ago. These include the certified pre-owned vehicle trial program that has been in place for several years. It includes, on average, higher-end cars that were sold when the penetration rate was lower. And, higher end cars convert at higher rates than less expensive vehicles.
While management has released the low-30% conversion rate, management statements suggest that it could go higher or it could go lower. CEO Jim Meyer discussed the issues around projecting used car buyer behavior:
And one of the things I learned is, you need to watch these subscribers and these segments for a long time before you can clearly say, this is how they behave and this is the way it's going be.
I think what's fair is that -- and by the way, one of the other reasons why I think it's too early to be able to predict is the used car buyers we're getting today are the closest to new car buyers in terms of demographics.
Because the cars that were built six and seven years ago went into highest level trim. And they are selling at the highest level of used today. So they are not -- you can't accurately predict what that macro is going to look like when it reaches maturity. But I think it's fair to say that it's going to be overall lower demographic and a more price sensitive customer.
And so I believe as we drive it, conversion will be lower for that segment and churn maybe higher. I can tell you today that's not true and particularly in churn. I can tell you second owners have a churn characteristic today that's very -- very, very similar to first owners, but it's too early to predict. September 26, 2013
Recent statements by CFO David Frear include:
I think we feel confident in new car conversion rate in the sort of 42% to 44% area. We are very surprised that the strength of the used car conversion rate that's seen at the low 30's and we'll see whether or not we can make changes in those numbers with various micro-marketing. ...
I think the big thing about following the subscriber numbers now is trying to estimate what's going to come over used car funnel, right? ...
The big trick there is getting them on trials. So this year we've talked about the used car business growing to about 2 million gross additions from little over 1.5 million last year, so 30%ish type growth. It's a category we expect to grow for years to come.
The conversion rate is much higher than I thought it was going to be when we started thinking about the used car business six or seven years ago and I just didn't expect low 30's. So I thought it would be like 20% and so I am very surprised by the strength in the number. June 3, 2014
The used car population with idle OEM-installed satellite radios will only get older and cheaper. This would strongly suggest that buyers of these cars will come from lower income households, households that Meyer has told us will convert at lower rates and may churn at higher rates. The company has provided no other information on churn, although Frear has said:
...for the first time today here is coming out and saying hey we see those rates in low 30% and that's because the numbers have sort of stabilized, so we will keep an eye on some of these other things. As we feel we have a better grip on the numbers, we see the statistical behavior stabilize a little bit, maybe we will open the covered a little bit.
Until Frear decides when to open up a little bit, we are left to guess how the used car segment is currently behaving. We know that the company will be running about 4 million used car trials. At a 30-33% conversion rate, that would generate 1.2-1.3 million self-pay additions. However, we have also been told by Meyer that Sirius is "on track to grow self-pay additions in this segment from approximately 1.5 million last year to close to 2 million this year." It would appear that there is a disconnect between these two figures, indicating that the company is also gaining subscribers from this segment without offering free trials.
Should this matter to an investor? It all depends on one's expectations. The growth in subscribers is a number that the market will focus on, but as far as the longer term success of the company, subscribers reached critical mass a number of years ago. In other words, the current level of self-pay subscribers throws off enough free cash flow to service the debt, fund the next generation of satellite launches and return capital to shareholders.
However, if one has unrealistically high expectations of share price appreciation, they could be disappointed. Self-pay subscriber growth has slowed down, and not just in percentage terms, but also in the number of self-pay subscriber net additions. The number had grown steadily from a low of 154k in 2009 to 983k in 2010, 1,222k in 2011, and 1,661k in 2012. In 2013 the number declined to 1,512k and the current guidance is for 1,250k. While management has stated the current guidance is conservative, are they likely to beat the number by the more than 20% to reverse the declining trend?
The numbers would seem to argue against significant additional subscriber growth. The size of the installed base exhibits churn characteristics that currently cost the company nearly 5 million self-pay subscribers each year, and the funnel from new car sales is barely enough to support that figure. Could Sirius increase the 70% OEM penetration level? It's possible, but there is a cost as penetration has increased, subscriber acquisition subsidies rose and the conversion rate has declined.
The company has been able to add subscribers with used car trial programs and re-activations, but these offers are rejected by more than two thirds of the potential customers. And, I expect that the 30-33% conversion percentage will continue to decline as the used car trials are offered to lower income demographics on less expensive vehicles. The larger question that remains is what penetrating this demographic will do to churn.
Increasing OEM penetration to 70% by Sirius, along with improved self-pay monthly churn, has been more than enough to overcome a decline in the new car conversion percentage and increase the point where self-pay subscriber growth driven by new car sales ends. In addition, aggressive efforts to market to owners of idle radios in used cars has also helped to forestall the end of that subscriber growth. Regardless, that growth is slowing despite these efforts. Once more information on the used car market metrics are revealed, investors will be in a better position to measure anticipated free cash flow and the growth of free cash flow per share.
While that growth is no longer critical to the survival of the company, and Sirius can be successful by continuing to cater to its target market(s), the market will likely re-price the shares based on the rate of growth.
Disclosure: The author is long SIRI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. In addition to my long positions, I have January 2015 $4 covered calls written against portions of my long positions in Sirius XM. I also trade blocks of Sirius XM on a regular basis.