Sirius XM: You Won't Believe What I Found In The Q2 Report

Jul.30.14 | About: Sirius XM (SIRI)


Sirius XM delivered an excellent second quarter report.

Analysis shows the company performing in strong fashion.

Some minor concerns are just that, minor concerns.

Immediate market reaction appears confused, but shouldn't be. Full steam ahead.

Given initial positive reaction to reported earnings and then the subsequent 'sell off' during the day I can only assume that there was quite a bit of confusion in the market surrounding Sirius XM's (NASDAQ:SIRI) Q2 report. There shouldn't be. Because of this I wouldn't be surprised if investors can't believe what I found contained within.

Sirius XM delivered a solid report that came in a bit better than expected in some areas, raised guidance, and showed that the company is not being destroyed by 'streaming music' as an inordinate number of articles have been suggesting.

Let's take a look.

For this comparison one may use the most recent 10Q found here, and last quarter's 10Q found here. The following company statements are taken directly from the most recent 10Q.

For the three months ended June 30, 2014 and 2013 , net additions were 475,472 and 715,762 , respectively, a decrease of 34% , or 240,290 . For the six months ended June 30, 2014 and 2013 , net additions were 742,271 and 1,168,652 , respectively, a decrease of 36% , or 426,381 . The decreases in self-pay net additions were due to increased churn associated with our larger subscriber base and vehicle turnover, partially offset by higher conversions from trial subscriptions. The decreases in paid promotional net additions were due to lower growth in auto sales and a change from paid to unpaid trials under a contract with an automaker.

While the decrease may sound particularly concerning, the fact that the company had a significant contract shift with General Motors (NYSE:GM) that moved trials from paid to unpaid, should be well known by now. With 196,925 fewer paid trials than last year it skews net additions to show a decrease. What investors should pay more attention to is quarter to quarter paid trials since the contract change, with year over year comparisons being appropriate starting in 2015.

Paid trials were up 2.6% from Q1 to Q2, driven by an increase in auto sales.

Similarly due to the lead and lag effect of this contract change, these new unpaid trials coming from General Motors' vehicle sales have taken time to work through their trial periods and then, hopefully, eventually convert to paid subscribers at the current 42% conversion rate. Q1 was impacted heavily by this effect, and Q2 to a much lesser extent. This makes comparisons difficult and the statistics may appear concerning.

Consider that compared with Q2 of 2013, Sirius XM added 10% fewer self paying subscribers, but compared with Q1 of 2014 Sirius XM added 119% more self paying subscribers in Q2 of 2014. Looks disappointing or outstanding depending on how you shine a light on it, but reasonable comparisons can only begin to be made in Q3 year over year, and then in Q4 on a quarter to quarter basis. Until then, analysis of these numbers must take into account this dramatic contract shift.

I was happy with 379,711 self pay additions in the quarter, and investors should carefully watch net subscriber additions going forward as I believe Sirius XM has remained very conservative in guiding to only 1.25 million additions. 715,762 subscribers have already been added out of 1.25 million guided.

This means that only 534,238 new subscribers are needed to reach this goal. This is important, because while the Q1 report for 2014 may have made 1.25 million net additions appear reasonable as net additions in that quarter were depressed at 266,799 due to the contract shift, Q2 showed 475,472 net additions. Quick math multiplying Q2 by 3 and adding it into Q1 shows that Sirius XM could post 1.7 million net additions if it remains on track in 2014 which is significantly above guidance. This is a 36% beat. Even allowing for a significant amount of error shows that Sirius XM should easily beat guidance on new subscribers for 2014.

This almost ensures that Sirius XM will be forced to raise guidance on new subscribers during the Q3 call. Investors should be prepared for this.

Average Self-pay Monthly Churn is derived by dividing the monthly average of self-pay deactivations for the period by the average number of self-pay subscribers for the period.

For the three months ended June 30, 2014 and 2013 , our average self-pay monthly churn rate was 1.8% and 1.7% , respectively. For the six months ended June 30, 2014 and 2013 , our average self-pay monthly churn rate was 1.9% and 1.8% , respectively. These increases for the three and six month periods were due to increased migrations of existing self-pay subscribers to unpaid vehicle trials.

The churn metric is important to watch as it can show weakness in the popularity of the service and willingness of current customers to remain customers in the face of competition, such as the often mentioned Pandora (NYSE:P) and Spotify. A variance as stated of 0.1% is not concerning and the company reasonably explains the variance as being due to increased migrations of existing self pay subscribers to unpaid trials.

Basically, when someone is a subscriber to the service and happy, and sells their vehicle and buys a new one, they are now a happy customer on a trial subscription. It's not so much a loss of a customer as it is a shuffling around of that customer. During the conference call Sirius XM mentioned that a portion of this 1.8% churn is due to such migration. It is reasonable, then, to assume that in the face of increasing auto sales along with an aging satellite equipped fleet of cars that churn may move slightly higher. Churn dropped from Q1 to Q2.

For the three months ended June 30, 2014 and 2013 , the new vehicle consumer conversion rate was 42% and 45% , respectively. For the six months ended June 30, 2014 and 2013 , the new vehicle consumer conversion rate was 42% and 44% , respectively. The decrease in the new vehicle consumer conversion rate for the three and six month periods were primarily due to an increased penetration rate and lower conversion of first-time satellite enabled car buyers.

Conversion rate year over year has decreased by 2%. This is, as stated, due primarily to the fact that Sirius XM increased its penetration in new vehicles. By pushing into some of the lower priced models with lower conversion rates it brings the average down. Does this mean less people are converting? Not really, and investors will need to trust that the company is making the proper decisions in terms of penetration in new cars related to their conversion rates. Conversion rates were stable from Q1 to Q2.

SAC, Per Installation, is derived from subscriber acquisition costs and margins from the sale of radios, components and accessories, excluding purchase price accounting adjustments, divided by the number of satellite radio installations in new vehicles and shipments of aftermarket radios for the period.

For the three months ended June 30, 2014 and 2013 , SAC, per installation, was $33 and $47 , respectively. For the six months ended June 30, 2014 and 2013 , SAC, per installation, was $34 and $47 , respectively. These decreases were primarily due to improvements in contractual OEM rates.

Subscriber acquisition cost, or SAC, is important, and that General Motors contract change has influence yet again year over year. Fewer paid trials also means a lower subsidy paid by Sirius XM on installed radios. Again it is better here to look at quarter to quarter until a full year has passed and the contract change is under the company's belt. From Q1 to Q2 SAC dropped by nearly 6% to $33. Lower subscriber acquisition costs allow subscribers to be monetized at a faster rate, and lower subsidies paid on radio installations allow for increased penetration.

Back up a moment to the lower conversion rate shown above. Is is really a concern when penetration is increased, cost per new subscriber continues to come down, and conversion is slightly lower? Absolutely not. I'll take a 30% reduction in subscriber acquisition costs and a higher penetration rate for a 2% reduction in conversion year over year any day of the week.

This is especially so when one considers that average revenue per subscriber continues to increase.

ARPU is derived from total earned subscriber revenue, excluding revenue derived from our connected vehicle services business, net advertising revenue and other subscription-related revenue, net of purchase price accounting adjustments, divided by the number of months in the period, divided by the daily weighted average number of subscribers for the period.

For the three months ended June 30, 2014 and 2013 , ARPU was $12.36 and $12.28 , respectively. For the six months ended June 30, 2014 and 2013 , ARPU was $12.27 and $12.16 , respectively. These increases were driven primarily by the contribution of the U.S. Music Royalty Fee, and the impact of the increase in certain of our subscription rates beginning in January 2014. The positive result was partially offset by growth in subscription discounts offered through customer acquisition and retention programs, lifetime subscription plans that have reached full revenue recognition, and changes in contracts with an automaker and a rental car provider.

Year over year revenue per user rose by only 0.5%, but again this has been affected by the General Motors contract change which moved away from paid to unpaid trials. Quarter to quarter is a bit more important, again, until year over year can be compared under similar circumstances. Q1 ARPU was $12.18. Q2 ARPU at $12.36 showed an increase of 1.5% in the 3 month period.

This is important to any subscription based service. As the base grows, growth not only comes from adding new subscribers but also comes from increased monetization of that base. Investors will often see claims that Sirius XM has 'slowing growth' on a percentage basis as it becomes more difficult to add the same percentage of subscribers as the denominator increases and the numerator stays stable. What investors want to focus on is not only new subscriber additions when considering growth, but also monetization of each subscriber and growth trends in that area as well.

Overall, Sirius XM delivered a fine Q2 report, and initial market reaction was on the right side of the coin. I am quite confident that net additions will exceed guidance this year and that guidance will have to be raised in the coming Q3 report. I'm also pleased to see continued lower costs associated with adding each new subscriber, a stable churn rate considering increased auto sales, and respectable increases in average revenue per user. Small adjustments to many different things drive significant changes in other areas, such as Sirius XM's important free cash flow.

Free cash flow provides the company with the ability to do things like repurchase shares of which it has allocated $6 billion to date. Free cash flow is up 42% year over year or 47% year over year on a per share basis. As Sirius XM moves forward and continues to repurchase shares, free cash flow on a per share basis will continue to rise even faster than free cash flow itself rises. Consider that as this free cash flow rises, Sirius XM will need to take on less and less, or even no new debt in order to perpetuate its buyback program and return long term capital to shareholders.

Moving forward

My disappointment with the market's immediate reaction to the call is assuaged by my understanding that the report was quite good. I believe the market got this wrong at first blush. The coming weeks will show if the market shares my sentiment, or remains confused. My money patiently sits on the side that believes the market will see what I see, which is an undervalued stock with Sirius XM at $3.40.

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.

Additional disclosure: I am long SIRI January 2015 $2.50, $3 and $3.50 calls. I am long SIRI August 16 $3.50 calls.